Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).  But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.  He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.   He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.  He discovered that an economic actor with an edge could size his bets as a ratio of his edge in  betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.  With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.  That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.  As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.  And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.  But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.  Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.  Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.  This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.  What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.  It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:  Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.  Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.  The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Working as the only analyst in a small broker dealer means you occasionally get some interesting projects.  There are many hucksters out there, and if they drop by your bitty broker-dealer to run their deal, skepticism, not hope, is the proper reaction.  “Why are we the lucky ones?” should be the skeptical question.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.  Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.  The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.  Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.  Here are the main points:

1. The key page of the entire document is page 18 of the PPM.  In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.  Also, 65.52% of the proceeds go to other than investment purposes.  Why so large?  (As an aside, this yield is at a discount to Treasuries.  An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?  Origination – 1%/month of the Matured Policy Increase Amount [MPIA - essentially a measure of cash flow profitability]?  Administrative expenses as well to third parties.  I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.  The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.  On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.  They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.  But beyond documents, we don’t have any sort of cash flow analysis.  How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.  Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.  Many of the things it lists as protections are weak.  Points 3 and 5 are the same points, but it makes them sound different.  Further, CN do not own AAACO, they have it in a form of semi-receivership.  If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]  She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.  They have assets of $500K, and liabilities of $2 million.  The assets are receivables from Servco.  Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.  They could not pass a GAAP audit.  Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.  If this gets originated, there will be a significant risk as they staff up.   They also don’t have licenses.  This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).  It is my belief that this is something that we don’t want to get mixed up with, at any price.  I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.  But if you want to look into this further, have them forward to me their cash flow analyses.  I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”  That is when something smells so bad, the odor can even travel over the Internet.  This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.  What an altruist!  Not.  Yes, the value of shares if you could sell them all at the “last trade” was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.  This is what I wrote:

Dear Boss,

This doesn’t smell good.  Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.  Little to no liquidity – huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.  $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.  I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.  And will be worth zero soon.

Project 3

Another life settlements securitization.  The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.  What I wrote:

Dear Boss,

I’ve read through the whole document.  Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.  They do have some experience with multifamily housing.  They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.  To me, that is pretty convoluted.  Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

• Need to see the financials of the GGG enterprises
• Correct address for their website.
• Who is HHH Capital Management?  Can’t find them – the portfolio managers.
• Need fees, policy data, and expected cash flows
• What are they doing to source portfolio 2?
• Need actuarial projections
• Exactly what are the trusts receiving as collateral for the loans?  I need pro-forma financials on the property(ies) to be developed…
• Where are the related party transactions?
• If this deal is 3x overcollateralized, where does the excess money come from?  Who is the equity, and what are their motives?

That’s all for now.  Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.      The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.  It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.  That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.      The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.  8.0% return to get T+100.  15.75% to get T+500.  What would it take to sell these notes?

3.      There is a low probability of full payment of principal.  A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.  I assume these aren’t going to be rated, right?

And I have additional data needs:

4.      Who is HHH Capital Management?  It looks like a new firm – do they have the ability to do their part?

5.      I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.      How were the life expectancies calculated?  That’s hard to do right.  Second opinions?

7.      I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.      Exactly what are the trusts receiving as collateral for the $40 million loan?  Pro-forma financials on the property(ies) to be developed… And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.  He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.  The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.  I experienced that myself.  Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.  What did I get get for my efforts?  The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.  Aim for simplicity, and put safety first in your investing.  It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.  Don’t let the multiplicity of words dull you to the risks that exist.  Even for small investors I would say avoid complexity.   Where there is complexity, there is a much higher risk of loss, almost always.  Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

To my readers: I am still in the process of blog repair.  I have heard from a few readers that I need larger type and more contrast.  I will fix that.  For now, use Ctrl-+ to expand the font.  I don’t want any of you going blind over me.

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Onto tonight’s topic: asset allocation.  So, we had a bad quarter for equities.  Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.  I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.  At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.  I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?  Next question: cheap relative to what?  It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

• Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.  Think of Buffett getting excited back in 1974.
• Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.  But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
• When there is significant debt deflation going on, determining cheapness is tough.  Better to ignore the market as a whole, and focus on survivability/cheapness.  Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
• I don’t have a good metric for when equities are cheap/dear to commodities.  Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.  Beyond that, the spread on GSE debt and guaranteed mortgages is thin.  TIPS look attractive, as few care about inflation.  The US dollar has been strong lately, largely due to weakness in the Euro.  I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.  There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.  Also, the private sector looks at the growing debts of the government, and gets concerned.  How will the government deal with it?  Higher taxes, inflation, default?  No good scenarios there.

When an economy is overleveraged, there are no good solutions.  If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.  High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.  Broadly, I am looking at a system that:

• Considers the credit cycle first.  Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
• Considers the slopes of the Treasury nominal and TIPS curves.
• Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
• Factors in safety provisions for each asset class.  Stocks need the most, then junk bonds, then investment grade.
• Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.  There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

One thing that I do differently than most investors is the concept of rebalancing.  I buy and sell positions to maintain their weights in the portfolio, within a 20% band around the intended weight.  As I wrote about it at RealMoney:

The two smaller purchases were done for a different reason than the other trades. I already owned Petrobras (PBR:NYSE) and Dycom (DY:NYSE) , but both had been performing badly. Their weight had shrunk to be the smallest in my portfolio. After a review of their fundamentals, I did what I call a rebalancing trade.

When I interviewed fund managers, I would often ask how they would rebalance positions in response to market movements. Many of them would do nothing; others had no fixed strategy. However, three of them had really worked on refining their strategies, and to my surprise, their outcomes were similar — even though other aspects of their styles were different. One was value, one was growth, one was core, but they each had evidence that their approach improved their returns by a few percent per year. That caught my attention.

One cost of trading comes from whether a trade demands or supplies liquidity to the market. When a trader posts a limit order, he or she offers other market participants an option to exchange shares for liquidity at a known price. In offering liquidity, the trader hopes to get an execution at a favorable price.

The approach that the three managers use — and that I employ in my personal account — is as follows:

• Define a series of fixed weights for the stocks in the portfolio.
• Do a rebalancing trade when any position gets more than 20% away from its target weight. The 20% figure is arbitrary, but I think it strikes a balance between excessive trading and capturing reasonable trading profits by providing shares and liquidity to the market when it wants them.
• Use this time as an opportunity to re-evaluate the thesis on the stock. If the thesis is no longer valid, exit the position and buy something that you like better.
• If the rebalancing trade generates cash, invest the cash in the stocks that are the most below their target weights, to bring them up to target weight.
• If the rebalancing trade requires cash, generate the cash from selling stocks that are the most above their target weights, to bring them down to target weight.

This discipline forces you to buy low and sell high and to re-evaluate your holdings after significant relative market movement. This method works best with companies that possess low total leverage relative to others in their industries. This helps avoid the problem of averaging down to a huge loss.

It also works best for diversified portfolios with 20 to 50 stocks, with reasonably even weights. In my portfolio, the weights range from 3% to 7%, with 33 companies altogether.

The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low and sells high.

Now, one aspect of this that I did not write about at RealMoney is that it saves on taxes.  In a very volatile market, like we have had over the last three years, and that we had 2000-2004, there were a lot of opportunities to buy low.  Now for someone like me, who runs with 30+ positions, a sharp move down and up feels like this:

• At the start of the move down, I have realized and unrealized capital gains.
• As the move down proceeds, I have realized gains but no unrealized capital gains.  I have redeployed  money into defensive industries, or, at least stocks that are undervalued.
• Further into the move down, I have no realized gains and and I have unrealized capital losses.  I am still redeploying money into defensive and cheap investments.
• Still further into the move down, I have realized losses and and I have large unrealized capital losses.  At this point I should be moving into economically sensitive names, and add cyclicality.
• I may have to do that twice, or even three times, but eventually a bottom comes.
• As the move up begins, I have realized losses and unrealized capital losses.  As I sell stocks to reinvest in better companies, I sell stable names to buy cyclical ones.  As stocks hit my upper rebalancing points, I sell high tax cost lots, and hold onto the low tax cost lots.  My realized losses grow.
• As the move up continues, I have realized losses and no unrealized capital losses.  I continue to sell high tax cost lots of companies that have hit my rebalancing points.
• Further into the move up, I have no realized losses, and unrealized capital gains.  My rebalancing and other sales are now creating small gains.
• Still further into the move up, I have realized gains and large unrealized capital gains.  I then look for my largest unrealized long-term capital gains in stocks that I would like to sell, and donate them to charity.  Fidelity Investments makes that very easy.  After the year end, I repeat that process.  The advantage is that I don’t get taxed on the capital gain, and I get a full tax deduction on the market value of stock donated.

I do almost all of my charitable giving via appreciated stock.  It works well.  Given the volatility of the markets, for those that have a diversified portfolio, and a dedicated reason to give to charity, it is a free lunch.  I marvel each  year at the ways that I eliminate capital gains, while still managing to make good money in stocks over the long haul.

The author of this book has been through the ringer.  As one who advised people to be careful in their investing, she found that her husband had been stealing from his investment clients.  Shades of Madoff and his sons.

She uses her ex-husband as an example of what to avoid in investment advisors, and adds in data from the Madoff scandal.  She then moves on to be more generic in what investors have to look for in order to avoid being cheated.

The book moves on to explain financial planning, and understand:

• Certifications
• Compensation and Fee Structures
• Formal Communications
• All the parties that affect pooled investments
• How to choose an advisor
• Red flags
• How to employ an advisor
• How to maintain the relationship
• How to deal with minor and major failure in the advisor relationship.

She covers all of it.  It is very basic, and not flashy.  The juiciest part of the book is the troubles she had with her ex-husband.  The rest is all business, which isn’t bad, but it could have benefited from counterexamples to explain why this is the right way to do things.

Quibbles

The book has an exciting start, and it is all business after that.  That is not horrible, but could have been more done to motivate the important aspects of protecting investments through citing more case examples.

If you want to buy the book, you can buy it here:  Who Can You Trust With Your Money?: Get the Help You Need Now and Avoid Dishonest Advisors

Who would benefit from this book

Most average investors could benefit from the book.

Full disclosure: This book arrived in my mailbox; to the best of my knowledge, I never requested a copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

This book gets a mixed review from me.  If I were reviewing it 14 months ago, when everything was in chaos, I would have given it a better review.  There are time to take credit risk, and times not to.  There are times to extend maturity, and times not to.  There are times to seek inflation protection, and times not to.  There are times to invest abroad, and times not to.

This book takes a view of income investing that is correct for average credit markets, for the most part.  But average credit markets rarely exist.  Few investors possess the fortitude to go through the nadir of the credit cycle, and ride it into the next cycle.

With high yield, he offers a simple stop-loss strategy.  Good.  But he should offer something similar on preferred stocks and dividend-paying common stocks, which are riskier than high yield bonds.

The chapter on writing covered calls is simplistic, but the truth is that most of us are simplistic with covered calls — we look for free yield, and often gain losses greater than the income received.

The book gives simple and reasonable descriptions of various bond types, and other income oriented assets.  In general, it understands the relative riskiness of all of them, with exceptions noted above.

The title is a great title, but I would have loved to have seen a different book that would have taught people to analyze yield spreads, and getting people to think when there is enough compensation for the risk involved, and when there is not.

If you want to buy the book, you can buy it here: Higher Returns from Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income

Who would benefit from this book

If you don’t understand income investments, this book could be useful to you, and the book is not long.  It is an easy read.  In general I don’t agree with the way the book is designed, but if you have a lot of self-discipline, the book will prove useful to you.

Full disclosure: I said I would review the book, and his publisher sent me a copy for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I usually do.

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Growth in total factor outputs must equal the growth in payment to inputs.  The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now.  It is very important to remember, because men are tempted to forget that financial markets depend on the real economy.  If the global economy grows at a 3% rate, well guess what?  In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate.  Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

• The value of equity is the capitalized value of the profit stream.
• The value of debt is the capitalized value of the interest stream.
• The value of property, plant and equipment is the capitalized value of the rent stream.
• The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right.  We no longer capitalize people, as if one could legally own a person today.  Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets.  We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three.  Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits).  Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates.  By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency.  It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining.  Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition.  Extreme profit margins tend not to last.

In many asset classes, investors were fooled.  Home buyers bought thinking the prices could only go up.  They ignored the high ratio of property value relative to what they would currently pay.  Commercial real estate investors bought at lower and lower debt service coverage ratios.  Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage.  With equity, investor assumed that growth in asset values in excess of growth in GDP would continue.  The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well.  Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run.  To be an excellent manager, focus on both factors — likely payments, and rate at which to discount.  But who can be so wise?

Most academic economists are irrelevant, so we can ignore them.  The few that are relevant are worth noting.  They can write such that ordinary people can understand — think of Milton Friedman with his “Free to Choose.”  Such economists are viewed skeptically by the “profession” because they interact with the unwashed.

So it is with Ayres and Nalebuff.  I have rarely been impressed with what they write.  Like Freakonomics, they write about stuff that is sensational, and challenge the conventional wisdom.  Yo, the conventional wisdom is right most but not all of the time.  Anyone that focuses on where the conventional wisdom is wrong will commit a lot of errors in an effort to be novel.

Now, Abnormal Returns and Sentiment’s Edge have made their polite comments, but now it is time for my less polite comments. I have five main critiques of their paper, which stems from the lack of practical experience in the markets for these two professors.

1) History is an accident.  It is fortunate that they are analyzing the US, rather than nations whose markets got wiped out during a war.  It is not impossible that the US could face a similar crisis in its future.  Try the same analyses with Argentina or Peru.  Will it work?

2) Even in the US stocks don’t outperform bonds by that much.  My estimate of the equity premium is around 1%.  Yes, the economics profession says the equity premium is higher, but they use a wrong metric; they should use dollar-weighted returns, not time-weighted returns.  The estimate of 4% equity returns over margin rates, which are higher than bond yields, is hooey.

3) Average people aren’t capable of managing portfolios that are 100% equities, much less levered equities.  It is well known that people invested in equity funds tend to buy and sell at the wrong times.  It would be far worse with leveraged portfolios.

4) Leveraged ETFs tend to underperform over time, have you noticed?  This is a mathematical necessity.  Through options and swaps, which have larger bid-ask spreads, maintaining the leverage is at low cost is tough.  If the advantage over margin rates were true, there would be real advantages to leverage.

5) What if everyone did it?  The paper is a typical, “If you had done this in the past, you would have done a lot better.”  Duh, and I can do better versions of that than the authors.  Going back to point one, history is an accident, and cannot be relied on.  Point two, their math is wrong.  Point three, average people can’t implement it.  Point four, those who try to do this don’t do as well as you might expect.

The last point is that everyone can’t do this.  Can you imagine what would happen if everyone aged 25-41 suddenly invested into equity exposure equal to twice their assets?  Stock prices would shoot up, and would offer little future returns to holders.  Stocks aren’t magic, and over the very long haul, they tend to return what the GDP does plus a few percent.

Think of Alan Greenspan encouraging people to finance using ARMs at the worst time possible.  The authors here encourage young people to speculate on equities with leverage at a time when the market is somewhat overvalued.  If this were a good idea, you would have seen many people doing it already, and it is not a common practice.  Don’t listen to academics that have little practical experience for investment advice.

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested.  Even the great Ben Graham never exceeded 75% invested.  My view is that average people must limit their risks or they will not be able to sustain their investment plans.  A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

Leverage is for experts only, and I have never used leverage.  Only use leverage if you are more of an expert than me.  (I write this not out of pride, but out of my experience where so many have gotten burned by taking too much risk.)

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.  As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.  Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.  But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.  I look at the individual risks and ask whether they are overpriced or underpriced.  Here is my current assessment:

• Equities — slightly undervalued at present, particularly high quality stocks.  (US and foreign)
• Credit — Investment grade credit and high yield are fairly valued at present.
  
• Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
• Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
• Inflation — Low, but future inflation is probably underestimated.
• Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
• Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
• Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.  I would leave more in money market funds than most would as a part of capital preservation.  I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.  I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.  (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.  My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.  Commodities and companies that produce them should play a small role as well.