I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

P&C Insurers and Reinsurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.  Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.  Would I increase the overweight here?  Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.  Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.

This is two books in one, and very well done.  The main part of the book explains risk and uncertainty in general terms, such that most people can understand it.  But for those that can deal with complex math, the latter part of the book offers a lot of additional firepower.

Risk is a tough subject because history only vaguely informs you as to how bad things can get.  Past is not prologue.  There are two possibilities, the past contains and event that was so horrible that it can never happen again, or, the past does not tell you how bad things can be.

Market observers took the first view, that the Great Depression could not repeat.  As a result, few prepared for a situation where there was too much debt, and insufficient ability to service it.

The subtitle of the book is rightly “Uncertainty at the Core of Finance.” Not risk, but uncertainty.  The distinct is important, because risks are things that we know some things about the possible economic outcomes, and can control them to a degree.  Uncertainty is where we don’t really understand the dimensions of the outcomes, and have little if any control.

There is fundamental uncertainty to the simplest aspect of finance, money.  Money seems stable enough in the short-run, but every now and then it fails due to hyperinflation, or the slow steady failure in the store of value sense of moderate inflation over long periods.

Wealth itself is uncertain.  Even if you own it free and clear, there’s no way to tell what it will be exchangeable for next year, much less further out.  There are a lot of people who thought they knew what their homes were worth 5-7 years ago that are decidedly disappointed.

Government debt is uncertain, as governments think they can always roll it over, but political and other obstacles can lead to a refusal to pay when debt service becomes high relative to tax revenues.

Banking is uncertain, mainly because of borrowing short to lend long.  If banks limited themselves to facilitating transactions, a lot of the uncertainty would go away.  Banks would be a lot smaller, less profitable, and there would be fewer of them, and the economy would be more stable.  (Entities with longer liability structures, like pension plans, endowments, and life insurers would become the new source of lending. More would be financed through equity.)

Credit is uncertain.  During boom times, corporate bonds behave independently, and diversification evens out results.  As a result, corporate credit seems safer than it really is, and marginal ideas get to borrow.  During bust times, far more corporate debt defaults than would be expected — there’s almost no such thing as an average year.  It’s either feast or famine.

There are things that can be done to try to mitigate uncertainty: credit ratings, or any scoring system for assets, lending at a more senior level, and Value-at-Risk.  Also using more robust assumptions on possible outcomes, which would lead to smaller position sizes, less leverage, or more cash.

The book has a real strength in showing how the the assumption of normally-distributed risks fails dramatically in many cases, and offers alternatives that would work better.  Trouble is, once you realize how volatile the world really is, a lot of strategies either don’t work, or need to be scaled back.

The book praises actuaries as risk managers, with their ethic codes and stress tests, as opposed to quants with Value-at-Risk and no ethics code.  Banks and Wall Street would be better off in the long run hiring actuaries, who think about risk more holistically, and getting rid of the quants in their risk control departments.  Same for the regulators who evaluate banks.

There are other controversial ideas here: is it possible that the strong economic growth of the past is an anomaly?  Is it possible that growth for nations, and the world as a whole follows S-curves, like products and companies?

This is an ambitious book, and I like it a lot because it is willing to cross boundaries and apply the principles in one  area to another that seemingly should not receive it.  I liked it a lot, and would recommend it to many.

Quibbles

On page 17, he thinks of currency as a put option, but I think of it as 0% overnight commercial paper.  On page 37, he confuses Moses and Joseph, having Moses predict the 7 good followed by 7 bad years, when it was Joseph who did that.

Who would benefit from this book: Every financial regulator should have this book.  Every academic burdened by the lies of Modern Portfolio Theory should get this book.  Anyone who fancies himself to be a risk manager should have this book.  Finally, if you want to understand why financial markets are inherently uncertain, this book will teach you well.  If you want to, you can buy it here: Pandora’s Risk: Uncertainty at the Core of Finance (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

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

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

This period of the Aleph Blog covers May through July of 2010.  The one big series that I started in that era was “The Education of a Corporate Bond Manager” series.  The idea was to describe how a neophyte was thrust into an unusual position and thrived, after some difficulties.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

Then there was the continuation of “The Rules” series:

The Rules, Part XIII, subpart A

On the biases the come from yield-seeking.

The Rules, Part XIII, subpart B

Repeat after me, “Yield is not free.”

The Rules, Part XIII, subpart C

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.  It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

The Rules, Part XV

Securitization segments a security into liquid and illiquid components.

The Rules, Part XVI

“Governments are smaller than markets; markets are smaller than cultures.“

A fundamental rule of mine, but one with a lot of punch.

The Rules, Part XVII

On the differences between panics and booms.

The Journal of Failed Finance Research

Much research fails quietly, but other researchers don’t learn about the dead ends.  Better that they should learn of the failures, and avoid the dead ends.

How I Minimize Taxes on my Stock Investing

Sell low tax cost lots and donate appreciated stock to charities.

Place Political Limits on Overly Compliant Central Banks

Gives a simple rule to control central banks so that they avoid the present troubles.

Yield, the Oldest Scam in the Books

Yes, offering yield is the oldest way to trick people into handing over their money.

A Summary of my Writings on Analyzing Insurance Stocks

A good place to get started if one wants to get up to speed on insurance stocks, but there is a lot there.

Economics is Hard; the Bad Assumptions of Economists Makes it Harder

Going over Kartik Athreya’s letter criticizing nonprofessional economics bloggers.  Why the math behind macroeconomics and microeconomics doesn’t work.

Why Are We The Lucky Ones?

When you are a part of a small broker-dealer, all manner of harebrained deals get offered to you.  This explores three of them.  Note: management did not ask my opinion on the fourth deal, and that is a large part of why they no longer exist.

One more note: the guy who was going to pledge $5 million of stock in example 2 for a $1 million loan?  The stock is worth $7,000 today.

Watch the State of the States

The economics of the states tells us a lot more about the national health because they can’t print money to buy national debts.  (Though they can can raid accrual accounts…)

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

My view is that neoclassical economists are wrong.  Aggregate demand has failed for four reasons:

1. Overleveraged consumers will not readily buy.
2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
3. Aggregate demand is mean-reverting.  It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.  The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
4. When the financial system is in trouble, people get skittish.

The Market Goes to the Dogs, Which Chase Their Tail Risk

Complex and expensive hedging solutions, many of which embed some credit risk, can be less effective than lowering leverage, and (horrors) holding some cash.

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

This one had its detractors, because I believe the paradox of thrift is wrong.  Too much aggregation, and it does not allow the dynamism of the economy to adjust over time, even from severe conditions.

I’ve had this idea for 15 years or so, but forgot about it until I sat down and talked with a friend who worked for a dysfunctional company that recently let him go.  My experience working in corporate America is that the best and most effective firms listen to their employees, and set up some means of obtaining their opinions on how the business could be improved.  Bad firms have managements that think that know it all, and the rank and file must merely execute what they imagine will work.

In all of the time that I worked in the insurance industry, or served on the boards nonprofit organizations, I have yet to have seen a situation where a consultant needed to be hired to solve a problem.  The middle management of the firms in question knew what the answer was, but senior management was either fighting with itself, or weak-minded.

I remember one situation where the Chief Investment Officer and the Chief Financial Officer hated each others guts, and could rarely agree.  The only way to solve a particular problem was to hire a consultant, who would neutrally give them an answer that they both would heed.

I was running a small line of business in the company, and the consultant approached me for data, which I gave him, but I asked my boss about the situation.  He told me that the company was spending roughly 7% of that year’s income to analyze the investment policy of the firm, particularly with respect to the liabilities of the firm.  I said to my boss, “If you gave me 3 months, I could solve this project on my own, and the cost would be 3% of what the consultant charges.”  He laughed and told me about the fighting above us, that led to the costs.

As it was, the consultant gave advice that was less detailed than I would have given, but was valuable, though embarrassing to the insurance company — they were invested two years shorter than they should be.  There a free lunch to pick up income and reduce risk.  You could go three years longer if you wanted to optimize risk.

Lovely, but if management had just asked its line of business actuaries to answer the questions it all could been solved for a small fraction of the cost, and with more precision.  Also, though no one talked about it at the time, it really showed that senior management really did not understand the core business, which was earning a spread over liabilities adjusted for risk.

I have another experience working with a non-profit where the executive was weak, and would never hire anyone more talented than himself.  As a board member, I was always shocked with how badly the place was run, but the board members suffered from the same disease; few were competent.  Management liked having incompetent board members.  Worse, the incompetent board members did not like anyone suggesting that there was a better way to do things, which is why I eventually left.

This management team hired consultant after consultant on things that I felt were answerable from resources within.  But being weak-minded, they did not trust their middle management to answer basic questions.  A lot of money was wasted in the process, which was particularly painful, because the non-profit did not have a lot of resources to spare.

Do You Really Need a Consultant?

There are cases where hiring a consultant is needed, but the first question should be whether those who work for the firm, particularly middle-management might be able to do a better job with it for less cost.  Going back to the first firm mentioned, I was hired by a division of the firm to provide exactly that expertise.

Even if employees are a little short of the expertise needed, giving the project to them will develop the expertise internally to deal with the question at hand and handle greater questions later.  More, it will improve morale, as employees deal with difficult problems and triumph over them.  If you want to read about one vignette in dealing with this, you can read it here.  It made me choke up as I re-read it, because it was such an amazing transformation/comeback that no one expected.

But the first priority of people management in a firm should be hiring bright people and set them free to act.  There was one firm I worked for where this was actually done, where the man in charge hired people, all of whom were brighter than him.  I was one of them, and I did not realize at the time that he had hired me to be his #2.  Small organization, informal, yeh.

He wasn’t always easy to deal with, and on a number of occasions people in our unit would come to me near the end of the day, and say “can we talk?”  When I learned the topic, I would say, “Close the door.”  Then I would listen to their grievances.

I responded to them, “Look, our boss is imperfect, but he means well, work with him.  He was courageous enough to hire people brighter than himself, which few will do.  Reason will win out here, and I will help the process along, but be sweet reason incarnate, try to convince, don’t gripe.”

And as it was, all such situations were resolved, and we produced a far better firm, with good results to the client, and good morale.  (And I quietly led useful change, which was the way I did things in my younger days.)

A New Business

So, if you as a management team think that you need a consultant to solve your problems, e-mail me.  For a nominal fee, I will ask you whether you have set up a culture with bright people who can solve problems, and whether they have tried to solve your problems.  If you have tried that, and your team can’t do it, yes, a consultant is warranted, otherwise not.  But it also means that you have hired wrong.  Get some talent in your door that can solve tough problems.

In essence, I would be a consultant telling you not to hire consultants, and to build up the talent base of your organization, such that you would never need me, or anyone more expensive than me again.  I would be a very cheap way of improving your organization.

Denouement

But what happened to the group where I became the #2?

Well, I briefly became #1 when the boss left prior to a merger.  We merged into a larger organization that didn’t really get how insurance assets should be run.  As it was, they lost the mandate, long after I was gone.

The rump of the organization now has a five star rating from Morningstar for high-yield bond management, and is happily managing assets in Charm City (Baltimore), while the immediate parent company (that they were sold to) is in NYC.

Oh, the boss who left?  He eventually found work  managing bonds near DC.  A good guy, if a little irascible. He is still a friend.  In fact, all the people I mentioned are still friends, because I don’t make permanent enemies.  I just try to promote what is best for all.

Yesterday I was a judge (one of five) for the Washington/Baltimore Investment Research Challenge.  Five teams from local colleges participated to analyze a prominent local company, Under Armour.  (My kids love the stuff, I hate to pay the price.)

I have to say that I admire all of the young men and women who presented to us.  It takes a lot of guts to present to people 30 years older then you.  The experience differential is considerable.

One practical difference is that the students apply many methods from Modern Portfolio Theory that are roundly ignored by most investment managers.  Few investment managers apply Discounted Cash Flows [DCF], because it is too flexible, with too many parameters that are hard to calculate.  Some apply reverse DCF, attempting to estimate the rate of return of companies at their current price… same problems exist, though the comparability of results is simpler.

My advice to future contestants would be to spend more time on qualitative issues, and less on quantitative.  Regarding quantitative issues, I would encourage abandoning DCF in favor of simpler valuation methodologies.

Also, I would discourage using regression unless you really understand what it means.  It’s easy to teach people to use advanced statistical methods, but tough to teach them the limitations of where the methods get abused, or don’t work.  As I have often said, I rarely see advanced statistics used properly by Wall Street, and yesterday was no exception.

But all that said, there are a lot of bright people entering the talent pool for investing; for investment firms in a given region, going to an event like this could be a good recruiting tool.

PS — make sure you understand the liability structure in full, also…

I often look through 13F filings to get investment ideas.  The last time I did it, one of my readers asked a question like this:

It’s nice to see how large the positions are of the investors that you track, but wouldn’t it be better to track the changes in positions?  After all, new allocations are more indicative of better value than older holdings.

That’s probably correct, though for my own investing it might not be as accurate, because I rank current positions against challengers – my current positions have to justify their existence to stay in the portfolio.

But I thought it would be worth trying to do that, and also do it as a percentage of each stock’s market capitalization.

Now, there are difficulties in doing an analysis like this:

• CUSIP changes
• M&A (takeovers, spinoffs
• CUSIP formats (some managers make it difficult to read)
• Deliberately difficult formatting
• One firm fills out the from wrong, swapping fields
• Multiple holders within a given firm
• You have to create a CUSIP/ticker database (paid my 13-year old assistant $50 to do that.)
• In short, a lot of data scrubbing.

Now the results of looking at 13Fs can be valuable, and there is a small cottage industry doing so.  Mebane Faber has done good work with this, as has Insider Monkey, Manual of Ideas and Street of Walls.  Following the ideas of some of the best investors leads to better returns, even if there is a lag involved.

And the lag doesn’t matter much.  Most of these investors invest for years not months, so if you get a signal it should be valid for some time after it is received.

Anyway, I calculated the positions for 74 investors that I have some respect for (listed at the bottom).  My objective is to look at them as a group.  For the most part, I don’t care which of them is investing in a given company.

Following this are a variety of tables with some commentary on what might be going on.  I think you might find some valuable ideas in the companies where  there are large additions or holdings as a proportion of market capitalization.

Tables

Stocks with the most new investors:

Stocks that had the most investors increase positions (including new owners):

Stocks that have the most owners at the end of the fourth quarter:

Stocks with the most selling out entirely (including M&A-related):

Stocks with the most decreases in positions (including selling out in entire):

With a few exceptions, the above reads like lists of common large cap stocks, with a few midcaps thrown in.  It doesn’t look that much different when the lists are done by dollar amount of change.  But what if we do this as a fraction of market capitalization?

(Please note, the 13F filings measure as of 12/31/2011, and my market caps are from mid-February.  That induces some distortion, but I don’t think that much.  Also note that large holdings as aproportion of market cap often come from one hedge fund and not necessarily many.

Here is a list of new purchases, in declining order of percentage of market capitalization:

Here is a list of position increases, including new purchases, in declining order of percentage of market capitalization:

Here is a list of position decreases, including total sales, in declining order of percentage of market capitalization:

Here is a list of positions sold out in entire, in declining order of percentage of market capitalization:

Holdings by Total Dollar Amount at the end of the Fourth Quarter

And the greatest holdings by percentage of market capitalization:

I appreciate the analysis as a portion of market capitalization, because it reflects the limitations of what managers can do.  Again, I will look most closely at current holdings and additions as a proportion of market capitalization.

Investor list:

• Akre
• Altai
• Ancient Art
• Appaloosa
• Atlantic
• Bares
• Baupost
• Blue Ridge
• BP Capital (Pickens)
• Brave Warrior
• Breeden
• BRK
• Capital Growth
• Centaur
• Centerbridge
• Chou
• Coatue
• Dodge & Cox
• Dreman
• Eagle Capital
• Eagle Value
• Edinburgh
• Fairfax
• Farallon
• Fiduciary
• Force
• FPA
• Gates
• Glenview
• GoldenTree
• Greenhaven
• Greenlight
• H Partners
• Harbinger
• Hawkshaw
• Hayman
• Hound
• Hovde
• Icahn
• Invesco Private
• Jana
• Jensen
• Joho
• Lane Five
• Leucadia
• Lone Pine
• M3F
• Markel
• Matrix
• Maverick
• MHR
• Montag
• MSD
• Muhlenkamp
• PabraI
• Parnassus
• Passport
• Paulson
• Pennant
• Perry
• Pershing Square
• Sageview
• Scout
• Soros
• Southeastern
• Third Point
• Tiger Global
• Tweedy Browne
• ValueAct
• Viking
• Weitz
• West Coast
• Wintergreen
• Yacktman

Full disclosure: Long WMT, ORCL, INTC, VOD, HPQ, COP, Short SPY

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

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

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

Third, health insurers face an uncertain future.  Obamacare may disappear, or Obamacare could slowly eliminate insurers.  It’s a mess.

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

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

Offshore

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

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

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

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

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

The fit is fairly tight, and indicates mostly logical valuations for this group.  The companies that are possibly overvalued are: Arch Capital [ACGL] and Global Indemnity [GBLI]. Possibly undervalued: Everest Re [RE] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.  Arch Capital may be that.  But with an expected ROE of less than 10%, it is hard to justify their valuation, when the average stock in this group needs an expected 13% ROE to be valued at book.

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

Life

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

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

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

A very tight fit.  The insurers that are undervalued are equity-sensitive ones: Phoenix Companies [PNX], American Equity Investment {AEL] , Lincoln National [LNC], and ING [ING].  Those that are overvalued are FBL Financial [FFG], and CNO Financial [CNO].  CNO has issues from long-term care, a coverage I dislike a great deal.  FBL is worth exploring.

One more note: to get book value in Life Insurance, you need an 11.7% ROE on average.  That’s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

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

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

Potential underperformers include Hallmark Financial Services [HALL], Hilltop Holdings [HTH], Eastern Insurance Holdings [EIHI], Old Republic International [ORI], and Erie Indemnity [ERIE].  Below the line: Hartford Financial Services [HIG], Allstate [ALL], Tower Group [TWGP], and Horace Mann [HMN].

Because of the lower risk in P&C insurers, a firm only needs to earn an ROE of 6.6% to have a book value valuation.

Health

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

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

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

It’s a pretty good fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and CIGNA [CI].  And the following overvalued:  Molina Healthcare [MOH] and Wellcare Health Plans [WCG].

I don’t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.  I include it for completeness, because I think the PB-ROE concept has value in insurance.  One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 7.8%.

Other Insurers and Insurance-Related Companies

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

Pretty tight for a non-group.  Perhaps it is because it derives off of a much larger group, some of which has died off, leaving behind profitable entities.

As it is the potential outperformers include  Assured Guaranty [AGO], the largest remaining financial guaranty insurer, Fortegra Financial Corporation [FRF] a third party administrator of sorts, and what remains of the title insurance industry, Fidelity National [FNF], First American [FAF], and Stewart Title [STC].  That is one beaten-down group, and, one that would benefit a lot if housing bounced back.  There is a lot of potential earnings power there, and it trades for little above book value.

Potential underperformers include AJ Gallagher [AJG] and E-Health [EHTH].  I’ve dealt with AJ Gallagher professionally, and have respect for their management team, but maybe the valuation is stretched there.  E-Health is a health insurance broker, and over its existence hasn’t done anything deserving of a premium valuation.

And, for this non-group, it is riskless enough that you only need a 4% ROE to have a book value valuation.  This is one beaten-down sector of the market, and one that I do not own any of, but that I will eventually return to, because I have owned I in the past.  Should residential real estate finally normalize, many of these companies will fly.

I write this as one that was bearish on housing-related stocks since 2005.  There is potential here.

Summary

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

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

Full disclosure: long ENH, but I may take other positions for clients in the next month

Finance Business

• Breaking Ranks: Former Broker Turns Bomb Thrower http://t.co/q1vpz9dh @reformedbroker interview previews his book: http://t.co/Yigg2sEE $$ Feb 24, 2012
• Why CLO managers continue to struggle http://t.co/a13j8jVG Low issuance, warehousing is tough, need more subordination, fewer senior buyers Feb 24, 2012
• My Favorite Quote from Baupost’s 2011 Annual Letter http://t.co/VOvbqab3 DIstressed bond mgrs get itchy in bull phase & buy new junk @ par Feb 24, 2012
• SEC IFRS Plan Endorsement http://t.co/8xguvs2G IFRS is not worth giving up comparability or sovereignty for. Project is a total loser. $$ Feb 24, 2012
• Very cool, congrats RT @Finovate: @AlphaClone to offer Alternative Alpha ETF from U.S. Bancorp http://t.co/srufb3qd Feb 23, 2012
• SEC May Ticket Speeding Traders http://t.co/oNCbF7pa Worthy of an experiment like the kind they did to study the “uptick rule” $$ Feb 23, 2012
• AQR’s Aaron Brown on Red-Blooded Risk http://t.co/ZM7hn5P4 When I was a bond mgr, could sense some aspects of risk listening 2 broker’s tone Feb 23, 2012
• The Volcker Rule is not going to bring your house back http://t.co/ADKMABfE Prop trading was not a leading cause of the financial crisis. $$ Feb 23, 2012
• Pimco Said to Quit Mortgage Bond Group http://t.co/YsQZs1IE Feels wrong parties (their clients) r paying 4 bad servicing,instead of banks Feb 23, 2012
•  If you want, I can dig up an old research piece on analyst coverage — there are basically 3 factors that explain 70… http://t.co/tBinshJJ Feb 21, 2012
• Stressed VAR is still a “protractor in the jungle” http://t.co/GRGgwvsd Risk management sh/not b done w/central measures but stress tests $$ Feb 21, 2012
• How One Company Teaches Employees the ABCs of Finance http://t.co/fqO19foq More companies should do this, they would b more profitable. $$ Feb 18, 2012
• Gross Fund at 66% Premium Shows Pimco Allure in Quest for Yield http://t.co/LY8Rv4SS Yield illusion distracts many investors. Avoid it. $$ Feb 17, 2012
• Read:Which three of DOL’s new 401(k) rules represent the biggest land mines for financial advisors and plan sponsors? http://t.co/ZVoMPmQu Feb 15, 2012
• The 400% Man http://t.co/nrRhYIZl Wish I could meet some of his disappointed investors who came to kick the tires and were disappointed. Feb 15, 2012
• Contra:Foot-Dragging on IFRS Decision Could Strip SEC of Power http://t.co/VNUFhWD5 The US could lose representation on IASB. Good, drop out Feb 14, 2012
• Notes from iGlobal’s Global Distressed Investing Summit: Part 2 http://t.co/9iOty0Iz Leveraged loan market seems to be in decent shape $$ Feb 14, 2012
• Pimco: $25 Billion Foreclosure Deal to Hit Pensions Harder Than Banks http://t.co/DKFtMI9B Gives MBS buyers a reason 2 sue originators $$ Feb 13, 2012
• Missing at MF: $1.6 Billion http://t.co/QSUMYbNO Included for the 1st time is roughly $700 million in client money residing in the UK $$ Feb 13, 2012
• Stockbrokers: A Guide to Private Placement Due Diligence http://t.co/tbwtu6Jy Illiquid investments are ways to cheat average people. $$ Feb 11, 2012
• Why illiquid? Can’t recover the commission otherwise.  Can deceive people that their investment is worth more than it… http://t.co/cYjvUhWx Feb 11, 2012

Market Strategy

• Jim Stack was right, and he’s still bullish http://t.co/GfEqtTKl Basically a forward P/E plus momentum argument, & lack of sharp falls $$ Feb 24, 2012
• S&P 500 Gets 9% Cheaper on Record Profits http://t.co/DWPGz5Y2 Makes a P/E argument; profit mrgns will eventually revert, may take a while Feb 23, 2012
• The dangers of dividend-paying stocks http://t.co/FymTmAAi Hint: they are stocks. No maturity date, no certain cash flow, low BK priority $$ Feb 23, 2012
• Falkenblog: Low Vol Commodity Timing Strategy http://t.co/M4FFRoCx Low volatility seems to work in a large number of areas, this is one $$ Feb 23, 2012
• Retro Investing—Look Back to Get Ahead http://t.co/vYiPCu9J The 50s, w/post-WWII financial repression, recurs as a current investing meme $$ Feb 22, 2012
• The Intelligent Investor: Are Index Funds Messing Up the Markets? http://t.co/VAoFtksw May also be traders following each other $$ Feb 21, 2012
• If history is any indication, high dividend stock outperformance should continue http://t.co/C5GaWmW8 Uses 40s & 50s as analogy $$ Feb 20, 2012
• Breakout or consolidation? http://t.co/GTSkBjIT Many market seem to be at inflection points. Which way will they go? Wildcards: EZone, China Feb 20, 2012
• RE: @alea_ Interesting analysis.  I would be wary of teasing too much out of the cluster analysis of sector correlati… http://t.co/zirdOJ8v Feb 18, 2012
• MORGAN STANLEY: January Exhibited This Tell-Tale Sign Of A Market Top http://t.co/IQqidpUE When everything rises at once, look out! $$ Feb 18, 2012
• Apple Stock May Not Be as Cheap as It Looks http://t.co/2dgfjfPq Earnings quality has declined, and so has the PE multiple $$ Feb 18, 2012
• @ampressman Common summary stat 4 acctg quality 4 $AAPL Net Operating Accruals / Assets, has been deteriorating 4 last 7 years + Feb 18, 2012
• @ampressman $AAPL acctg used to be very conservative, now modestly liberal by that statistic. It’s a bad direction, not a bad position, yet Feb 18, 2012
• Should the Rich Invest Like Colleges? http://t.co/M9OaPEPA Better question: what are your goals? Do you have an infinite horizon? $$ Feb 18, 2012
• High Yield Bonds as Equity Indicator | The Reformed Broker http://t.co/OXUtZrWG Meet my friends & former colleagues Ed Meigs & Sean Slein $$ Feb 17, 2012
• When Earnings Slow, Focus on Big Cap, Quality http://t.co/zjD3RPKA High quality is the place to be at present, credit cycle shifting some $$ Feb 16, 2012
• A Lesser Known Indicator http://t.co/8oivTJFl Cash enters market through IPOs, employee grants, & exits through cash buyouts, buybacks $$ Feb 16, 2012
• Parabolas have 2 end somewhere $$ RT @ReformedBroker: $AAPL sold off because people were getting impatient with how slowly it was moving up. Feb 15, 2012
• FPA Capital’s Bryan Beats Peers Embracing Oil Volatility http://t.co/7ebuGmrb A clever focus on absolute retruns, w/a long horizon $$ Feb 15, 2012
• Paulson Gives Activism a Go http://t.co/dkHb3cht Not as easy as it looks w/ $HIG. Acctg may not fairly capture variable liabilities $$ Feb 15, 2012
• RE: @SoberLook DB hedges its bets.  Average years rarely happen in high yield, they are either good or bad. http://t.co/0C51uulu Feb 14, 2012
• THE 1987 MYTH…. http://t.co/mHSU4nM3 “Illusion of stability within disequilibrium” Very well said, in one short phrase. $$ Feb 14, 2012
• America Inc. Faces Margin Stall http://t.co/RbqvqbT9 US companies have begun to see rising costs eat into the bottom line. Finally. $$ Feb 13, 2012
• Hulbert: Insiders Selling at Heavy Pace http://t.co/qOPk2cbY Just another straw blowing in the wind, but insiders usually have good sense $$ Feb 10, 2012

Greece

• Greek PSI outcomes tree: credit event probability at 93% http://t.co/jcLBc04c Clever grraphic shows high likelihood of Gk CDS triggering. $$ Feb 23, 2012
• The market is now pricing in Greek sovereign CDS trigger http://t.co/w5vJ42Fa Upfront prices for Greek CDS moving up $$ Feb 22, 2012
• Despite Pact, Unease Lingers for Greece http://t.co/Urp7mmag “Many Problems Remain Even Under Best-Case Scenarios” Shrink, shrink… $$ Feb 22, 2012
• Greek Rescue Is Not the End of the Story http://t.co/IOCVcCTb Won’t save Greece on its own & there r other fringe nations 2 deal with $$ Feb 20, 2012
• ECB Greek Plan May Hurt Bondholders While Triggering Debt Swaps http://t.co/Aya9urfV ECB may get better treaqtment than private holders $$ Feb 20, 2012
• So, what would your plan for Greece be? http://t.co/SAd2f28O Play the game, and let Keynes sneer @ u as u attempt 2 solve the impossible $$ Feb 18, 2012
• Greek Economy Shrinking Rapidly http://t.co/VzXi375M And it may shrink more rapidly depending on what the rest of Europe does $$ Feb 14, 2012

Eurozone

• ECB’s Mario Draghi magic corrupts bond markets http://t.co/r0ZCmYpb Banks become dependent on ECB, bank bondholders more subordinated $$ Feb 24, 2012
• European Banks May Tap ECB for $629 Billion Cash http://t.co/Re5TjLR5 “There is a ‘lose-lose’ air around the ECB’s auction next week,” $$ Feb 24, 2012
• The Eurozone should be prepared for a new government in France http://t.co/qGFPC20S And that govt will be more hostile to current actions $$ Feb 22, 2012
• Spain Sinks Deeper Into Periphery on Debt Rise http://t.co/wkuef6tS As debts grow higher, the probability of escape gets lower. $$ Feb 22, 2012
• Iron Lady Merkel Bucks German Street on Greek Aid http://t.co/Wc95xI47 Strategy working 4 now, but what if colleagues lose their seats? $$ Feb 20, 2012
• Moody’s Cuts European Sovereigns http://t.co/GvJuES7t Spain, Italy, Portugal, Slovakia, Slovenia & Malta all cut. France & UK -> neg outlook Feb 15, 2012
• Unlisted in euroland http://t.co/AQQrJMUf Didn’t catch this in Jan. Private bonds can offered 2 ECB as collateral; helps French banks $$ Feb 13, 2012

The Well-off Fringe Nations

• Icelandic Anger Brings Debt Forgiveness http://t.co/P4BH8HKN If the debt problem is not severe, austerity. If it is severe (Iceland) default Feb 22, 2012
• Nordic Currencies Stung in Crisis http://t.co/teorxG1P Much of the world, looking for a store of value, drive fringe currencies up $$ Feb 21, 2012
• Canada housing market: poised 4 ‘severe correction,’ George Athanassakos says http://t.co/05kaVIAD Canada is used to the boom/bust cycle $$ Feb 21, 2012
• @joshuademasi You’re right, but most of the fringe currencies are facing the same dilemma; who to favor, consumers vs exporters, etc… $$ Feb 21, 2012
• Israel Safest as Investors Discount War Threat http://t.co/3oXTlILj Well-capitalized banks & balanced economy w/much high tech $$ #warrisk Feb 20, 2012
• A hedge fund bets big on a Canadian mega quarry http://t.co/k7OZBC9u Property rights r tough here. What if an existing farmer tried this? $$ Feb 18, 2012
• Australia’s Gillard Urged to Increase Mortgage Purchases http://t.co/ylsCuvq4 A mistake, far better to let the market fail. $$ Feb 17, 2012
• You’re right, reminds me of an old piece I wrote: http://t.co/XkgO7z7A Thanks $$ RT @joshuademasi: The 5 stages of USD grieving ! Feb 15, 2012
• Norway’s Rate Policy Dilemma Pits Household Debt Against Krone ‘Headache’ http://t.co/Ud4FCOsI Cut rates, asset bubble grows, Krone weakens Feb 15, 2012

China

• Plan B for China’s Wealthy: Moving to the U.S., Europe http://t.co/X9jRPy6q Wealthy Chinese know their govt, thus the need for flight $$ Feb 22, 2012
• China’s FDI and Trade Outlook Horrible Says Commerce Spokesperson http://t.co/LIlvmxIL Hard 4 Comm Party 2command domestic consumption up $$ Feb 18, 2012
• ‘Mother of all bubbles’ will pop China stocks: GMO http://t.co/OMENKZOI Low prob: China successfully navigating soft landing out of a bubble Feb 18, 2012
• China’s excess exports turn negative http://t.co/CiLgTKqC Key Q: how will China grow its economy by stimulating domestic consumption? $$ #uh Feb 18, 2012
• Too many bearish on China, but I’m bearish also.  What to do? Seek out China bulls.  If their arguments sound dumb, d… http://t.co/vrhUIdsh Feb 17, 2012
• The Silent Victims of the U.S.-China Currency War http://t.co/6DXAnE3m Smaller nations get caught in crossfire of competitive devaluation $$ Feb 17, 2012
• China’s Military Spending to Double by 2015 http://t.co/5Va8kiLr I think it take some losses before DC takes this seriously. $$ Feb 17, 2012
• China’s Tenuous Hold on Peace http://t.co/dOFr68tL Tibet is restive, China blames its problems on the economic mismanagement of foreigners Feb 14, 2012
• Glimpses of a Chinese Town Under Lockdown http://t.co/AFoW0zsM some reporters managed to get there to document the heavy security presence Feb 14, 2012
• Liu Mingkang Outlines the Reforms China needs to Undertake http://t.co/L0cXMoIf Will the communist party willingly reduce its power in China Feb 13, 2012

Japan

• Japanese Equities Herald Return to Inflation http://t.co/rxlt5OhI If Japan bond market breaks, ructions will be felt the world over. $$ Feb 23, 2012
• Energy imports will pressure Japan’s trade deficit http://t.co/lieDm3T4 But, Japan has a current account surplus from its net foreign assets Feb 23, 2012
• Japan Suggests No Quick G-20 Deal on IMF Funding http://t.co/RZYF5EB2 non-European members of the IMF waiting on the Europeans to act $$ Feb 22, 2012
• Tokyo Small-Caps Set for Longest Win Streak http://t.co/mD3ySrzh Unnoticed but true, look @ this CEF: http://t.co/VcdMQDxL FD: long $JOF Feb 22, 2012
• Yen Slumps After Japan Expands Bond Buying http://t.co/L6yImwzC Competitive currency devaluations driving Forex $$ #beggarthyneighbor Feb 15, 2012

Iran

• Japan Refiners Said to Stall on Iran Deals http://t.co/uEq1DYtb Life is harder on those that need Iranian oil, like India, China, Japan $$ Feb 21, 2012
• Iran Says It Loaded Locally Made Fuel to Nuke http://t.co/6HkMaEFj Not sure I believe this, but if it’s true, the Israelis will know $$ Feb 15, 2012
• Iran presses ahead with dollar attack http://t.co/Hd4Qtnvz Unlikely to work, but it’s all they can do w/oil transport shut down $$ Feb 14, 2012
• Letter Writers Break Iranian Taboo http://t.co/M3NMfmk1 They are so desperate that they write the Ayatollah and criticize conditions. $$ Feb 14, 2012
• Iran Sanctions Tighten as Shippers Stop Loading http://t.co/ubEtI6om Risk goes up, shipping insurance premiums rise, shipping stops $$ Feb 13, 2012

Rest of the World

• Record Redemptions Loom Amid Akbank $1.3 Billion Loan Talks http://t.co/x5iDTSwE Never knew Turkish firms financed w/so much Short debt $$ Feb 18, 2012
• Chavez Missing $10 Billion a Month by Curbing State Oil Investment http://t.co/uTG1Z8d8 PDVSA falls behind Pemex? How low can you go? $$ Feb 15, 2012
• Chávez Opposition Faces Hard Election http://t.co/YBWi9PaW Chavez controls media & oil wealth; tough for Capriles, but he can still win. Feb 14, 2012
• Gunfights in Saudi Arabia Show Spread of Tensions http://t.co/dNxhg2ij Shia in Saudi Arabia fight the govt. Biggest split in Mideast $$ Feb 14, 2012
• The Real Reasons the Rich Are Moving Cash to the Caymans http://t.co/gh7d85ZA Litigation risk, and US political risk; diversify yr govts Feb 13, 2012

Federal Reserve / Monetary Policy / Fiscal Policy

• Those believing the Fed is on hold for the next 3 years will be in for a rude awakening http://t.co/VYggm431 FF futures & TIPS betray mkt $$ Feb 24, 2012
• Exported Inflation to Return Home, but When and in What Form http://t.co/UHT61w4Y The Fed will find it hard to shrink its balance sheet $$ Feb 24, 2012
• Healthcare expenses will overwhelm the US federal budget http://t.co/lLUABMYy Suspect a deal will b driven 2 reduce benefits somehow $$ Feb 23, 2012
• “Fiat Money and Collective Corruption” http://t.co/lRAa2xnG Hard money would help, the bigger problem is light regulation of banks/credit $$ Feb 23, 2012
• Fed Writes Sweeping Rules From Behind Closed Doors http://t.co/UtozNgly Q: Why? 2 avoid bank influence, or 2 hide bank influence? $$ Feb 21, 2012
• The Race To Debase In All Its Glory http://t.co/rPtS9EqD Balance sheets of major central banks expand rapidly $$ #racetothebottom Feb 21, 2012
• Wealthy Enriched by Double-Dipping U.S. Plan http://t.co/YtGTfakC Long article describing unethical use of SBA $$ . #eliminatetheSBA Feb 21, 2012
• Over-regulated America http://t.co/uMKtg2W0 The home of laissez-faire is being suffocated by excessive and badly written regulation $$ Feb 18, 2012
• Geithner: GOP Walked Away From Tax Overhaul – Bloomberg http://t.co/yupPqVeO Articles like this indicate another stalemate in the making $$ Feb 17, 2012
• Potomac Divide Shows Foreclosures Thru Courts Slow Home-Price Recovery http://t.co/kilW75GM MD has slow foreclosures, housing mkt lags VA Feb 16, 2012
• Sober Look: Regulate it all, ask questions later http://t.co/qnpfakfJ New regulations reduce the liquidity of the corporate bond market $$ Feb 16, 2012
• FHA is almost broke. What will DC do when it goes critical? RT @HousingWire: FHA defaults up for ninth straight month http://t.co/TSZFHCeD Feb 15, 2012
• Pentagon May Oust Troops Involuntarily to Meet Reductions in Budget Plan http://t.co/VnY4At7J Tough time 2b let go if you r a veteran $$ Feb 14, 2012
• What a surprise! $$ RT @pdacosta: Bernanke’s big housing speech makes no mention of the Fed’s regulatory laxity in run-up to the crisis. Feb 10, 2012

Bonds

• Contra: Should Mortgage Rates Even Be Lower? http://t.co/lODEFb1P Mortgages do not price off of Tsys, but swaps and bank bond yields $$ Feb 22, 2012
• Wall Street Crowds Into Trader Joe’s http://t.co/dHZT83VK CMBS mkt getting heated; loans linked 2 retail rose to 45% 4 bonds sold in 2011 Feb 22, 2012
•  Have a lot of friends who have lost a lot of money waiting for $TLT to break. FD: long TLT http://t.co/Lw6Rqn02 Feb 21, 2012
• A $360 trillion confidence trick http://t.co/Kar0f3Cz I have argued that LIBOR should be based off of binding offers to borrow/lend $$ Feb 14, 2012
• http://t.co/VOIG2gUk W/TIPS NY Fed concentrates on the long on-the-run & nearby, w/nominals opposite. Makes implied inflation look higher $$ Feb 10, 2012

Muni Bonds

• Stockton, CA, to Weigh First Steps Toward Bankruptcy http://t.co/d2lsCmx8 Start of negotiations to reduce emplyee pensions & healthcare $$ Feb 24, 2012
• Good piece, thx RT @munilass: Evaluating Chapter 9 Bankruptcy for City of Detroit: Reality Check or Turnaround Option? http://t.co/PxWo5qHA Feb 21, 2012
• Yes. http://t.co/4DUVVTKi $$ RT @BarbarianCap: @munilass isn’t this the muni book that @AlephBlog reviewed very favorably a few days ago? Feb 20, 2012

Pensions

• New Rules Wreak Havoc forRetirement-Plan Sponsors http://t.co/HzHWTTtL I would expect rules to be modified, else headaches 4 DC plans $$ Feb 24, 2012
• @BarbarianCap Looking at the RFP, that is one of the few things *not* under consideration, pity too, because it is more important. #DumbOCPP Feb 23, 2012
• @BarbarianCap The audit is a test of methods and data, not assumptions. That’s actually pretty normal unless you an assumptions outlier $$ Feb 23, 2012
• @BarbarianCap I’ve said it many times b4, if life insurers have 2b conservative in accounting, DB plans s/b more so, but they r less so $$ Feb 23, 2012
• @BarbarianCap Some cases, deals will be driven to reduce benefits, depends on state/muni laws, Ch 9 allowable; not protected by ERISA/PBGC Feb 23, 2012

Stocks

• The Capabilities Premium in M&A http://t.co/9CdZIugk Long piece that explains why some mergers work; they aid organic growth & r small $$ Feb 22, 2012
• Elemental to Raise $1.7 Billion Next Year to Mine Potash http://t.co/w7GNsA2H Potash pricing has been volatile lately, cross-currents $$ Feb 22, 2012
• Gamestop to J.C. Penney Shut Facebook Stores: Retail http://t.co/zSui0fCf $FB may have a more difficult time w/retail than some expect $$ Feb 20, 2012
• Hewlett-Packard’s Message: We’ve Been Here All Along http://t.co/vU8piGMt Note: long $HPQ . HPQ definitely sounds more certain now. $$ Feb 16, 2012
• Icahn Pushing CVR’s Sale Means $1 Billion Gain for Shareholders http://t.co/TfBKGErf What refiner wants more capacity now & fertilizer? $$ Feb 16, 2012
• Hedge Funds Switch Positions, While Paulson Switches Investing Style http://t.co/MznmLhci Issue w/ $HIG is value of Variable product biz $$ Feb 15, 2012

Miscellaneous

• The Control Revolution And Its Discontents http://t.co/FY4XgPde There is a “sweet spot” for market efficiency, too much & things get chaotic Feb 24, 2012
• The Decline In Inventory Right Now is NOT a Good Sign http://t.co/Ra1Iz65H Fall in seller confidence & decline in new distressed inventory Feb 23, 2012
• Spring Lambing in UK Turns Deadly as New Virus Kills Young http://t.co/PrO4neT1 Infects pregnant sheep, cows and goats, 5% infection rate Feb 22, 2012
• Midwest Farmland Prices Update for the Year 2011 http://t.co/se9DbEgB Good discussion after a good article; things r getting a little bubbly Feb 22, 2012
• Finding Treasures Among Insurer’s Wreckage http://t.co/jiFZiydE Never bot Atl Mutual’s Surplus Notes, but historical curiosities, wow $$ Feb 18, 2012
• @StockTwits Insurance is boring, but antiquities at the oldest companies are fascinating. Wonder what Nationwide did w/Provident Mutuals? $$ Feb 18, 2012
• @StockTwits I would hold meetings every now and then in Provident Mutual’s underused antiquities room; would start good conversations $$ Feb 18, 2012
• Why Is Violent Crime Declining in US Cities? http://t.co/SLgD8bEL & http://t.co/RRRI2m8X Smarter law enforcement makes DC safer. Wow! $$ Feb 18, 2012
• Thanks, liked it. RT @onwrdnupwrd: you will like this one from this weeks economist http://t.co/DMqhgXBB Feb 18, 2012
• Interracial Marriages in US Reach a Record http://t.co/RJjWnTso Interesting that it is more prevalent with college educated people. $$ Feb 18, 2012
• Harvard Mapping My DNA Turns Scary http://t.co/m5stl0d2 Journalist learns hard things about his DNA. Would he be better off not knowing? $$ Feb 18, 2012
• Groupthink: The brainstorming myth http://t.co/7VBlhzKC People do better solving problems on their own, and sharing ideas w/the group $$ Feb 18, 2012
• Fear, Submission, and Authoritarianism; a Disturbing Trend http://t.co/0lb32tOw Negative social mood leads to loss of liberties $$ Feb 16, 2012
• Santorum’s Electability Pitch Undermined by 2006 Senate Re-Election Loss – Bloomberg http://t.co/8xglQQPJ Shouldn’t be an issue, here’s why: Feb 15, 2012
• As the late Bob Casey said, “You can’t lose if you are a pro-life Democrat.” This is true, and it is why Santorum lost to his son. $$ Feb 15, 2012
• Cracking the Long-Jump Code http://t.co/MN9d9EdJ Fascinating science applied; the key seems 2b2 jump higher, not just longer $$ Feb 15, 2012
• The Best Foods for Thought, Literally http://t.co/tMyLW9E2 Perhaps the Mediterranean diet can aid brain function, or a lowcal diet $$ Feb 14, 2012
• Contra: Almost Half the Price of Oil is Speculative Premium http://t.co/z8t51JOl It should be impossible to so overprice such a large mkt $$ Feb 14, 2012
• The Hunt Brothers thought they could corner a much smaller silver market, and were not able to do it.  The oil compan… http://t.co/MLYVH5w3 Feb 14, 2012
• So, What’s Your Algorithm? http://t.co/lC4voWCI Being able 2 crunch large amounts of data can lead to more objective decisions $$ #ornot Feb 13, 2012

Do you want to read an entertaining book about risk and insurance?  Right, I know that it is not likely that anyone could do that, but this book succeeds at the the task.  How does it do that?

1) It approaches the topic without using a lot of math.

2) It introduces you to the practical problems that anyone would face in trying to insure against any catastrophe.

3) It offers an entertaining story at the end of each chapter, some of which build off of prior stories.  The stories have farfetched elements to them, but they illustrate the main points that the chapter has made, while making you laugh.

The author gives no hints to his views on religion, but uses the concept of “acts of God,” to describe events which are out of our control, and thus need risk pooling (insurance), to contrast with “acts of man,” which potentially are controllable, though often not practical to do so.  Insurance may still have a role there, but there will be many more terms and conditions in the insurance contract.

One dominant theme of the book is how one estimates likelihood in the absence of a large amount of data.  Do you:

a) take what little data you have, and calculate an estimate? or,

b) get expert opinion on the matter, and let the small amount of data modify the experts?

The book takes the second position.  I lean toward the first position, but am not dogmatic about it.

When you are done reading this book, you will likely have skepticism toward much economic, sociological, and biometric research, because their foundations are very weak.  Estimates made are not from repeatable processes.

This is a good book.  It takes some effort to read, because the concepts are dense, but the structure of the book lightens things up.

Quibbles

Math error on page 89 — 1.5 should be 1.25.

Who would benefit from this book: Those who want to understand insurance, probability, or research better would benefit from this book.  If you want to, you can buy it here: Acts of God and Man: Ruminations on Risk and Insurance (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

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I’ve seen a number of articles recently arguing that high yield bonds are still cheap. Today I began an investigation to analyze this claim.

Here’s my bias: at the first investment shop I worked in, the high yield manager told me that there is a nominal yield for high yield bonds which reflects the risk.  It doesn’t matter where Treasury yields are, high yield bonds don’t care.  As a result, when people in the media, or writing blogs those argue that high yield is cheap because yield spreads are wide, it is time to disregard then when Treasury yields are artificially low, because of government interference.  (Financial Repression)

High yield bonds do care about credit conditions.  High yield bonds do care about the stock market.  From all of my research, high yield bonds are highly sensitive to credit conditions, particularly those of its industry.  They are also sensitive to the stock market.  After all, if the high yield bonds are doing badly, the stock is doing worse.

And here’s the rub: high yield bonds do not react to yields on Treasuries, except negatively, because when Treasuries rally hard, times are not good, and high yield bonds do poorly, with yields rising.

Here’s a graph to show how yields have done over the last 15 years for various corporate bond ratings.

My data this evening comes from the Federal Reserve Bank of St. Louis’ website FRED.  Been using it for 20 years, it is one of the best economic data repositories on the web.  Even used it during the bulletin board era, pre-web.

Merill Lynch has recently provided many of its bond yield indexes to FRED.  Previously, all that was there were two long yield series from Moody’s.

Now, if the concept of yield spreads is valid, when I do regressions of treasury yields on corporate index yields, I should see tight correlations of the yields versus Treasuries, and beta coefficients near one.  Here’s what I obtained:

AAA-CCC refer to ratings categories.  HYM is High Yield Master II, which is an average of high yield bond yields, and is usually very close to single-B yields, no surprise.

As you will note, spreads work reasonably to poorly for investment grade bonds.  The yields on investment grade bonds do not fall as much as yields on Treasury bonds do.  The yields on high yield bonds are barely affected when Treasury yields fall.  Look at the R-squareds on the regressions versus Treasuries only, high yield bonds do not have any economically significant relation ship to Treasuries alone.

Thus, it doesn’t make sense to talk about high yield bonds in terms of spreads over Treasuries.  High yield bonds react more to lending conditions, and derivatively, how well the stock market is doing.

But if we introduce credit spreads into the analysis, everything changes, and R-squareds skyrocket.

To me, BBB bonds are the touchstone for credit conditions.  Why?  They are on the edge of investment-grade creditworthiness.  They are also a large part of the corporate bond market.  When their yields rise or fall, it is a sign that financing rates for corporations are changing.

So, when I did regressions including BBB yields in addition to 5-year Treasury yields, guess what?

• Junk yields were highly geared to BBB yields.
• When Treasury yields fall, junk yields rise, and vice-versa.
• These relationships are in general more statistically significant than those of high investment grade corporates versus Treasuries.

So what does this prove?

• Yield spreads over Treasuries are not a good way to define value in bonds, and particularly not junk bonds.
• Better to analyze high yield bonds versus BBB bond yields, and consider Treasury yields as a negative factor when rates are low.

So, is high yield cheap or dear at present?

Whether I look at the Merrill High Yield Master 2, BBs, or Bs, junk bonds look expensive.  CCCs look a little cheap.  The yields on the High Yield Master 2 look about 0.8% expensive in terms of yield (that’s the residual in the above graph).  I will be lightening credit bond/loan positions in the near term.  Of course this is just my opinion, so do your own due diligence.

And, please realize that movements in the stock market may swamp my observations.  If the stock market runs, high yield can run further… but there will be an eventual snap-back.   The bond market is bigger than the stock market, eventually the stock market reacts to bond market realities.