Category: Portfolio Management

Could Have Been a Lot Worse…

Could Have Been a Lot Worse…

One month down, eleven to go?? Can we stick our heads out of the foxhole yet?

Personally, I was off just a little in January.? Comparing myself against a bunch of value indexes, which did better than growth indexes in January, I did better than all of them.? We’ll see what the future brings, though, these things can turn on a dime.

So what worked for me?? Arkansas Best, National Atlantic (not out of the woods yet), Charlotte Russe, Gehl, YRC Worldwide, Alliance Data Systems, Reinsurance Group of America, and Honda.

What hurt?? Nam Tai, Gruma, Valero, Deutsche Bank, Royal Bank of Scotland, and Anadarko Petroleum.

Common factors:

  • Financials with complexity got hurt
  • Energy was lackluster at best
  • Industrials, Retail, and Trucking did well
  • Value took less pain
  • What got whacked before went up

One final note here.? Look at this graph from Bespoke.? The “sea change” there mirrors my own turn in performance.? What does that tell me?? Perhaps it tells me that in late 2007 there were a lot of hedge funds liquidating positions that value managers liked to own.? After the end of the year, the selling pressure ebbed, and value seekers came in.? At RealMoney today, both Cramer and Marcin were commenting on they could find stuff to buy when the market was down in the morning.? I agreed; I haven’t seen this many good values since 2002.? I’m not counting on anything here, but I think my portfolio has attractive valuations and prospects.? Much as I am not crazy about the macro environment in many ways, I have some confidence that my portfolio should do better than the S&P 500 in 2008.

Full disclosure: long NTE GMK VLO DB APC RBS ABFS NAHC CHIC GEHL YRCW ADS RGA HMC

Time to Begin Increasing Credit Risk Exposure

Time to Begin Increasing Credit Risk Exposure

Ugh, today was a busy day.? My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.? The bond market direction I got right.

Look at this post from Bespoke.? Ignore the percentage increase, and just look at the raw spread levels.? Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.? When you get to 10% yields, the odds tip in your favor on high yield.? That said, today’s crop of high yield corporate debt is lower rated than in the past.? Don’t go hog wild here, but begin to take a little more risk.? I was pretty minimal in terms of credit risk exposure for the last three years, owning only a? few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

  • For which of the following risks am I being adequately rewarded?? Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
  • What are my client’s tax needs?
  • How much volatility is my client willing to tolerate?
  • How unconventional can I be without losing him as a client?
  • What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.? That is where I have been for the past three years, and now it is time to adjust that position.? With respect to the list of risks:

  • Illiquidity: indeterminate, depends on the situation
  • Credit/Equity: begin adding, but keep some powder dry
  • Negative Convexity: attractive to add to prime RMBS positions at present.
  • Duration: Avoid.? Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
  • Sovereign Risks: Avoid.? You’re not getting paid for it here.
  • Complexity/Taint:? Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
  • FX: Neutral.? Maintain core positions in the Swiss Franc and the Yen for now.? Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.? The biggest changes are on credit risk and FX.? That’s a big shift for me.? If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.? Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.? I’m not trying to catch small moves.? Instead, I want to average into troughs before they hit bottom.? If you wait for the bottom, there will not be enough liquidity to implement the change in view.

Completion of the Reshaping

Completion of the Reshaping

I ended up doing more in the first quarter reshaping than I had originally intended. Here are the trades:

New Buys

  • Avnet
  • Ensco International
  • Alliance Data Systems

New Sales

  • Bronco Drilling

Rebalancing Sales

  • Valero Energy (that was fast)

The trades left me with 5% available in cash, and my normal 35 positions, with one being a double-weight (NAHC), and one being a 1.5x weight (JOF).

I didn’t want to go a lot heavier into financials, and particularly not insurance. Ensco ends up replacing Bronco; it’s time to move from the land to the sea in drilling, at these oil price levels. In addition, much as I admire Third Avenue and Curtis Jensen, I reckon their efforts to renegotiate the merger might end up with no merger, as likely as a better deal.

In technology, I tend to buy cheap simple building block companies rather than companies that face possible obsolescence from technological change. Avnet fits that bill.

As for Alliance Data Systems, they are cheaper than before the attempted acquisition, and still have decent growth prospects. This is not usually my style, but the free cash flow can support the current valuation. Yes, it is a financial, but very different from the other companies that I hold.

That’s all. Oh, what a snapback in Valero. When I bought more, I could feel the panic in the market. I bought it anyway; don’t give in to feelings of panic when you are dealing with well-capitalized companies that are leaders in their industries.

 

Full disclosure: long JOF NAHC AVT ADS ESV

My Best Relative Value Week in a Long Time

My Best Relative Value Week in a Long Time

I’ve worked for years to take the emotions out of my investment processes, with some success.? Where it gets tough is when I am in an absolute and relative drawdown, as I was for most of the second half of 2007.? Nonetheless, I stuck with my disciplines.? This week, a lot of things went right:

  • Retail
  • Insurance
  • Trucking
  • Energy
  • Small cap value was the best style

Will this persist?? Who can tell…? I was ahead of the Russell 2000 Value index this week, even though my portfolio is more midcap value in nature.? I’m still wrestling with where to deploy incremental funds.? I’m 2-3 positions light at present, and I know I am already insurance-heavy, with many of my best candidates being insurers, and the rest Irish Banks.? I don’t want to get too heavy in financials… I’m overweight there now.? Ideas are welcome.? Oh, at the end of the day I did make a small purchase:


David Merkel
Rebalancing Buy
1/25/2008 4:02 PM EST

Bought some Gruma, SA into the close. Tortillas and other Mexican foods are not going out of style, even if the Mexican stock markets are having difficulty of late. I’ve had a good week. Hope you did too.

Position: long GMK

The market always has a new way to make a fool out of you, so I am not relying on a change in the financial weather here.? I just keep doing what I do best.

Full disclosure: long GMK

Miscellaneous Musings on Our Manic Markets

Miscellaneous Musings on Our Manic Markets

1) I had another good day today, but my body is telling me otherwise.? As I wrote at RealMoney:


David Merkel
Two Positive Surprises; Two Things I Don’t Do
1/24/2008 3:11 PM EST

Two more news bits. I don’t buy for takeovers, but today Bronco Drilling got bought out by Allis-Chalmers Energy. (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of RGA, I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re. So, today’s good earnings are a surprise, but the quality of RGA is not.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long RGA BRNC

2)? There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them.? For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism.? I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book).? Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year.? If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE.? No one would pay that.? So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist.? (Well, the Bible warns us of the dangers of being a third-party guarantor…)

Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable.? The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.

3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come.? No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier.? But Bill Gross leaves me cold here.? He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%.? These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.

I also think that David Wessel and many others let the Fed off too easily on their misforecasting. ? Who has more Ph.D. economists than they do?? I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming.? Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.

As I commented last night, Bernanke is a bright guy who will not let his name go down in the history books as the guy who allowed Great Depression #2 to emerge.? So as? the bubble bursts, the Fed eases aggressively.? Even Paul Krugman points to the writings of Bernanke on the topic.

One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed.? I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought).? Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview.? That’s difficult to do without overseeing the capital markets, post Glass-Steagall.? Unfortunately, that is what creates at least the appearance of the “Greenspan Put.”? And now the market relies on its existence.

4)? But maybe the Fed overreacted to equity markets getting slammed by SocGen exiting a bunch of rogue trades.? Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the US equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm.? Risk control begins with personnel control, starting with separating the profit and accounting functions.? Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management.? I have experienced these audits in my life, and it is a normal part of good business.

Because of that, I fault SocGen management most of all.? For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign.? There is no excuse for not having proper controls in place for an error that large.

That’s all for the evening.? I am way behind on my e-mail, so if you are waiting on me, I have not given up on responding to you.

Full disclosure: long RGA BRNC

What a Day!

What a Day!

I didn’t feel well today, but my broad market portfolio did better than me. I probably could not have picked a worse day to do my reshaping, but here are the results:

Sales:

  • Aspen Holdings
  • Flagstone Reinsurance
  • Redwood Trust
  • Mylan Labs
  • Lafarge SA

Purchases:

  • Reinsurance Group of America (old friend, cheap price)
  • Honda Motors

Rebalancing Buys:

  • Valero
  • ConocoPhillips
  • Vishay Intertechnology

Rebalancing Sale:

  • Deerfield Capital

I’m not done. My moves today raised cash from 5% to 10%, and trimmed positions from 36 to 33. I have room for two more ideas, and am working on where to place cash. My timing of buys and sells today was good — not that that is a key competency of mine by any means.

Aside from the sale of the reinsurers, which were just cheap placeholders, the other positions were not as relatively cheap as they once were. RGA and Honda are quality companies selling at bargain prices. If I had more names like those, I would buy them all day long.

Away from my broad market portfolio, I raised my equity exposure in my mutual funds fractionally today. Time to rebalance.

PS — I can’t remember another day quite like this, where the late negative to positive move was so pronounced.

Full disclosure: long DFR RGA HMC VLO COP VSH

A Bonus from <I data-src=

A Bonus from MoneySense Magazine

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.? In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.? Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.? Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.? It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.? This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.? That said, valuations are more compelling than they were, especially compared to Treasuries.? Compared to BBB corporate yields, they are still attractive.? I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

Insurance Thoughts

Insurance Thoughts

I am known for my views on insurance stocks, and I wrote about those views at RealMoney yesterday:


David Merkel
Buy Insurance Stocks. Really.
1/18/2008 12:04 PM EST

Bouncing off Adam?s comments on the XLF, the insurers in the index are getting drubbed, and in my opinion, for little good reason. On an earnings basis, many of them are the cheapest I have seen maybe ever, and while some of their earnings prospects will be diminished by the fall in the market, and difficulties in the bond market, in general, the asset side of their balance sheets are in good shape. So, if you are looking for ideas, here are a few I am looking at: MetLife, Hartford, Travelers, Lincoln National, ACE, Chubb, Principal and XL. Hopefully this will do as well as my PartnerRe trade last August.

Position: Long LNC

I would add to that list SFG and DFG. After some thought, I acted:


David Merkel
Bought Some Hartford, Added to Lincoln National
1/18/2008 12:45 PM EST

Lincoln National was a rebalancing buy, Hartford is a new position. Both are quality competitors with good balance sheets. The only possible drawback is in a protracted decline, earnings from variable products could suffer.

Position: long HIG LNC

Then, at the end of the day, I added:


David Merkel
The Dike Has Sprung a Leak
1/18/2008 4:30 PM EST

Fitch downgrades Ambac to AA from AAA. Stock has a temporary rally. Is this a great country or what? Because of the social dynamic of the rating agencies, and the existence of one downgrade, the dike has been breached, and I would expect more downgrades.

Hey, maybe it?s time for the financing of last resort: Ambac could issue a convertible surplus note. Maybe even sell it privately to Buffett, who could own 30% of the company if things turn around. He won?t delta-hedge common against it. They might even be able to get away with a coupon below 15%. Package it with a reinsurance agreement, and the NY State commissioner smiles on it.

Okay, I went overboard there, but there was no reason for Ambac to have its short-lived rally. That?s probably why it didn?t stick.

Position: none

My last note was half-whimsical and half-serious. Buffett likes convertibles, particularly if they offer attractive optionality at the right price. The question is how big the problems are at Ambac relative to their small capital base.

Now, after the downgrade of Ambac, Fitch moved to downgrade Ambac-guaranteed bonds. This is serious stuff. Moody?s and S&P will also likely move on Ambac, and MBIA, FGIC, SCA, and more. Channel Re is toast, and PartnerRe and Ren Re have written off their stakes in them (what of MBIA?).? ACA Capital is dead, or nearly so, facing a midnight deadline for forebearance from their counterparties.

I should also add that there are reinsurance issues among the financial guarantee companies have reinsurance issues.? I mentioned Channel Re, which mainly provided insurance to MBIA.? MBIA and Ambac, from what I remember, mutually reinsure about 10% of each other’s liabilities.? Beyond that, you have poor RAM Re:?

RAM Re attempts to absorb a quote share of the liabilities of the primary financial guarantors.? I met their management team during their IPO.? They seemed to be good people, and talented managers.? But having a quota share of the seven soon-to-be-formerly-AAA guarantors is a ticket to not being AAA oneself.? They face risks of insolvency of primary writers, which could lead to their own insolvency.

What I am trying to convey here, is that stress at one guarantor could have ripple effects at other guarantors.? The least affected would be Assured Guaranty, FSA (a Dexia subsidiary), and Berky (of course).

As for the recent Barron’s article on MBIA, I would only say that it all depends on structured finance losses.? If losses on CDOs are severe, MBIA could be a sell even at these levels.

These are unusual times, and it pays for investors to avoid for the most part the financial guarantee space (mortgage and title too).? Other insurers (life, health, P&C) are likely better than other financials, and generally cheap; I own a bunch of them.

Full disclosure: long LNC HIG

Tickers mentioned: SCA RAMR AGO ACAH MBI ABK BRK/A BRK/B HIG LNC MET PFG DFG SFG CB TRV MET ACE XL

Shrink Positions or Position Sizes?

Shrink Positions or Position Sizes?

In the past, when I hit a major downdraft in the market, I find myself debating whether I should reduce the number of positions in my portfolio, or shrink the mean position size.? The latter is the easier choice, which is why I take the former, and shrink the number of positions, forcing me to eliminate marginal names in the portfolio.

Today I added to Nam Tai Electronics and Deerfield Capital, bringing my over all cash position down to 8%.? As I work through my reshaping, I expect my cash level to decline further, but I would probably liquidate one of my 35 stocks without replacement to help fund the reshaping and rebalancing.

At times like now, this is a process that hurts, and sometime next week, I will announce my portfolio shifts.? That said, the portfolio has held up better versus the market recently.

Full disclosure: long NTE DFR

Unstable Value Funds?

Unstable Value Funds?


David Merkel
Things That Go “Bump” in the Night
1/17/2008 1:45 PM EST

One piece that I wrote three years ago for RealMoney has relevance today in a new way. Stable Value Funds often invest in AAA securities (some are solely invested in AAA securities), and some funds will have above-average exposure to securities credit-wrapped by the financial guarantors, and possibly, to some asset-backed securities that were rated AAA at issue, but don’t deserve that rating now. For those who have exposure to stable value funds through their defined contribution plans, it might be wise to check what exposures your funds have to the guarantors, and to AAA structured securities that are trading significantly below amortized cost. The summary statistic to ask for (not that they will give it to you) is the market-to-book ratio of the fund. If it gets lower than 97%-98%, I would avoid the fund.

Now for the good news: If a stable value fund breaks, the total loss is likely to be small, like that of a busted money market fund. The one exception would be if a stable value fund manager tried to meet withdrawals while facing a run on the fund, and ratio of the market value of the assets to the book value of the assets kept falling.

In such an event, better for the fund manager to stop withdrawals early and announce a new NAV that counts in the loss.

I don’t know of any stable value funds that are in trouble, so take this with a grain of salt. Most stable value funds are managed conservatively, so any testing will likely reveal that most of them are fine. There may be a few that aren’t fine, though, so a little testing is in order.

If you do find a need to move, money market and high quality bond funds are an excellent substitute for stable value funds. Be aware that you might have to leave funds in a non-competing fund option for 90 days to get there. In this market, the risks there could be as great as the losses on the stable value fund, so think out the full decision before making any change.

Position: none

That was my post at RealMoney today.? I wrote it with some degree of uncertainty, because stable value funds have a defense mechanism.? They can lower the crediting rate to amortize away the difference between book value and market value, and in a crisis, many will not argue with the credited rate reductions.? They are just happy to preserve capital.

Do I think this is a big problem?? No.? Do I think that no one is talking about this?? Yes.? The thing is, a lot of things can be hidden by the various wrap agreements that stable value funds employ.? If I were a stable value fund, I would not want to publish my market value to book value ratio.? If it’s above one, the fund will attract inflows, diluting existing investors.? If it’s below one, net outflows will increase, threatening a run on the fund.

Just be aware here, because if you can’t get a feel for the underlying economics of your stable value fund, you should probably seek another investment in the present environment.

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