Category: Portfolio Management

Musings on the Fed and Yesterday’s Article

Musings on the Fed and Yesterday’s Article

Posted on by David Merkel

From Tuesday’s Columnist Conversation over at RealMoney.com:


 David Merkel
Thinking About the Fed
11/20/2007 1:51 PM EST

One of my maxims of the Fed is that it is better to watch what they do, and pay less attention to what they say. The markets are saying that they expect Fed funds at 3% sometime in 2008. The Fed governors see that also, and are being dragged there, kicking and screaming. They don’t want to do it; there is real risk to the US Dollar, and there are inflation risks as well. As they measure it, the economy is growing adequately, and labor employment is fairly full. But as Cramer and others point out, the financial system is under stress, manifesting most sharply in mortgage lenders and insurers. Secondary stress is in the investment banks and financial guarantors.

But what exactly has the Fed done so far? Most of the monetary easing has not come through growth in the monetary base, but from continued relaxation of reserve requirements. Given that the Fed is loosening, I would have expected a permanent injection of liquidity by now. As it is, the last one was May 3rd, when there was no hint of the loosenings coming.

So what then for future FOMC policy? The banks are increasingly incapable of levering up more. The monetary base will have to grow. With the Treasury-Eurodollar spread at over 170 basis points, the big banks don’t trust each other. Again, this measure points to 3.00-3.25% Fed funds sometime in 2008.

I see them getting dragged to cuts, kicking and screaming, until a combination of inflation and the dollar force them to change. Then the real fun begins.

Fed minutes out soon. Watch them make a fool out of me.

Okay, the FOMC minutes did not make a fool out of me.? Neither did the market action.? I’m in the weird spot of thinking that nominal economic activity is higher than expected, on both an inflation and real GDP basis.? I don’t like the mortgage and depositary financial sectors at present, two areas that are dear to the FOMC.? That’s where I stand.

One reader asked, what do you mean by, “Then the real fun begins.”?? Maybe I have to do a book review on James Grant’s, “The Trouble with Prosperity.”? James Grant is very often correct, but usually way too early, which is why it is hard to make money off of his insights.? The “real fun” is watching FOMC policymakers squirm as they balance off costs of inflation and economic growth on the negative side, as it was in the late 70s and early 80s.? It is also the fun of watching policymakers at the Treasury Department squirm as they realize that the the fiscal wind is in their face and not at their backs anymore, as the demographic winds spin 180 degrees.

Other readers e-mailed, asking the practical question of how to invest in such an environment.? First, don’t overdo it.? Invest for a normal market scenario, and then tweak it to add more short bonds, TIPS, Commodities, Foreign bonds, and stocks with good inflation pass-through.

I got a few questions asking me to justify my bearish view on the US Dollar.? On, a purchasing power parity basis, the US Dollar is fairly valued now.? (What goods can the Dollar buy versus other currencies?) Unfortunately, currencies react more to forward covered interest parity in the short run. (What will I be able to earn by investing my money in dollar denominated debt, instead of another currency?)? Low intermediate term interest rates in the US portend bad returns from investing in US Dollar denominated debt, so the US Dollar declines.? The rest of the world seems to be bracing for more inflation and more growth.? Because US policy is headed the other way, the US Dollar is weakening.

As for my longer-run negative view on US Bonds, US government policies are designed to undermine bonds.? They have made more future promises than they can keep.? Who will they renege on their promises?? Bond investors are the easiest target; they don’t vote in large numbers.? It will be harder to turn their backs to those receiving social insurance payments, at least in nominal terms.? They have a lot of votes.

That’s all for now.? More tomorrow.

Book Review: What Works on Wall Street

Book Review: What Works on Wall Street

Posted on by David Merkel

This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

  1. Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
  2. Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
  3. Value and Momentum both work as strategies. They work best together.
  4. He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

  1. Low P/B
  2. Low P/E
  3. Net Insider Buying
  4. Significant Declines in the Stock Price (anti-momentum)
  5. Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.

Book Review: The Intelligent Investor

Book Review: The Intelligent Investor

Posted on by David Merkel

Fifteen years ago, my mom gave me a book that would change my life: The Intelligent Investor, by Benjamin Graham. Prior to that time, I was primarily investing in mutual funds, and did not have a coherent investment philosophy. The Intelligent Investor provided me with that philosophy.

What are the main lessons of this book?

  1. Don’t overinvest in equities. Markets wash out occasionally, and it’s good to have some bonds around.
  2. Don’t underinvest in equities. Bonds can only do so much for you, and it is good to deploy capital into equities when they are out of favor.
  3. Stocks provide modest compensation against inflation risks.
  4. Avoid callable bonds. Avoid preferred stocks.
  5. Be conservative in bond investing. Read the prospectus carefully. Often a bond is less safe than one would expect, and occasionally, it offers more value than one would expect.
  6. Purchase bargain issues on a net asset value basis when you can find them, but be careful of quality issues.
  7. Volatility of stock prices can be your friend if you understand the underlying value of a well-financed corporation.
  8. Having a longer-term investment horizon is valuable, because one can take advantage of short-term fluctuations in price.
  9. Growth is worth paying up for, but be disciplined. Don’t overpay.
  10. Be wary of mutual funds.
  11. Be wary of experts.
  12. Pay attention to the balance sheet; don’t invest in companies that are inadequately financed.
  13. Review average earnings of cyclical companies.
  14. Buy them safe and cheap. Don’t overpay for growth and trendiness.
  15. Avoid highly acquisitive companies.
  16. Watch cash flow, and question unusual accounting treatments.
  17. Be careful with unseasoned (new) companies.
  18. Strong dividend policies, in companies that can support the dividends, are an indicator of value.
  19. Aim for a margin of safety in all investing.

That’s my quick synopsis of the book. Though I am not a strict Graham-and-Dodd investor (who is?), I apply the basic principles to most of what I do. This is still a relevant book today because the principles are timeless. If you want the updated version with writing from Jason Zweig, that’s fine. You gain in current relevance, and lose a little in nuance. Graham was a very bright guy. I give Zweig credit for trying, but aside from Buffett or Munger, who would really be adequate to revise The Intelligent Investor? I don’t think I would be adequate to the task….
Classic:

As Revised by Jason Zweig:

Fighting Illiquidity in my Nonsponsored ADRs

Fighting Illiquidity in my Nonsponsored ADRs

Posted on by David Merkel

I own three nonsponsored ADRs, and the liquidity of them is relatively poor: Royal Bank of Scotland [RBSPF], Dorel Industries, and Lafarge SA.? I have an opportunity now to improve the liquidity of Royal Bank of Scotland now.? They have recently created a sponsored ADR [ticker RBS].? I wrote Investor Relations at RBS to see if I could exchange my nonsponsored ADR shares for the new sponsored shares.? This is what they wrote back:

Dear Mr Merkel,

Thank you for your email regarding your RBS shareholding.

In order to convert your RBSPF ADRs your broker will need to contact our US depositary and paying agent, the Bank of New York who can transfer your shares to their CREST account and issue you with new ADRs. Contact details for the Bank of New York conversion desk are as follows:

Jaswinder Goraya or Rubely Marte – tel no 212 815 4502 / 2724

Your broker will also need to advise the Bank of New York’s Manchester office of the deposit into their CREST account.

Contact details:

Luke Owen or Mike Ashcroft – tel no. 0161 725 3433 / 3438

Please note that Stamp Duty Tax will need to be paid on each share as well as an ADR conversion fee. With the US share price currently at US$9.24 the conversion fee would be 4 cents per ADR (Please see attached Standard Fee schedule).

If you require further information please do not hesitate to contact me.

So, I contacted Fidelity, and we are doing this.? One down, two to go.? Perhaps my next move is to contact Dorel Industries and see if I can exchange my illiquid ADRs for shares that trade in Toronto.

Full disclosure: long RBSPF, DIIB, and LFRGY (pink sheets all)

Value Investing is Dull

Value Investing is Dull

Posted on by David Merkel

In The Art of War, Sun Tzu makes a great deal out of concealing one’s intentions, even to the point of making it look like you are dumb.? Value investing has elements of that, though we are not trying to deceive anyone.

Most investors fall for the idea that rapidly growing companies will produce greater returns.? Sadly, that’s not true most of the time, because investors usually overpay for growth.? That leaves investors like me puttering over companies that have grown slowly and have modest valuations.? They are in boring industries: cement, insurance, shoe retailing, etc.

This is a major reason that I like value investing.? It doesn’t appeal to most people.? Buying exciting companies with great stories is a lot more fun than buying slow-growing companies at modest multiples of earnings.? Sad, but the growth investor will earn less over the long haul.

My way of managing money will go out of favor someday.? That’s the nature of money management, though for the last seven years I have been immune to troubles.? I keep applying my strategy, because over the long run it will out perform indexes.? Courage is most needed, and least available, during the bear phase.

Gone for Two Days

Gone for Two Days

Posted on by David Merkel

Sorry, but off on church business for two days.? As a parting shot, this is what I wrote on RealMoney yesterday:

 
 

David Merkel
What Do You Say When You Are Wrong?
11/8/2007 5:34 PM EST

Well, I say I was wrong, then. Wrong about National Atlantic. Ordinarily, reserving at short-tail insurers is hard to mess up, because the claim cash flows quickly reveal mistakes. This is one of the exceptions to the rule.I hate losing money; the only thing I hate more is losing money for others. My sympathies to anyone who has lost along with me. I am still playing on this one, because the company is valued as if it will never make money again, and my opinion is that they will make money again, or, there might be M&A activity.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic 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: still long NAHC, longer even


 David Merkel
How Do You Minimize The Costs Of Being Wrong?
11/8/2007 6:40 PM EST

You diversify. Even with National Atlantic, my portfolio was even with the market today. Though it was my largest position, it was still only one of my positions, at less than 5% of the portfolio. Diversification is underrated, and we neglect it to our peril.Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic 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 NAHC

Holding My Nose, Still

Holding My Nose, Still

Posted on by David Merkel

Three companies of mine reported after the bell, Flagstone, Deerfield, and National Atlantic. I’ll take them in that order.

Flagstone beat handily, as I would have expected a property-centric reinsurer to do in this environment. Let’s see what optimism tomorrow brings. At 96-97% of book value, it seems cheap, but I can’t imagine property reinsurance rates will be that robust next year.

Deerfield is a little more tricky. They took a loss due to mark-to-market events in their portfolio. REIT taxable income is reasonable at 50 cents/share, and much of the writedown is a GAAP anomaly that shaves $1.20 off of the current book value. Economic book value is $11.84, which provides some support to the stock. The dividend of 42 cents is still intact. There is reasonable excess liquidity, even after the increase in repo margins during the third quarter. Let’s see what the market thinks.

Now for the problem child, National Atlantic, which takes an 83 cent loss. Here’s the main offending paragraph from the press release:

“For the three months and nine months ended September 30, 2007, reserves have increased by $17.6 million and $9.4 million, respectively, principally as a result of the strengthening of the reserves for bodily injury claims. During the third quarter it was determined that the Company’s policy related to claims handling procedures and reserving practices were not applied consistently, primarily within the bodily injury claims unit. As part of the resolution of this matter, the Company retained an independent claims consulting firm.”

For a company the size of National Atlantic, these are huge reserve changes, particularly for a short-tail line like auto. What I am about to write here is only a guess, but this likely was building up since sometime in 2006. One of the reasons I am willing to be a little more bullish on short-tail insurers is that it is a lot harder to get the reserve wrong. Looks like I am getting one of the rare events that teaches greater caution. (That said, my average cost is $8.85, so I’m not that badly hurt.) Given the large reserve change this period, ordinarily, the decks are cleared for future periods, but who can tell for sure? Also, this places the combined ratio since 2002 at 103.7%. It makes me think that the company will do well to eke out any underwriting profit.

I’ll be listening to the call tomorrow. What’s the endgame here? Given the marginal ability to earn underwriting profits, perhaps the company would best be reconciled by merging with another firm. That wasn’t my opinion over the past three years, but it is my opinion now. There are many firms that could have an interest at the right price, which probably approximates the book value of $13.28. That said, many of them may have kicked the tires already and passed, some probably thinking that a bid at book value would not be honored. All I can say is, give it a shot. Rumor is that Commerce wasn’t offering more than book, so if you want a greater presence in NJ personal lines, it may be available at a reasonable price.

Full disclosure: long FSR DFR NAHC

Buying Cheap and Holding My Nose

Buying Cheap and Holding My Nose

Posted on by David Merkel

How comfortable would you be buying National Atlantic Holdings?

Or Deerfield Triarc?


Or YRC Worldwide?

I could go on, after all, recently I bought some Redwood Trust, and a number of smaller cap value names that don’t seem to be getting much respect right now. Value as a strategy is lagging now, and I am feeling that in my performance. Financials that deal with mortgages are out of favor also.
So why mortgage REITs now? Take a look at this chart of the 10-year Treasury yield less that on mortgage REITs:

Mortgage REIT yield spread
Yields are pretty high relative to “safe” Treasuries, comparable with 1990 and mid-2002 spreads. Only the bad old days of 1974 surpass the yield spreads of this era by a significant amount. As I recall, REITs had a really bad name in the late 1970s after the mid-decade shellacking. I remember technical terms like “fraud,” but then, I was an impressionable teenager with an active imagination. 🙂

Now consider this chart of the 10-year Treasury yield less that on equity REITs:

Equity REIT Yield Spread

The result is closer to fair value. I certainly would not call equity REITs as a group cheap; future returns rely on property price appreciation, which doesn’t seem likely to me at present.
Now, I’m not endorsing all mortgage REITs. Review funding structures and excess liquidity; you want excess cash flow and conservatism at this point. Heroics offer more downside than upside here.

As for YRC Worldwide, trucking is needed in our economy, and even with some slowdown, YRC should still make money, just not as much. On National Atlantic, I would only say that it seems that there is a forced seller in the name now, and when he is exhausted, the stock will lift. It is difficult to destroy a personal lines insurer with a conservative balance sheet. At 60% of a conservative book value, I can live with adverse outcomes.

Remember, do you own due diligence here. Just because it looks cheap does not mean it can’t get cheaper.

Full disclosure: long RWT NAHC DFR YRCW

The Problems of Ruin, Near-Ruin, and Decay

The Problems of Ruin, Near-Ruin, and Decay

Posted on by David Merkel

Many investors, both institutional and individual, take too much risk. Taking too much risk can take a number of forms:

  • Buying companies with weak balance sheets.
  • Buying companies with high valuations.
  • Inadequate diversification, whether by number of companies, number of industries, or some risk factor like buying only high-yielding stocks.
  • And more…

There are three ways that problems can manifest themselves.? The first way is ruin.? An investor is so certain of himself that he uses a large amount of leverage to express his position.? When the bet goes wrong, he loses it all; he is ruined.? The second manifestation is near-ruin.? As ruin is threatening, the investor sells everything to preserve some of his assets, often near the local bottom for that set of assets.

The third manifestation is decay.? In this case the investor says, I will never take losses greater than x% of my position.? Nice intention, but it raises the spectre of the death by a thousand cuts.? Many assets fall before a significant rise; why get stopped out?? Instead, use falls in price to re-evaluate positions, and consider adding if the original thesis is still valid.

To be a little more controversial here, I don’t trust the bold claims of most technicians who place stops on their positions, and claim to have good performance.? Once one places stop orders, the probability rises for multiple small losses that exceed the few larger gains in the portfolio.? Call me a skeptic, but I would rather re-evaluate my positions than automatically sell, which seems to me to be a recipe for decay.

For My Canadian Readers

For My Canadian Readers

Posted on by David Merkel

If you are looking for more of me to read, pick up a copy of the November 2007 MoneySense magazine for my article “Nerve Medicine.”? It describes five points on risk control for individual investors.? Thanks to MoneySense for publishing my article.? The magazine costs only C$5.50 at the newsstand.? That’s about $6.00 US, right? 😉

As an aside, to editors of publications that peruse my blog, I am available for other writing assignments.? I enjoyed writing a longer article for a retail audience, and would accept the challenge again.? E-mail me if you have interest.

Theme: Overlay by Kaira.