A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.

Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…

I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.

If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.

Enough about my review process; on with the review:

When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.

The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.

Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.

I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.

Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?

Commend

• Momentum effects do tend to persist across equity styles.
• Momentum effects do tend to persist across international regional equity returns.
• Momentum effects do tend to persist on high yield returns in the short run.
• The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
• Keeps investment expenses low.
• Gives you some more advanced strategies as well as simple ones.
• The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)

Discredit

• The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
• I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
• I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
• They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
• If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
• Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
• It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.

The Verdict

I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:

• There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
• International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
• Interest rates are low today, and equity valuations are not low.

Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.

Full disclosure: If you buy anything from Amazon after entering through one of my links, I get a small commission.

1) Liberty Mutual buys Safeco?  Pays 1.75x book, and 11x estimated earnings?  Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal.  They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead?  This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions.  There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present.  There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer.  Off of Safeco, he likes Chubb.  Okay, I like Chubb too.  Great company, and cheap.   I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative.  Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds.  With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold.  With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings.  With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool.  I wouldn’t go there.

3) I don’t get Bill Miller.  I’m a value investor.  I like companies that trade at modest multiples of book and earnings.  I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies.  Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis.  At this rate next year, he might be behind the S&P over ten years.  Quite a flameout for one who was so lionized.  Could he be fired?  Yes, but not by Chip Mason.  They are too close.  If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade.  Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility.  I’m a professional, and I think humility is a key virtue in handling money.  As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net.  Hey, I’ve paid market tuition, and it is painful.  But boy, I learned a lot, and I don’t repeat mistakes often.  (Repeating mistakes sometimes is bad enough… )

Full disclosure: long SAFT (not SAF)

National Atlantic has filed its Preliminary Proxy Statement. I’m only going to tackle one part of it here tonight — the section starting on page 24, “Opinion of the Financial Advisor.” Those who have read me for a long time know that I am neither biased for or against any “fairness opinion.” For those who want to go back to my early days on RealMoney, you can view what I wrote on the MONY acquisition by AXA. The fairness opinion was correct, and the contesting value investors were dead wrong. Part of the problem was not understanding the insurance accounting.

With National Atlantic, I think the fairness opinion does not truly represent the value of the company. Let me go through a few critical bits of the fairness opinion:

(Page 26)

     Selected Publicly Traded Companies Analysis. Banc of America Securities
reviewed publicly available financial and stock market information for National
Atlantic and the following seven publicly traded personal lines property and
casualty insurance companies with a market capitalization below $2.5 billion:

        o   Mercury General Corporation
        o   State Auto Financial Corporation
        o   Horace Mann Educators Corporation
        o   Infinity Property & Casualty Corporation
        o   Safety Insurance Group, Inc.
        o   Donegal Group, Inc.
        o   Affirmative Insurance Holdings, Inc.

Banc of America Securities reviewed, among other things, per share equity
values, based on closing stock prices on March 7, 2008, of the selected publicly
traded companies as a multiple of calendar years 2008 and 2009 estimated
earnings per share, commonly referred to as EPS, and as a multiple of book value
per share as of December 31, 2007 (in the case of Safety Insurance Group and
Affirmative Insurance Holdings, as of September 30, 2007).

Affirmative and Infinity do not belong in this group, because they are both nonstandard auto writers, which get lower valuations than standard writers. Donegal is mainly a commercial writer when last I looked… the rest are fine. I might have included Gainsco, Commerce Group, or Universal Insurance Holdings. In any case, it biases the calculation of the estimated price low.

     Implied Per Share Equity Value Reference Ranges for National Atlantic         Consideration
     ---------------------------------------------------------------------         -------------

          2008E EPS                                    2007 Book Value
       ---------------                               -------------------

        $3.27 - $4.20                                   $5.24 - $7.85                   $6.25

It also would have been better to do a scatterplot of Price-to-book versus expected ROE on compared companies. I will have to perform that analysis eventually.

(Page 27)

        Selected Precedent Transactions Analysis. Banc of America Securities
reviewed, to the extent publicly available, financial information relating to
the following twenty selected transactions involving property and casualty
insurance companies with a transaction value below $500 million:

  Announcement
      Date                                    Acquiror                                         Target
- ---------------       --------------------------------------------------    -----------------------------------------

     2/20/08          o    Meadowbrook Insurance Group, Inc.                o   ProCentury Corp.
      1/3/08          o    QBE Insurance Group Ltd.                         o   North Pointe Holdings Corp.
      4/4/07          o    Fortress Investment Group LLC                    o   Alea Group Holdings Ltd.
     3/14/07          o    Argonaut Group, Inc.                             o   PXRE Group Ltd.
     12/4/06          o    Elara Holdings Inc.                              o   Direct General Corp.
     11/22/06         o    Clal Insurance Enterprises Holdings Ltd.         o   GUARD Financial Group Inc.
     11/13/06         o    Tower Group Inc.                                 o   Preserver Group Inc.
     10/31/06         o    American European Group, Inc.                    o   Merchant's Group Inc.
     10/6/06          o    Affordable Residential Communities Inc.          o   NLASCO, Inc.
     10/3/06          o    Affirmative Insurance Holdings, Inc.             o   USAgencies, L.L.C.
     9/28/06          o    Arrowpoint Capital Corp.                         o   Royal & Sun Alliance Insurance
     8/16/06          o    QBE Insurance Group Ltd.                         o   One Beacon Insurance Group, Ltd.
      8/4/06          o    Delek Group, Ltd.                                o   Republic Companies Group, Inc.
     7/19/06          o    Inverness Management L.L.C.                      o   Omni Insurance Group Inc.
     11/4/05          o    General Motors Acceptance Corp.                  o   MEEMIC Insurance Company
     5/22/03          o    Liberty Mutual Holding Company Inc.              o   Prudential Financial Inc.
     5/22/03          o    The Palisades Group                              o   Prudential Financial Inc.
     3/26/03          o    Nationwide Mutual Insurance Co.                  o   Prudential Financial Inc.
     11/1/00          o    American National Insurance Company              o   Farm Family Holdings, Inc.
     10/25/00         o    State Automobile Mutual Insurance Company        o   Meridian Insurance Group, Inc.

The only deal here that would truly be a “comparable” might be Republic Companies. It was a company that was mainly a personal lines company, unlike many of the rest of these deals which are for commercial insurers and reinsurers (I am not familiar with all of them). Republic was sold significantly over its book value. And, where is Commerce Group? I know it is too big to meet the cutoff, but there is a sale of a single state insurer. I would think that valuation would be relevant.

                 Implied Per Share Equity Value
              Reference Ranges for National Atlantic            Consideration
            ------------------------------------------        ------------------
               2008E EPS             2007 Book Value
            ----------------       -------------------

             $5.36 - $6.30             $8.51 - $9.82                $6.25

So, I think these values are low as well. There is far more certainty to the valuation of the reserves of a short-tailed insurer, which usually deserves a higher valuation.

(Page 28)

     Discounted Cash Flow Analysis. Banc of America Securities performed a
discounted cash flow analysis of National Atlantic to calculate the estimated
present value of the standalone unlevered, after-tax free cash flows that
National Atlantic could generate during National Atlantic's fiscal years 2008
through 2012 based on the National Atlantic management forecasts. Banc of
America Securities calculated terminal values for National Atlantic by applying
terminal forward multiples of 7.0x to 9.0x to National Atlantic's fiscal year
2013 estimated GAAP earnings and of 0.40x to 0.70x to National Atlantic's
estimated 2012 year-end book value. The cash flows and terminal values were then
discounted to present value as of March 7, 2008 using discount rates ranging
from 15% to 17%. This analysis indicated the following implied per share equity
value reference ranges for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                       $5.42 - $7.42                            $6.25

I’d like to see them spill the guts of the calculation, and the other calculations above as well. Using “0.40x to 0.70x to National Atlantic’s estimated 2012 year-end book value” and “discount rates ranging from 15% to 17%” is too severe. This is a company with no debt. It’s marginal cost of capital, using the “pecking order” theory is low. Also, short-tail P&C companies under competent management teams don’t retain valuations below 0.8x book.

     Run-off Analysis. Banc of America Securities also performed a run-off
analysis of National Atlantic to calculate the net present value of dividends
that would be paid to shareholders over the remaining life of the company
assuming that it serviced its existing policies without writing any additional
policies or renewing any existing policies. Based on the assessment of National
Atlantic management that the company would not be permitted to pay annual
dividends by the New Jersey regulators, this analysis calculated the net present
value of the final dividend available for distribution to shareholders after all
payouts on loss reserves and losses on unearned premium reserves, estimated to
be approximately $88.0 million payable in 2016. Banc of America Securities
applied a sensitivity analysis to assess a range of values if the loss reserves
were inadequate by up to 10% or were overstated, showing a redundancy of up to
10%. The range of final dividend distributions were then discounted to present
value as of March 7, 2008 using discount rates ranging from 13% to 17%. This
analysis indicated the following implied per share equity value reference ranges
for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                      $1.36 - $3.60                             $6.25

Again, the discount rate is too high. Beyond that, they make the fatal assumption that the company can’t close its books until 2016. If National Atlantic stopped writing policies today, then, one year from today, it would receive its last premium. The company would operate with a skeleton staff for one more year, after which, the remaining book could easily be sold to a company specializing in run-offs. You wouldn’t get your money in 2016. It would be more like 2010. Six years of interest discount at 13-17% makes a huge difference in the price.

=-=-=-=-=-=-=-=-=–=-==-=–=-==-=-=–=-==–=

I have more work to do here, but my fundamental view is not changed. I will be voting against the deal, and encouraging others to do the same. Should the deal succeed, I will likely file for appraisal rights. As I have noted before, I believe that I have meritorious arguments for a better price.

Full disclosure: long NAHC SAFT

When I wrote my last piece, “The Financings of Last Resort,” I did meant to add that this will be a common phenomenon for a year or so. Pretend you are part of a senior management team of a credit-sensitive financial institution, and your worst nightmare is slowly unfolding in front of you. You’re looking looking at delinquency and loss statistics stratified by year of issuance (”vintage”) and time since issuance. Every vintage since 2003 looks worse than the prior year, and the loss seasoning curves are all pointed upward — in the early vintages, mildly, and in the 2006-2007 vintages, wildly.

You are seeing current losses come through, and they are erasing much of current profits, or, creating crushing losses if you try to get ahead of the loss curve and put in sufficient reserves to handle likely future losses. Any loan loss estimate toward the beginning of a “bust” phase is a wild guess, and management teams are often behind the curve as they hope that the most recent data point was a statistical fluke.

But management teams often think along two tracks. The first is the “best current estimate,” which they give to the market through GAAP accounting. The second is “What if things get bad, and we run short of capital? Better to get financing now, while our stock price is relatively high, and bond and preferred spreads low.”

That reasoning drives two types of capital raising — financings of last resort, and protective financing. That second class of financing was what I commented on at Felix Salmon’s blog regarding JP Morgan.  Borrow when you can, not when you have to.  Get in front of the loss curve, not behind it.

But, for those that are behind the curve, the financings of last resort are protective, at least for a little while, of management teams and bondholders.  Consider the actions at:

• Citigroup
• CIT Group
• National City

But who loses? Current stockholders get diluted.  I can imagine the management consoling their consciences with the thought, “Yes, the stockholders lose, but what would they get in bankruptcy if things got worse, and we didn’t raise capital?”

So, even if credit-sensitive financial companies avoid going broke, they may not be good equity investments because of the dilution.  I said that early on with the financial guarantors.  The big guys are still alive, but their stock prices are down significantly.  (Oh, and note that the regulators like this approach.  No public funds get used.  No embarrassing front page insolvency news.  “What was the regulator doing?”)

How long will this continue?  Financings of last resort can go on until the stockholders rebel and throw out management (hard to do), or the estimated net present value of the profit stream of the company is negative; no one will finance that.  (Think of ACA Capital Holdings, maybe.)  The nature of a financing of last resort is that the financier hands over cash in exchange for cheap equity that can be recycled into the market.  It’s a coercive way of doing an equity or debt offering, and requires a significant discount to current financing valuations.

So, how long will the bailouts go on?  I think for quite some time, which I why I am avoiding that area of the market.  Avoid the equity “fire sales” if you can.  Remember, management teams usually know more than the average analyst when it comes to knowing the true value of cash that can be generated from illiquid assets.  So when you see financial firms pursuing liquidity during a time of debt deflation, don’t be a hero — avoid those companies.

1)  Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?  Because Wall Street has always been very good at cutting off overleveraged clients in the past.  LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.  Wall Street grabs collateral first, and then lets the client argue to get it back.  The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

The real worry here is that the investment banks don’t have good enough risk controls for each other.  Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers.  No one knows whether the reserves are right.  No one can.  Confidence is a necessary part of the game, which is made easier at lower levels of leverage.  But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy?  Yes.  The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.  As I will point out later, that is already having impacts on the rest of the world.  As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.  That might be correct if inflation mean-reverts.  Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit?  A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.  In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.  When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China?  Maybe.  China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.  And what will they do with all of those dollar reserves?  Beats me.  After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.  My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5)  What of foreign food riots; are they a worry?  (More, and more.)  A little.  They are a canary in the coal mine.  They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.  But, one practical thing that it implies is that energy and food prices will remain high for some time.  We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil  production?  Yes, worry.  As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.  Mexico, Venezuela, and Russia have declining production, to name a few.  The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.  Or maybe they can’t…

7) Worry about falling housing prices?  Yes.  The problems in the housing market stem from overbuilding.  There are too many houses chasing too few solvent borrowers.  This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.  Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail.  We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry.  For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.  If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies?  Yes, worry.  It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency?  A little.  All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.  Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.  The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about.  As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.  But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.

For this quarter, I sold two my two placeholder assets, the Industrial and Technology SPDRs, and Arkansas Best, which had richened enough for me to trade out of it.

I had two rebalancing buys, Charlotte Russe and Avnet.  On Charlotte Russe, the rebalancing buy occurred because I tendered all my stock @ $18 in the Dutch Tender, and 45% of it got bought.  On Avnet, things aren’t as bad as the market thought on 4/15, in my opinion.  I had one rebalancing sell, Helmerich and Payne.  Just taking some off the table for risk reduction purposes.

Here is my final comparison file that was based off of data at the close of business on Monday.  To comply with the Bloomberg data license, all numeric fields remaining are ones that I calculated.  The columns of the file rank the 290 stocks on the following metrics (lower better unless noted):

• 52-week RSI
• Trailing P/E
• P/Book (2)
• P/Sales (2)
• P/2008E
• P/2009E
• Dividend Yield (higher better)
• Net Operating Accruals (2)
• Implied Volatility
• Neglect (higher better)

The grand rank sums up the ranks giving double weights to P/B, P/S, and NOA.  My current stocks are highlighted in yellow, except for the two middle ones, which are in orange.  Candidates for sale come from the lower half (high grand ranks), candidates to buy from the upper half.

Here were my purchases (P/2008E):

• International Rectifier — 9.5x
• Group 1 Automotive — 7.1x
• OfficeMax — 9.3x
• Universal American Financial — 5.8x

Cheap names all (and could get cheaper?).  If you asked me what my concerns might be over this group of names, I would say that credit quality is adequate but not stellar.  I would also confess a little doubt on Universal American.  It looks cheap, and lines of business they are in are stable lines.  They lost money on mezzanine subprime mortgage ABS.  I looked at the writedowns, and they seem adequate.  If you send the security vintages 2006-2007 to zero, this stock is still cheap, in my opinion.   What I can’t evaluate is whether they could have operational problems in their senior health insurance business.  It’s a good business, if managed properly.

As for International Rectifier and Group 1, I have owned them before.  With IRF, I like industrial technology — stuff that is harder to obsolete.  On Group 1, I looked at all of the small cap auto retailers, and picked this one.  I liked its business mix, and what seemed to be a clean balance sheet, with few immediate needs for liquidity.  The group as a whole has been smashed, and is discounting very unfavorable conditions.  I don’t think things are that bad, and besides, a lot of the revenues come from repairs and sales of used cars.

With OfficeMax, I think prospects are less cyclical than the market seems to believe.  Office supplies get purchased during bad economic times as well, and the current price already discounts  a lot of pain.

Well, those are my purchases.  Let’s see how they fare over the coming years.

Full disclosure: long HP CHIC AVT GPI UAM OMX IRF

Okay, here are my industry ranks for April 2008. Please remember that my model can be used in value mode (the green zone) or in momentum mode (the red zone). I usually just stick to the green zone, but this time I included a few red zone ideas. So, this time I added in technology companies, insurance, industrial and healthcare companies. Yeah, I know that’s a lot, and my results reflected that — usually I have just 20 or so companies from the screen, but this time it is 80+.

Oh, my screen, aside from industry, has only two factors: market cap greater than $100 million, and Price-to-book times Price-to-forward earnings must be less than 10. Ben Graham had a similar criterion, except that he used trailing P/E, and his cutoff was 22.5. Here are the tickers:

ABG ACGL ACMR ACW ADPI AEL AFFM AGYS AHL AIG AMSF ARM AWH AXS BBW BC BRLC BRNC CBR CHUX CLS CMOS CNA CVGI DK EDS ENH ENSG FFG FL FLEX FMR FRPT GPI HMX HOTT HTRN IKN INDM IPCR IRF KEM KG LAD LNY LTR MENT MIG MRH MRT MWA MXGL NCS NNBR NSIT NSTC NYM OCR ODP PCCC PDFS PKOH PLAB PMACA PNX PRE PSS PTP RE RMIX RNR ROCK RTEC SAF SAH SANM SEAB SMP SNX TECUA THG TRS TRW TRX UAM UNM XL XRIT

Lots of insurers — what can I say, the group is cheap… cheaper than the lack of pricing power should make them. Add in two more tickers that crossed my desk today: MRO and AWI, and I think I am ready to put my spreadsheet together and start analyzing promising cheap companies. One nice thing about my methods is that it can accommodate a large number of tickers. When you add up the tickers from yesterday and today, and add in the 32 existing tickers, that’s almost 300 tickers altogether.

Fortunately, my ranking system helps my winnow down the list pretty quickly, as it scores cheapness on a wide number of variables at once, and throws in many of the anomalies that are mispriced in the markets. Then it is up to me to use business judgment to decide what makes sense, because most cheap stocks are cheap for a reason, while the gems are merely overlooked.

Feel free to pitch in more stock ideas. I should come to decisions within a week or so.

PS — Have you checked out Newsflashr.com yet? It looks like a promising way of aggregating financial news, as well as other news.

After seeing the amazing “refinancings” done by entities like MBIA, Thornburg, WaMu, and Rescap, I felt it was right to comment on last-ditch financing methods, so that you can recognize desperation (if it’s not obvious already).  Here are some methods:

• Borrow money using a healthy subsidiary while limiting capital flows up to the less than healthy holding company (e.g., MBIA) .
• Do a rights offering at a significant discount, diluting existing shareholders if they don’t participate.
• Offer common stock at a significant discount to a private buyer (perhaps with warrants), diluting existing shareholders, but perhaps allowing the company a chance to play again another day. (e.g. WaMu, Thornburg).
• Offer a convertible bond/preferred to monetize the volatility of the stock price, contingently diluting existing shareholders. (e.g. Lehman, Citigroup, Merrill)

With the exception of the first one, all of these dilute existing shareholders, usually driving the stock price down in the short run, unless the removal of fear of bankruptcy is the dominant factor.  With the first one, it is an example of structurally subordinating lenders to the holding company, who now lose “first dibs” on the value of the healthy subsidiary.

I try to avoid companies that do financings like these, or are likely to do them.  They have a high default rate.  And what goes for the stock here, goes triple for the corporate bonds, where you have all of the downside of the stock, and little of the upside, if the company should manage to survive.

Well, it’s that time again. Time to make a few portfolio swaps. At present I have two placeholder securities, the industrial Spider, and the technology Spider. Those will go, and I may sell one more security, but that’s it. I will use the proceeds to buy 2-4 positions, so that I will end with 34-35 positions.

When I run across an idea between quarters, I write it down on a sheet and wait for the next reshaping. Well, here is the list of tickers I came across over the last 3 months:

AAUK ACE ADI ADPT ADSK ALB ALL ALV AMAT AMGN AMH AN ANDS APD ARG ASH AW AZN BA BDK BGC BNI BRCD BTU CAG CB CC CCI CHRS CIU CLNE CNQ CONN CPB CRC CRI CSCO CSE CSX CTHR CVG CVI DEO DITC DKS DNR DRI EMC EQ ETFC ETP FMX FRX FSII FTD GDI GIII GT GTI GTS HAR HBOOY HCC HD HOC HTCH HTH HUM IBM INFS ISLN ITRN JBL JCI JCP JRT JTX KFS KMP KMX KOP KR KSS LAMR LDIS LM LOW LXK MAS MCHP MMP MNKD MSN MTA MTW MYE NII NSC NTGR NTT NUHC OMX ORCL OVTI OXY PARL PAYX PBR PCZ PERY PHH PMRY POM PTEN PVX PX QTM RAI RDC RDS RELL RES RHD RJF ROST RSC S SCSS SCX SHW SIRF SNDK SNY SPIL STX STZ SU SUN SUR SVU T TBAC TDW TGT TM TOT TRV TSN TSO TXN TXT TZOO UNP UPRT URBN VMW VOXX VZ WAG WC WDC WHR WIN WLP WNR WPC WTM XRX YUM ZURNY

One of the fun parts of this exercise is that I invite readers to submit their own ideas as well. Feel free to leave them in the comments below.

From here, I will update my industry model, run some screens, and post additional tickers. After that, I will compare the replacement candidates against my existing portfolio, using my multifactor appoach. I will keep you apprised of my thoughts as I move toward making the portfolio changes.

Full disclosure: long XLI XLK

I received this in the mail on Saturday:

ABC logo

March 31, 2008

Dear Investor,

I am writing to tell you that my firm is in very good financial condition. Normal market conditions would not require this correspondence. But I understand that many people are deeply concerned about the stability of their brokers at this time.

I have always tried to earn my clients’ trust by running the firm conservatively, with clients’ interests in mind. Today, 75% of the Company’s assets are in cash or cash equivalents and we have no debt. In addition, we have no investments in collateralized debt obligations or similar instruments. As a matter of policy, we do not carry positions or make markets.

Throughout the years, in making decisions about my business, I have always put the safety of my clients’ assets first. This is one of the primary reasons my firm clears on a fully disclosed basis through DEF LLC (DEF), a GHI company. DEF clears our clients’ trades and is in custody of their accounts. Their name appears with ours on monthly statements and confirmations. As of December 31, 2007, DEF had net capital in excess of $2.1 billion which exceeded its minimum net capital requirement by more than $1.9 billion.

In addition, when you do business at ABC, your account receives coverage from the Securities Investment Protection Corp. (SIPC) as primary protection for up to $500,000, including a limitation of $100,000 for cash. SIPC coverage is required of all registered broker-dealers. Since most “cash equivalent” money market mutual funds are considered securities under SIPC, investments in money market mutual funds held in a brokerage account are protected by SIPC along with your other securities to a maximum of $500,000. Of course, there is no protection that will cover you for a decline in the market value of your securities. You may visit www.sipc.org to learn more about SIPC protection.

Furthermore, DEF has arranged for additional protection for cash and covered securities to supplement its SIPC coverage. This additional protection is provided under a surety bond issued by the Customer Asset Protection Company (CAPCO), a licensed Vermont insurer with an A+ financial strength rating from Standard and Poor’s. DEF’s excess-SIPC protection covers total account net equity for cash and securities in excess of the amounts covered by SIPC, for accounts of broker-dealers which clear through DEF. There is no specific dollar limit to the protection that CAPCO provides on customer accounts held at DEF. This provides ABC clients the highest level of account protection available in the brokerage industry to the total net equity with no limit for the amount of cash or securities. And, unlike many other brokers, there is no “cap” on the aggregate amount of coverage for all of our customers’ assets. You may access a CAPCO brochure about “Total Net’ Equity Protection” at ABC.com [deleted]….

If you are concerned about the status of your assets at another brokerage firm, you might consider moving them to ABC. It is easy to transfer assets. If you have friends who are concerned about their brokers, you might consider referring them to us. We continue to offer free trades for asset transfer and referrals. If you have questions about anything in this letter, please feel free to call us at 800-xxx-xxxx from 7:30 a.m. –7:30 p.m. ET, Monday-Friday. Once again, thank you for your trust and your loyalty.

Sincerely,

President and Chief Executive Officer of ABC

I used to do business with ABC, and I presently do business with GHI. Both of them are good firms, doing business on a fair basis for their clients. To me, it is interesting to use financial strength as a marketing tool.

On another level, how many people actually check the solvency of their brokers before doing business with them? On a retail level very few, if any. On an institutional level, that’s a normal check for sophisticated investors.

That said, I would be surprised to see any major retail brokers go insolvent aside from those with significant investment banking exposure. Even there, accounts are segregated, and client cash typically has the option of being in a money market fund.

This is not something that I worry about in investing, but if I were worried about my broker, I would make sure that my liquid assets over $100,000 were in a non-commingled vehicle, most likely a money market fund.

What of Excess Insurance?

Now, I will add just one more note in closing. CAPCO is a nice idea, but I am always skeptical of small-ish insurers backing large liabilities with a remote possibility of incidence. There aren’t that many AAA reinsurers out there, and I am guessing that Berky is not one of them. Buffett does not like to reinsure financial risks, aside from municipal debt. That leaves the AAA financial guarantors — Ambac, MBIA, Assured Guaranty, and FSA (though I am open to a surprise here). I’m guessing it’s the first two, and not the last two. CAPCO is owned by many of the major brokers, but in a crisis, CAPCO has no recourse to its owners, but only to its reinsurers, should that coverage be triggered. The recent financial troubles have led S&P to place CAPCO on negative outlook, mainly because:

Standard & Poor’s assigns a negative outlook when we believe the probability of a downgrade within the next two years is at least 30%. The revised outlook reflects the challenging environment for broker/dealers and their parents. Deterioration in their credit quality and risk-management capabilities could affect CAPCO’s financial strength. In the past couple of months, Standard & Poor’s has revised the outlook on several of CAPCO’s members’ parents to negative. Also, the ratings on a couple of members are on CreditWatch with negative implications, which means there’s the potential for a more imminent downgrade. The capital of CAPCO’s members and–in some cases–their parents is an important resource for mitigating CAPCO’s potential payments for its excess SIPC (Securities Investors Protection Corp.) coverage.

It would be interesting to know for certain the underwriters and terms of CAPCO’s reinsurance. I’m not losing any sleep over it, though… there are bigger things to worry about, my personal broker is well-capitalized, and I have less than $100K at risk in cash, and that is in a money market fund. So long as accounts remain segregated, risks are small.