There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

• Chasing performance
• Over-diversification
• Benchmarking / Hugging the index
• Over-trading
• Relying too heavily on earnings growth
• Analyzing the income statement only
• Refusing to analyze industries
• Buy newsy companies
• Relying on the sell-side
• Trusting management too much

Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.  I am against regret.  Don’t buy something after you have missed most of the move, as if future stock price movement is magically up.  Unless you can identify why the stock is underappreciated after a strong move up, don’t touch it.

Over-diversification

Most managers hold too many stocks.  There is no way that a team of individuals can follow so many stocks.  Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.  Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.  You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.  Aim for a large active share, differing from the benchmark index.  Make some real nonconsensus investments.     Show real moxie; don’t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?  More volatility in search of better overall returns is what investors need.  If they can’t bear short-term volatility, they should not be invested in stocks.

Over-trading

We don’t make money when we trade.  We make money while we wait.  Ideas take time to work out, and there are frequently disappointments that will recover.  If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.  For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.  Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.  For value companies, far less so.  Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.  In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.  Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.  One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.  Macroeconomics rarely translates into useful portfolio decisions in the short run.  Even when you are right, it may take years for it to play out, as in the global financial crisis – the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely “bottoms up,” and not gaining the broader context of the industry.  As a young investor that was a fault of mine.  As a result, I fell into a wide variety of “value traps” where I didn’t see that the company was “cheap for a reason.”

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.  I think most of those companies are overanalyzed, and as such, don’t offer a lot of investment potential unless one thinks the news coverage is wrong.  I actually like owning companies that don’t attract a lot of attention.  Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.  What are the key drivers to watch?  What management teams seem to be building value the best?  This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.  Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren’t.  Who is honest, and who bluffs?  This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever – you might lose some advantage doing that, but you won’t be tricked by a slick-talking management team.  Trusting management implicitly is the big problem to avoid.  They are paid to speak favorably regarding their own firm.

Summary

This isn’t an exhaustive list.  I’m sure my readers can think of more foibles.  I can think of more, but I have to end somewhere.  My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

A little more than two years ago, I wrote Goes Down Double-Speed.  I wrote it after the market had doubled from its lows two years earlier.  I want to update the piece and explain we have learned over the past 2+ years, and maybe discuss what could happen over the next 2+ years.  Anyway, here is the modified table of bull and bear markets:

Since the last piece, the gains have come slowly, validating my comment, “But it would be unprecedented for the market to continue to advance at a 3% [per month] pace from here.”  In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.  Things are coming quickly again now, but who can tell how long it might persist.

Maybe Goldman Sachs can tell us.  After all they increased their price targets for the S&P 500 yesterday.  Now let me republish my updated bull market graphs from the prior piece:

And now look at the cumulative gain:

The predictions of Goldman Sachs are both believable and unbelievable.  Believable: it’s not historically impossible for a rally to last that long, or for it to be so large.  That said the probability historically has been low.

Unbelievable: Unless revenue growth kicks in, that means the profit margin, already at record highs, will soar to an astounding record.  But won’t revenue growth begin again?  That’s hard to say, but if revenue growth starts in earnest, the Fed will start removing policy accommodation, because bank lending will be perking up.  At that point, it is anyone’s guess as to what will happen.  Therefore, I rule out Goldman Sachs’ forecast as a possibility.

The rally continues to get longer in the tooth, and its has been aggressive this year.  I repeat how I ended the original piece: “Consider trimming some of your hottest positions.”

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”  So the saying goes for those that blindly follow momentum.  The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.  (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

1. In 1998-2000, tech and internet stocks were the only place to be.  Even my cousins invested in them and lost their shirts.  People looked at me as an idiot as I criticized the mania.  Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
2. In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.  This was not, “Buy what you know,” but “Buy what you assume.”
3. In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.  A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.  Both trades went badly.  Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to  blow up, and the least levered to suffer considerable losses.
4. 2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.  There were earlier shocks around 2002, and the late ’90s.  Those buying them in 2008 and crying foul neglected the lessons of history.  The underlying collateral possessed no significant diversification.  Put a bunch of junk debt in a trust, and guess what?  When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.  Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

• The go-go years of the ’60s or the ’20s
• The various times the REIT market has crashed
• The various times that technology stocks have wiped out
• And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.  But recently, there has been some discussion of a possible “safety bubble.”  The typical idea is that investors are paying up too much for:

• Dividend-paying stocks
• Low-volatility stocks
• Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.  It is possible to have one?  Yes.  Is it likely?  No.  Are we in one now?  Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.  But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.  At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.  Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.  They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?  Tenuously, but yes.  Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.  In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market  history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.  When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.  Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.  You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.  You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.  I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.  But with stocks, I would simply say look forward.  Analyze:

• Margin of safety
• Valuation, absolute & relative
• Return on equity
• Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.  If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”  Just don’t  compromise margin of safety in the process.

I have not been a fan of this rally, and I have been selling into it.  I do have a rule for equity clients — cash never goes above 20%.  I have been close to that recently, and after rebalancing some companies that have hit the top of the weighting band, I have bought those companies with the lowest weights in the portfolio.  I have also added some stable companies in the recent past — Berkshire Hathaway, Ingram Micro, Validus Holdings, AFLAC, and CST Brands.

My next quarterly reshaping comes up next week, and again, I will be looking at neglected industries in the market for areas to purchase.  When the momentum runs this hard, I have to be content to trail (though I haven’t been trailing).  I have to ask where things will be three or more years from now, rather than ponder the next quarter.  The answer to that is more murky than I would want, because of abnormal economic policy.  It makes us all more skittish, and obscures price signals.

I have suggested in the past that a good solution in the face of uncertainty is to do half of what you would like to do. Doing half breaks the psychological stranglehold of fear and greed, because regardless of what happens, part of your decision was a success.

You could also start to make a “shopping list.”  Start looking for names that you would like to buy 10, 20, 30% lower, and set alerts.  Who knows how rapidly things will move when the correction or bear market comes.

You could keep a close eye on the 200-day moving average for the S&P 500, waiting for the index to cross under that as a sell signal, but if you want to be ahead of the crowd, maybe you want to use the 190-day moving average.

I tend to use industry selection and other factors, like balance sheet strength and reliability of cash flows as my main risk reduction tools rather than outright reduction of equities owned.  In general, I have been a good picker of stocks over the last 13 years, and I want to continue using that advantage.

With bonds, I am playing it safe with short and intermediate corporates, and taking reasoned chances with emerging markets debt.  Beyond that, I am thinking of buying long Treasuries as a deflation hedge.

The equity market is well above where long-term valuation measures like the Q-ratio, and CAPE10 would value it.  Most of that is due to low interest rates and high levels of QE.  How certain are you that both will persist, and for how long?  Personally, I think both will persist for some time, but not forever.  Profits attract competitors, and low rates discourage savers.

Though we don’t know when change is coming, we have to be ready for change.  Whatever you do for defense, make preparations now to be defensive; this era and valuation levels will not persist.

Aside from that, remember that when a system is so artificially supported, it relies on peace & continued support from governments.  Either could vary.  Peace is not certain, and neither is the current set of economic policies.  Be ready, because there can be all manner of surprises.

Full disclosure: long BRK/B, IM, VR, AFL, CST

I have a saying that when there is no news, the market reveals its true direction.  That applies to individual securities as well as the market as a whole.  Why?

Think of institutional traders, who drive much of the market.  They are so big that they have to spread out their orders over time, or they would move the market against their positions.  On days when there is no news, volume tends to be light, displaying the actions of the big traders.

Valero recently spun off CST Brands, which was their retailing arm, selling gasoline, and things you find at convenience stores.  Seems cheap to me.  Over the last few days it has been rising on no news.  To me that means some institutional investors are buying.

I’ve seen the same thing happen when a stock falls on no news.  That’s usually a bad sign if you are long, because it means someone is selling for a reason you are not aware of.  Now, if you have done your homework, and know more than the seller, a lower price is to you advantage if you want to buy more.  The trouble is, you don’t know how much the seller has to unload.  To use CST Brands as an example again, I received some shares as a result of holding Valero for clients (and me, I get what my clients get), but I estimated how much index related selling had to happen as a result.  I bought a full stake for my clients at the point where the total volume from the prior “when issued” trading, plus actual trading on the first day hit my estimates.  It was close to the low for the day, though someone more enterprising could have picked up shares cheaper during the “when issued” trading, if he was clever.

But sometimes when there is news, you need to try to gauge whether something is an over- or under-reaction.  My favorite example here is RGA, the prominent well-run life reinsurer.  Once every eight quarters or so, they report a lousy quarter.  Why?  Because of the law of small numbers.  The large claims inside a life reinsurer are few, but make a considerable difference to the earnings when a bunch of large policy deaths happen at the same time.  The general public does not get this, so when RGA has a bad quarter, it is usually a good time to be a buyer.

The same applies to P&C reinsurers during crises.  I added to my reinsurance holdings post-Sandy, because I knew that the reinsurers would take relatively few claims because they don’t cover flood for residential, though they might have commercial-related claims.  As it was, none of my insurance holdings had any significant claims from Sandy, and the portfolio did well.

Toss out another example, but Endurance Specialty is one of the leading underwriters of crop insurance.  Crop insurance was a horrible place to be last year, and that put pressure on ENH as a stock.  But that neglected all of the other lines of business of Endurance that were performing well, as well as the risk controls that Endurance placed on its crop insurance business.

Perhaps the broad message here is to know your stocks well, so well that you can gauge whether a  market reaction to news is overdone, underdone, or meh, normal.

Analyzing the reaction to news (or no news) bonds and other assets as well.  When I was an institutional bond manager, I would watch the results of trading on the slow days, because it would give a clue to what the “big guys” were doing.  Also, when an event that has been anticipated occurs, like a ratings downgrade on the bonds of a troubled company, the market reaction says a lot, because often there are many who were waiting to buy once the downgrade happened, so price rises a lot at the downgrade.  (Think of the USA downgrade by S&P.)  The reverse is true for downgrades that are more of a surprise.

In summary, all news is not equal.  The reactions to news, and the lack thereof, can tell us a lot about the intentions of large market actors.  Do your homework well, and prosper off of the knowledge that it gives you regarding reactions, over-reactions, and under-reactions.

Full disclosure: long VLO CST RGA ENH

I wrote this piece once, and lost it, 1000 words.  Going to try again.

1) The first thing to realize is that diversification across insurance subindustries usually does not work.

Do not mix:

• Life & P&C
• Financial & Anything
• Health & Anything

Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.  The main point is this.  Insurance is not uniform.  Coverages are sold and underwritten differently.  Generally, higher valuations will be obtained on “pure play” companies  Diversification is swamped by management inability.  These are reasons for AIG and Allstate to spin off their life operations.

2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.  With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.

3) Be aware of total subindustry capital relative to need.  After a big disaster, those that underwrote well will have capital to deploy into a stronger underwriting environment, where capital is scarce.  But don’t make too much of it because capital has become very fluid in insurance; the barriers to entry and exit are low.  Still, it is best to be an investor after a disaster, when everyone is running scared.  When total capital is high, and companies are fat, dumb, and happy, it is time to leave.

4) It’s good to look through the Statutory statements [regulatory statements filed with state insurance regulators] of their operating insurance subsidiaries to look for odd entries.  Occasionally, you will run into problems that do not have to be reported under GAAP accounting.  (Note: they should be reported under the spirit of GAAP, but not the letter of GAAP.  I have a saying, “It is okay to violate GAAP to be more honest, but not to be less honest.”)

Here’s an example: I ran across a life company that had to post an extra statutory reserve because they would lose money if interest rates rose.  That’s a significant admission, and the company was invested far more aggressively than almost all the other life companies we were tracking.  We shorted it, and got ripped as the credit markets surged 2003-2005.  We got out with a small gain when their earnings proved inadequate as interest rates rose, and credit losses rose.  But it took a long time.

At this point, I would be looking for special reserves established for secondary guarantees established for Term and Universal Life, and Variable Life & Annuity policies.  There is no specific requirement to hold those reserves on a GAAP basis, even though there may be general principles that would encourage additional reserves or disclosures.

5) There are ways of multiplying capital across subsidiaries — Subsidiary A reinsures liabilities of subsidiary B, while Subsidiary B reinsures liabilities of subsidiary A.  This is a way to create hidden leverage, so be aware of what is being done at the subsidiary level.  Doing these sorts of things is dumb, though legal.

Reviewing leverage is a good idea as well, where it is located, and what conditions it has.  The practice of insurance subsidiaries issuing surplus notes to parent companies has become all too common, which allows subsidiaries to write more business at the risk that when a subsidiary becomes impaired, the domiciliary state takes it over, and the parent company gets little to nothing.  (Payments on surplus notes can only be made with the approval of the insurance commissioner. In insolvency surplus notes typically receive nothing.)

The thing is, it is a lot harder to produce return on assets than return on equity. Though part 6 focused on ROE, in the short run, insurance companies can improve their ROE through substituting debt for equity.  The same applies to insurance companies that write GIC Medium Term Notes.  It’s just a cheap way of making a little extra income arbitraging your subsidiary’s high claims paying ability rating.  It fascinates me that regulators have allowed the insurance industry such latitude with deposit contracts that are called annuities, but have never once been annuitized.

Another hidden source of leverage are financial reinsurance agreements.  Down in the insurance subsidiaries, companies trade away a portion of future profits for surplus today.  These are usually bad deals to enter into, but because some insurance companies have a sales culture that requires continual growth, even if the sales that don’t justify the cost of capital required to back the policies.

6) Free cash flow is difficult to determine for financials, this applies to insurers as well.  Each regulator has rules on how much can be paid in dividends to their holding company.  Typically, subsidiaries can dividend away surplus so long as they are still strongly capitalized after the dividend.  (If it is large, they may have to petition their regulator for approval)  So if you want to approximate free cash flow for an insurer, try the following:  (Income or loss outside your insurance companies for the current period) + (Distributable Income from insurance companies for the current period).  The latter figure is statutory income +/- any decrease/(increase) in capital required to maintain the remaining business with adequate financial strength, calculated separately for each subsidiary.

7) Last note: on DAC/VOBA [deferred acquisition costs, value of business acquired; they  are similar, so I will just talk about DAC].  Once I had to convince a boss that though it is an intangible, like goodwill, it is not like goodwill in that it is more rigorously tested for recoverability.  If DAC gets written down (as opposed to amortized) that means that the future sum of profits on some of the insurance business is expected to be less than the acquisition costs deferred for the business.

Now, DAC can be done conservatively, by product and class year.  The more disaggregated it is, the more conservative, generally.  A few cells getting written down is no big thing.  But DAC can be as liberal as having one cell, which means if DAC is written down, the total value of future profits from existing business has been reduced — the company is worth a lot less.  The change in value is even more than the reduction in the DAC, because in the writedown process, the discount rate on the DAC went from a positive number to zero.  All other things equal, a DAC asset is worth more the higher its discount rate.

S0 pay attention: if DAC amortization is high relative to net income before tax, it means there isn’t that much margin for adverse deviation in the DAC.  Also, all other things equal, lower levels of DAC as a fraction of net worth are better.

Close with a story: before Mony Group was bought by AXA, it was doing DAC for the company as a whole.  A value investor, seeing the discount to book value, and sensing opportunity bought a lot of Mony.  Profitability was so bad, they had to write down DAC.  Book value declined & price to book value declined as well.  The value investor agitated for a sale, and AXA stepped in, buying it for moderate premium to where it was trading.  The group I was with went long for an arbitrage trade on a cash deal.

But the value investor thought the premium wasn’t high enough and agitated for more.  Because the takeout price was 70% of book, the idea seemed plausible.  But when you factored in the DAC earning 0% and a few other items, it looked generous enough to me.  So when the price got several percent above the deal terms we sold our stake and went short as much as we could find without having to pay much interest on the borrow.  Bit-by-bit the stock price moved down until a few days before the deal would close, when the price collapsed below the deal price, and we covered.  We even arbed a little more on the long side, but the trade was over.

And the point is this: it may look cheap, but test your assumptions on the values of assets and liabilities before committing a lot of capital to a any insurance stock.  GAAP, Tax and adjusted Statutory income validate book value, so a cheap stock with a low return on equity or assets is often not cheap.

This piece is the sixth out of seven in a series that I have been writing at Aleph Blog.  Here are links to the first five pieces:

• On Insurance Investing, Part 1 (reducing share count)
• On Insurance Investing, Part 2 (growing fully convertible book value per share)
• On Insurance Investing, Part 3 (price momentum and mean reversion)
• On Insurance Investing, Part 4 (Management & reserving conservatism)
• On Insurance Investing, Part 5 (Management quality & product quality)

Recently I decided to spend some time analyzing the insurance industry.  It’s a different place today than when I became a buy-side analyst ten years ago.  Why?

First, for practical purposes, all of the insurers of credit are gone.  Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.  The rest have disappeared.  In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.  I’m not even sure it is possible to have that.

Second, the title insurers are diminished.  Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, buying up a restaurant chain last year.

Third, health insurers face an uncertain future.  Obamacare may disappear, or Obamacare could slowly eliminate insurers.  It’s a mess.  Insurers debate to what degree they should compete in insurance exchanges.

But beyond all of that, valuations are fair-to-cheap across the insurance industry.  Part of that may stem from ETFs.  Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.  Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.  There are other aspects, which I will try to address as I go through subindustries.

Offshore

By “Offshore” I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.  Most of them are located in Bermuda.

In 2011-2012, many of them were challenged by the high levels of catastrophes globally.  But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].  For more details, you can read my article here.  The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.  The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

Companies above the line may be overvalued, and companies below the line may be undervalued.  ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.  The companies that are possibly overvalued are: Arch Capital [ACGL] and Renaissance Re [RNR]. Possibly undervalued: Tower Group [TWGP] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.  Arch Capital and Renaissance Re may be that.  But with an expected ROE of less than 20%, it is hard to justify their valuation, when the average stock in this group needs an expected 11% ROE to be valued at book.

Why such a high ROE to get book?  Earnings quality.  Reinsurers have noisy earnings due to catastrophes.  You don’t give high valuations to companies that run hot or cold.  But the trick here is to see who is accumulating book value the fastest – they tend to be the stars over time.  Endurance and Arch have been good at that.

Life

The life insurance business would be simple, if it indeed were only life insurance.  Much of the industry is handed over to annuities, and all manner of asset gathering.  Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.  When I see those products, my reaction is usually, “How do they hedge that?!”

Thus I am concerned for insurers that are “equity-sensitive” as I reckon them.  Here is the PB-ROE scatterplot:

A tight fit.  The insurers that are seemingly undervalued are equity-sensitive ones: Phoenix Companies [PNX], Aegon [AEG], and ING [ING].  Those that are overvalued are Citizens [CIA], Eastern Insurance Holdings [EIHI], and Atlantic American [AAME].  For the undervalued companies, I am unlikely to buy because I am skeptical of the accounting.  I would look further down the list and consider buying some companies that are more reliable, like Assurant [AIZ], National Western [NWLI], and Fortegra Financial Corp [FRF].

One more note: to get book value in Life Insurance, you need a 9.8% ROE on average.  That’s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

It’s a good fit.  Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include First Acceptance [FAC], Employers Holdings [EIG], and Erie Indemnity [ERIE].  Below the line: Hartford Financial Services [HIG], Hilltop Holdings [HTH] Hartford Financial [HIG], and United Insurance Holdings [USIH].

Again, these are only screening tools.  Before buying or selling, understanding management and reserving quality, and riskiness of the lines of business makes a considerable difference.  Erie Indemnity has an “asset light” model where it manages insurers, but does not bear underwriting risk.  Hartford has a significant life insurance and annuity exposure.  Models are models, and we have to understand their limitations.

Health

With Obamacare, I don’t know which end is up.  It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.  You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I’ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That’s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It’s an okay fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and Humana [HUM].  And the following overvalued:  Molina Healthcare [MOH].

I don’t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.  I include it for completeness, because I think the PB-ROE concept has value in insurance.  One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 1.8%.

Financial Insurers

This group comprises the surviving mortgage, title and financial insurers, and two companies in the ghoulish business of buying life insurance policies from sick people.  Here’s the PB-ROE graph:

This graph is weird, because it slopes down, and does not have a good fit.  That’s because we’ve been through a rough period financially, and in many cases GAAP accounting does not do a good job with these companies that take a lot of credit risk.

We can still look for companies that have high price-to-book, and low ROEs – note Life Partners [LPHI] and Radian [RDN] as possible sell candidates. We can also look for companies that have low price-to-book, and high ROEs – note Assured Guaranty [AGO] and MBIA [MBI] as possible buy candidates.

This subsector is more difficult than most, because credit is not an underwritable risk.  It is feast and famine.  We are in a period of feast now, so in some ways what is bad is good.  The more risk, the more return.  But winter may come soon – who knows what the Fed may do?  In general, I avoid this subsector for longs.

Insurance-Related Companies

This is a group that is a non-group.  It comprises brokers and insurance service providers.  Here’s the PB-ROE graph:

It doesn’t look like much of a group.

As it is the potential outperformers include Brown & Brown [BRO], and Aon [AON], two leading insurance brokers.  A potential underperformer Willis Group [WSH], another leading insurance broker.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.  But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when a decent amount of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

In the final part of this series, I will go over some nuances of insurance accounting – I leave it to the end because it is kind of dull, but can make a lot of difference, because some companies look cheap and aren’t really cheap.

Full disclosure: long AIZ, ENH, NWLI for clients and myself

Market Impact

• Gold Buyers Throng Indian Stores for Second Week on Rally http://t.co/ilkuosl43D Physical gold is receiving much attention, futures not $$ Apr 26, 2013
• Renaissance Funds Take a Tumble http://t.co/U3x0uboqPA Hedge Funds in aggregate r2 large &2 similar. They r an inferior way 2 invest. $$ Apr 26, 2013
• Investors Say No to Sallie Mae Bond Deal http://t.co/ZOmyJpDWJL Another sign of bad credit building up $$ Apr 26, 2013
• Silver — The Poor Man’s Gold Crossing Wall Street http://t.co/CTWhiJTXNX @eddyelfenbein retells the attempted corner on silver story $$ Apr 25, 2013
• Cleveland Fed leads in measuring stress http://t.co/sdL7KsNSax Aggregate financial stress gauge measures current risks daily $$ #kicksthevix Apr 24, 2013
• Emerging-Market Returns Unhinge From Developed http://t.co/Ml8iBjGkPy Perhaps a sign that the risk trade is getting past the peak $$ Apr 24, 2013
• TradeBots, Social Media Form Volatile Combination http://t.co/QTiRnL6ZKt U mean u can’t trust everything u read on Twitter? $$ #scandal Apr 24, 2013
• Watchdog: Banks R Still Too Intertwined http://t.co/8hkaUWCJyg TBTF not solved, mortgage assistance may have harmed more ppl than helped $$ Apr 24, 2013
• Pimco’s Rising Stars Pull in Money for Future After Gross http://t.co/Xda08qQ8U4 Pimco is a quant bond shop; not reliant on 1 person $$ Apr 24, 2013
• Hulbert on Investing: How to Time the Market http://t.co/QfH1yd8J70 Value Line’s Median Appreciation Potential is 50%; yellow/red light $$ Apr 22, 2013
• Hedge funds: Launch bad http://t.co/tLk5swElr7 Breaking into the hedge-fund world is harder than before, fees coming down, game 2 tough $$ Apr 22, 2013
• Apollo-to-Goldman Embracing Insurers Spurs State Concerns http://t.co/uMylWdF9pE Newcomers to life insurance invest more aggressively $$ Apr 22, 2013
• Reminds me of bad old days of life insurance investing, thinking the old rules don’t apply, using novel capital structures & investments $$ Apr 22, 2013
• BTW, the bad old days were 1982-2002. Other similarities r the use of too much leverage & scrimping on actuarial/other specialty talent $$ Apr 22, 2013
• Why Does Financial Innovation Sometimes Make System Riskier? http://t.co/WbEHfNyiUc something new to wager on, can amplify bets elsewhere $$ Apr 22, 2013
• Other reasons — regulatory arbitrage, relief frm accounting rules, tax advantages, agency problems (heads I win, tails the company loses) $$ Apr 22, 2013
• JPMorgan Said to Plan CMBS Deal With Sales at Post-Crisis Peak http://t.co/elhMy69Q2O If u could borrow @ ~4%, u might buy commercial RE2 $$ Apr 22, 2013
• Lurching Gold ETF Veers From Metal Most in Year Amid Selloff http://t.co/8CyKR7Ptsr Less of a factor now, as $GLD is trading near NAV $$ Apr 21, 2013
• Gold slide flashes warning signs for global economy http://t.co/x5w7HWaZ1s Significant but just one sign, Long US Tsys have also rallied $$ Apr 21, 2013

Rest of the World

• Japan’s Investment Banks Once Ugly Sisters Turn Into Cinderellas http://t.co/GuRw6T3LLG When finance is expanding, it is not prosperity $$ Apr 26, 2013
• The Poverty Lie: How Europe’s Crisis Countries Hide their Wealth http://t.co/F3OikdTHs6 Germany getting restive over requests 4 bailouts $$ Apr 24, 2013
• After the Flash Crash http://t.co/elcHKBo6hX Andy Xie bullish on Agriculture & Gold, bearish on Japanese monetary policy $$ Apr 24, 2013
• Xinhua: Overcapacity troubles Chinese economy, reform needed http://t.co/UU2Guow1M5 2 much investment in heavy industries 4 export $$ #Japan Apr 24, 2013
• Bernanke Peer Quits in Sweden as Inflation Targeting Tested http://t.co/uM6zq4Gjw0 Apostle of salvation via inflation finally quits $$ Apr 24, 2013
• Spain’s population falls as immigrants flee crisis http://t.co/aNHDMURxqq Foreigners came in good times, now leave in hard times $$ #byebye Apr 24, 2013
• China alert to debt risk fears http://t.co/BjyjB1rEXw Local governments keep borrowing $$ & selling land; how will it get paid back? Apr 24, 2013
• Greece’s great fire sale http://t.co/X6LXA5Wbhd Selling pristine beaches to palaces, entire islands & its London embassy $$ #regretitlater Apr 24, 2013
• Inside Merkel’s Bet http://t.co/uNdfdGUR0U Merkel pushes dirty work to the Troika, stays popular in Germany resisting bailouts 4 fringe $$ Apr 24, 2013
• Japan’s population suffers biggest fall in history http://t.co/I48upsEBQM Japan, Germany, China, Russia lose vitality as populations drop $$ Apr 24, 2013
• Why the US is looking to Germany http://t.co/OtxDy8W5g0 With their labor market, the US is suffering from a rising case of ‘German envy’ $$ Apr 22, 2013
• China’s cooldown: Charting a new path for commodities http://t.co/L5aFpZ8jml Feels like the global economy is slowing, debt-heavy $$ #soggy Apr 22, 2013

Companies

• Jim Grant on the Most Undervalued Stocks http://t.co/xz9K18lKbo Someone must have given him a double-shot of espresso b4 this lively chat $$ Apr 25, 2013
• Few $1-Salary CEOs Make a Buck as Ellison Gets $96MM http://t.co/9HisNA97zH Avg comp 4 S&P500 CEO is $1.1MM, which sounds low $$ #avoidenvy Apr 25, 2013
• Verizon-Vodafone Chatter Picks Up Again – Corporate Intelligence http://t.co/cFu4NsKLYI $VZ should buy $VOD , &sell off what it doesn’t want Apr 25, 2013
• Last tweet full disclosure: long $VOD Apr 25, 2013
• Apple, the Fed and the financial fallacy http://t.co/FdjDLxLoEt @jamessaft compares the Fed’s & $AAPL ‘s willingness2dabble in fin’l mkts $$ Apr 24, 2013
• Illinois Tool Works’ Plan Faces Major Test http://t.co/aF3lEsa1x5 Probably being done 2 meet management ROE incentives $$ $ITW #wouldnotdoit Apr 24, 2013
• Netflix Shows It Pays to Buy Index Flotsam – Focus on Funds http://t.co/3aRurKK4bw Index departees often rally hard after forced selling $$ Apr 24, 2013
• He’s Not Short: Dude Likely Cheered On IBM Plunge http://t.co/CQLhwgusLn Warren the wonderful has $$ 2 reinvest, likely buying more $IBM Apr 24, 2013
• U.S. Aid Drove Fisker to Overreach http://t.co/X4hrc1quB9 It would b cheaper 4 the Govt 2 finance alt energy research, no companies $$ #duds Apr 24, 2013
• Hewlett-Packard and Its Obstinate Director http://t.co/WCqgabIayk Easier 2 toss out a sitting congressman than a public company director $$ Apr 22, 2013
• More than 90 pct of NY, NJ Sandy claims settled -trade group http://t.co/cvnVlJLEwo 3rd largest loss event in real $$ terms v Katrina,Andrew Apr 22, 2013

Wrong

• Wrong: Health Insurance Actuaries In the Hot Seat On ‘Rate Shock’ http://t.co/HQDkLjzfF4 Actuaries r generally honest, unlike politicians $$ Apr 25, 2013
• Wrong: Boston and the Un-Bush http://t.co/AuUBsA1zTH Obama is Bush-plus. That doesn’t make it right. Free societies take losses $$ Apr 25, 2013

US Politics & Economics

• It’s A Bit Early To Declare A Winner In The Economic Debate http://t.co/5NAAQJbI8F High debt levels do slow growth; they create uncertainty Apr 26, 2013
• Bombing Victims Get Millions as Internet Redefines Giving http://t.co/mgy3peyEmA It works 4 now, b/c it’s new. Donor fatigue will set in $$ Apr 25, 2013
• Americans Paying Up Wherever They Reside Beseech Congress http://t.co/h9QPtCgpw5 Congress forgets expatriates, IRS remembers $$ #youlose Apr 24, 2013
• Rand Paul Tries to Transform a Moment Into a Movement http://t.co/PbAV8wu4JK Libertarianism rarely wins in the US; here goes another try $$ Apr 24, 2013
• Deflation – A Three Act Play http://t.co/0VvU2Qi8E1 Fed’s lengthy battle w/deflation 2 weaken the $$ & rejuvenate inflation expectations Apr 24, 2013

Other

• If u want 2learn best tonality 4 your voice, sing the highest note u can clearly, then the lowest note, best tone is 25% from low 2 high $$ Apr 24, 2013
• Changing the Sound of Your Voice http://t.co/xh2ABsnKfw The quality of your voice affects how people perceive u; retraining can help $$ Apr 24, 2013
• Chili Peppers Seen Helping 36 Million Migraine Sufferers http://t.co/RSg5Zk0iHU This is the next hot idea in pharmaceuticals $$ #sorryihadto Apr 22, 2013

Replies, Retweets & Comments

• Thx 4 realspeak $$ RT @jckhewitt: but you don’t understand man. They made a spreadsheet error. Infinite debt is infinity plusgood now. Apr 26, 2013
• Not surprising, almost all fail for lack of volume $$ $MKTX RT @Alea_: BlackRock Crossing Bond Platform KAPUT http://t.co/U7Thmd1API Apr 25, 2013
• @AppFlyer Capital needed to escape one’s country during times of panic to obtain a safe life in the US Apr 25, 2013
• @VCEO_Vision I am a life actuary by training. Living benefits r not adequately reserved, & r improperly priced; regulators should ban them Apr 25, 2013
• “Not only was it short, it was small.” — David_Merkel http://t.co/rI3NOhOD2w Regarding the twitter “Flash crash” Apr 25, 2013
• ‘ @timmelvin @TimABRussell MD searches 4 $$ , then 4 a justification; more imperial overreach in the People’s Republic of MD #raintax Apr 24, 2013
• ‘@dpinsen @EddyElfenbein Here’s my article on the topic: http://t.co/HkHilkN5rV At the end I conclude that 1.5x growth is the outer limit $$ Apr 23, 2013
• Owners of bank common stocks RT @MattGoldstein26: This CSFI, Cleveland financial stress index, is fascinating stuff. So who is shorting it? Apr 23, 2013
• @kyith I would never buy a dread disease policy; typically the claim pmt/premiums ratio is low. People overestimate incidence Apr 22, 2013
• @fundmyfund My wife says @theEconomist always tries to save money on pictures by using funny captions $$ “Plan B for finding seed capital” Apr 22, 2013
• RT @Galrahn: One terrorist had over 1,000,000+ Americans across 100+ square miles hiding in houses for safety. Boston is how not to do Home… Apr 22, 2013

FWIW

• My week on twitter: 22 retweets received, 4 new listings, 67 new followers, 25 mentions. Via: http://t.co/cPSEMLXpb8 Apr 25, 2013

The following was published by RealMoney on 4/26/2006.  As with all of these “classic” articles, I republish them because they aren’t available at RealMoney any more.  They changed their system for links, and so articles and comments that I put a lot of work into have disappeared.

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Investing

If you believe in the trend but prices are high, take a half position.

Despite U.S. automakers’ woes, cars will be built by someone; this makes stronger parts suppliers a good play.

Global economic development means more demand for chicken.

One of the most important things to understand with investment ideas is what time period they are for. Sometimes a given asset can take different directions over the short, intermediate and long terms.

Imagine for a moment that you buy the thesis that a large portion of the world is joining the capitalist economy, and that this will lead many more people and businesses in developing countries to demand more goods consistent with what we view as a middle-class lifestyle. That’s a secular trend that will play out over many years. It can be a guiding theme that can help organize investment ideas over the long term.

Now, say that your interpretation of that secular trend implies higher worldwide demand for foodstuffs, metals, timber and energy. However, when you look at the valuations of some of the companies affected by the trend, they appear to be too high, and profit margins are above historical norms. (Valuations are in fact reasonable for many companies in these sectors, but play along with me for a moment.)

You are faced with a problem, then. You think the secular trend is valid, but that much of the story is presently anticipated by current valuations. What to do? One technique that I have used in situations like this is to buy half of what I would if valuations were reasonable (which occasionally aggravates my boss, who is an all-or-nothing kind of guy).

If the stocks go down, I would come up to a full position. If the market gets crazier and valuations rise, I would punt out the smaller position for a gain. If the market muddles somewhat trendlessly, I would buy and sell using my rebalancing discipline, which will clip a couple of extra percentage points over time.

There are alternatives, though. You could buy a full position, but then you are committing to the stock for the long run on the idea that the secular trend will dominate over valuations. You’d better be right, because with higher valuations than normal, being wrong has a greater cost.

You also could do nothing. After all, valuations are extended, and you won’t just pay anything for a stock. This strategy presumes an interruption in the general trend will be coming. That may or may not happen; high valuations often get higher for stocks in a winning thesis. Paying up for a good idea is often a good strategy, but the tradeoff between valuation and the secular trend is a difficult balancing act.

Part of working that tradeoff comes with experience, but I would argue that it also requires humility — the market always finds a new way to make a fool out of you. Always consider what could go wrong. Conservatism means that you will always stay in the game, and staying in the game for a long time is the secret to compounding returns.

The Internet Bubble

Let me give you a few real-world examples. Think of the Internet bubble. The long-term prognosis that the Internet would be big was correct (in hindsight), but valuations were screaming “Don’t play here,” and many concepts were quite marginal from a cash-flow standpoint. That said, the technicals were screaming, “Momentum, baby! Time to play!”

My solution was to sit it out. I figured that, eventually, the cheap financing would run out and the market trend would shift. The problem was, it lasted two years longer than I anticipated.

Maybe I left something on the table. I could have played with smaller position sizes, or played with a mental “stop order” in the back of my mind. That said, it didn’t fit my personality, and I didn’t feel that I could evaluate who the survivors would be, so my optimal decision was to sit it out. (I didn’t short it because the momentum was too great. Never argue with a liquidity wave.)

Industries in Secular Decline

What if you are looking at an industry in secular decline, such as the photo film business (think of how Kodak (EK:NYSE) has fumbled, or, worse, Polaroid), fixed-wire phone service companies, or the newspapers? All of these are being displaced by new technologies.

Verizon (VZ:NYSE) looks cheap and has a nice dividend. Is it a candidate to buy?

This is an example of Warren Buffett’s concept of “cigar butt” investing: Someone may have tossed it on the ground, but you can still get a few good puffs out of it. The company has limited growth potential unless a radical new strategy gets introduced, and that could be costly, or even fail. I had better get this company extremely cheap to compensate for potentially falling earnings at some point in the future. Even a wasting trust has a proper price, so if I can get it at a level that reflects a 15% annualized return, that could be a great investment.  One nice thing about declining industries is that there usually isn’t a lot of direct competition.

Here’s one more example: auto parts. I own Johnson Controls (JCI:NYSE) and Magna International (MGA:NYSE) , two companies with strong balance sheets that are picking up market share against weaker competitors. Automobiles are going to be built, even if GM and Ford aren’t going to be building as many of them.

This is one part of the auto sector where you can have moderate growth, and the stronger suppliers can do far better than the average. I still want to buy them cheap, but I can afford to pay a little more for quality in markets where quality is scarce. In this case, lower-quality companies could be cheaper, but they aren’t the ones to buy when an industry is under stress.

Playing Chicken

As the developing world grows, so will demand for animal protein. To me, that means chicken.

Valuations are favorable here, because many investors are scared about avian flu. Whole flocks of birds might have to be culled if even a few get sick. That said, large North American poultry producers isolate their birds from wild birds, and even from humans who have the flu.

The risk is overstated, and once the pandemic is over, valuations will rise. (Some people are mistakenly avoiding chicken, even though there is no chance of getting avian flu if the chicken is properly cooked.) I own Gold Kist (GKIS:Nasdaq) and Industrias Bachoco SA (IBA:NYSE) , but am considering whether I shouldn’t increase my exposure and add Pilgrim’s Pride (PPC:NYSE) , or Sanderson Farms (SAFM:Nasdaq). Tyson (TSN:NYSE) is too diversified, and I’m not crazy about the management.

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Full disclosure in 2013: I am still long Industrias Bachoco SA [IBA] — what a great unknown company.

Note: this was published at RealMoney on 7/2/2004.  This was part four of a  four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.  If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.

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Investing Strategies

Some groups can reinforce their own behavior in the market, causing booms and busts.

Balance sheet players tend to be strong holders.

Liquidity can change the market landscape.

In Part 1 of this column, I began describing the various classes of investors and their investment behavior. In Part 2, I’ll continue that description, and will follow it up by explaining how some classes of investors can temporarily reinforce their own behavior, causing booms and busts. Finally, I will offer practical ways you can benefit from understanding the behaviors of different investor classes.

8. Leveraged Private Investors

The use of leverage gives the investor the ability to make more out of his bets than his equity capital would otherwise allow, but eliminates some of the advantages that the unleveraged possess. Investors that are leveraged do not entirely control their trade; if their assets decline enough in value, either they or the margin desk will reduce their position.

Leveraged investors are in the same position as the European banks that I discussed in Part 1. Worry sets in as one gets near a margin call, not when the margin call happens. As worry sets in, mental pressures to change the asset positions materialize. The challenge to the investor is to decide whether to liquidate, or take chances. Being forced to make a decision leads to a higher probability, in my opinion, of making the wrong decision.

In addition, leveraged longs have to pay for the privilege of financing additional assets. With overnight rates low today, that might not seem like much of a cost. But when the market is in the tank and interest rates are sky-high, as they were from 1979 to 1982, the cost of leveraged speculation is a deterrent and helps keep a lid on the market.

9. Short-Sellers

Being short is not the opposite of being long. It is closer to the opposite of being a leveraged long. Shorts do not entirely control their trade; if their shorts rise enough in value, either they or the margin desk will reduce their position. This is the opposite of leveraged longs. Remember, unleveraged longs can stay put as long as they like, and almost no one can force them to change. Shorts can be forced to cover through a squeeze, whether through rising prices threatening their solvency or a decrease in borrowable shares from longs moving their shares from margin to cash.

Stocks with a large short interest relative to the float, like Taser (TASR:Nasdaq) , can behave erratically with little regard to anything more than the short-term technicals of trading. (If fundamental investing is akin to a chess game, trading Taser is more akin to a street brawl.)

Short-sellers also have costs that unleveraged longs don’t face. When it is difficult to borrow shares (i.e., the borrow is tight), you might have to pay for the privilege of borrowing. As an example, when I was short Mony Group, I had a 2% annualized rate to pay on the last block of shares that I shorted. The rest came free, but that was before the trade got crowded. (When the borrow is not tight and if you are big enough, it is possible to get a credit, but that’s another story.)

Another cost is paying any dividend that the company might pay. Granted, the stock is likely to drop by the amount of the dividend, but cash going out the door to support a trade makes a trade more difficult to hold on to.

10. Options Traders

Buyers of options fully control their trade and pay a premium for the privilege. Sellers of options give up some control of their trade and receive a premium for their trouble. Being short an option is like being short a stock; theoretically, the risk is unlimited. If the short options of an investor rise enough in value, either they or the margin desk will reduce their position. Long option investors face no such constraints, but they do face the continual decay of the time premium of their options.

When there are company-issued options outstanding, such as warrants, convertible preferreds and convertible bonds, another trading dynamic can develop. Because the company has offered the call options on its stock, unlike other investors, it can issue stock to satisfy calls. The dilution from share issuance can put a ceiling over the price of the stock near the strike price for the call options until enough demand exists for the stock that it overcomes the dilution.

One more example of embedded options shows up in the residential mortgage bond market. Residential mortgages contain an option that allows the mortgage to be prepaid. Mortgage bond managers, who often manage to a constant duration (interest-rate sensitivity), run into the problem that their portfolios lengthen when rates rise, and shorten when rates fall. This can make them buyers of duration (longer mortgages or noncallable Treasuries) when rates fall, and sellers when rates rise.

In either case, with enough mortgage managers (and mortgage originators, who are in the same boat) doing this, it can become self-reinforcing because many market players buy into a rising market and sell into a falling market. This has an indirect effect on the Treasury and swap markets because mortgage hedgers use them to adjust their overall interest-rate sensitivity. In general, mortgage hedgers are weak holders of Treasuries, which they sell off as rates rise.

Balance Sheet Players vs. Total Return Players

I find it useful to divide the players in the investment universe into two camps: balance sheet players and total return players. Balance sheet players can lose it all and then some. Total return players can lose only what they have invested and include mutual funds (including index funds), unleveraged private investors, defined benefit plans, option buyers and endowments. Balance sheet players include banks, insurance companies, leveraged private investors and option sellers.

Total return players tend to resist — or at least are capable of resisting — market trends, which provide stability in the market. At the edges of negative price movements, balance sheet players find that they have to sell risky assets in order to preserve themselves. In severe market conditions, balance sheet players can make market movements more extreme.

I think it helps to view the behavior of balance sheet players through the lens of self-reinforcement. When there are too many of them crowding into a trade, there is the potential for instability. If the price of the asset has been bid up to the point to where a buy-and-hold investor would feel that he could not obtain a free cash flow yield adequate to compensate him for the risk of the purchase, then the asset is unsustainably high, which does not mean that it can’t go higher. When you see long-term investors exiting, it’s usually time to leave.

Fueled by leverage, some players will increase their bets as the price of the asset rises because they have more buying power with a more expensive asset. Finally, a few smart players start to sell and the process works in reverse as leverage levels increase for balance sheet players with a large concentration in the stock and a self-reinforcing cycle of selling begins. The same boom-bust cycle can happen with total return players, but it would be more muted because of the lack of leverage.

At the end of the bust, the buyers typically are unleveraged buy-and-hold investors. For example, I remember picking over tech and telecom stocks in 2001-02 that had been trashed after the bubble burst. This is a sector of the market that I don’t play in often, because I don’t know it so well; that said, it became 30% of my portfolio. Many of those stocks were trading for less than their net cash and a few were even earning money. My thought at the time was that if I tucked a few of these stocks away and held them for five years or so, I’d have something better at the end. With the bull market of 2003, my exit came sooner than I expected; other market players saw the potential of the cheap, conservative tech companies that I held and liked them more than I did.

This brings me back to weak and strong hands. In general, total return players have stronger hands than balance sheet players, at least when market values are out of whack with long-term fundamentals.

Illiquidity and LTCM

An asset is illiquid when the bid-ask spread is wide, or even worse, when there is no bid or ask for a given asset in the short run. This can happen with large orders in small-cap stocks and in “off the run” corporate bonds. Often an illiquid asset offers a higher potential return than a more liquid asset; given the disadvantage of illiquidity, in a normal market it would have to. Even a liquid asset can act illiquid if you hold a large amount of it relative to the total float. Trying to sell rapidly would drive down its price.

To hold illiquid assets, you either have to hold them with equity or a low degree of leverage with a funding structure for the leverage that can’t run away. One example is the type of portfolio I ran in the mid-1990s: unleveraged micro-cap value stocks. Another example is Warren Buffett’s portfolio. He buys whole companies and large positions in other companies, and funds those purchases with a modest amount of leverage from his insurance reserves.

My counterexample is more interesting (failure always is). Long Term Capital Management for the most part bought illiquid bonds and shorted liquid bonds that were otherwise similar to the illiquid bonds. When LTCM was small relative to the markets that it played in, it could move in and out of positions reasonably well, and given the nature of bonds, absent a default, there was a natural tendency for the bonds to converge in value as they got close to maturity.

As LTCM became better known, it received more capital to invest. Assets grew from profits as well. Wall Street trading desks began to figure out some of the trades that LTCM was making and started to mimic the firm. This made LTCM’s position more illiquid. It was fundamentally short liquidity, leveraged up using financing that could disappear in a crisis and had LTCM wannabes swarming around its positions.

At the beginning of 1998, it had earned huge returns and its managers were considered geniuses. The only problem was that they were running out of places to put money. The yield spreads between their favored illiquid and liquid bonds had narrowed considerably. “The juice had been squeezed out of the trade,” but they still had a lot of money to manage.

By mid-1998, with the Asian crisis brewing and Russia defaulting, there came a huge premium for liquidity. Everyone wanted to get liquid all at once. Liquid bonds rose in price, while illiquid bonds fell. The LTCM imitators on Wall Street got calls from their risk control desks telling them that they had to liquidate the trades that mimicked LTCM; the trades were losing too much money. In at least one case, it imperiled the solvency of one investment bank. But at least the investment banks had risk-control desks to force them to take action. LTCM did not, and the unwinding of all the trades by the investment banks worsened its position.

When the severity of the situation finally dawned on the investment banks, with the aid of the Federal Reserve, the investment banks realized that there was no way to easily solve the situation. LTCM couldn’t be liquidated; its positions were so large that a “fire sale” meant that the investment banks that lent it money would have to take a haircut. LTCM needed time and a bigger balance sheet, if the investment banks were to be repaid. The investment banks eventually agreed to recapitalize LTCM funds and unwind the trades at a measured pace. Even the equity investors got something back when the liquidation of LTCM was complete. LTCM’s ideas weren’t all bad, but it was definitely misfinanced.

Final Advice

Keep these basic rules in mind as you consider how to apply these concepts to your own trading. They aren’t commandments, but paying attention to them will help you make more informed investment decisions.

1. All good investment relies at least implicitly on sound asset-liability management. Assets should be matched to the type of investor and funding structure that can best support them.
2. Understand the advantages that you have as an investor, particularly how your own cash flow and funding structure affect your investing.
3. Try to understand who else is in a trade with you, what their motivations are, their ability to carry the trade, etc.
4. Don’t overleverage your positions. Always leave enough room to be able to recover from a bad scenario.
5. Be aware of the effects that changing demographics may have on pension plans and individual investors.
6. Always play defense. Consider what can go wrong before you act on what can go right.
7. Be contrarian. Maximize your flexibility when the market pays you to do so. Be willing to sell into manias and buy after crashes.