Category: Quantitative Methods

The Great Garbage Post

The Great Garbage Post

Perhaps for blogging, I should not do this. My editors at RealMoney told me that they liked my “Notes and Comments” posts in the Columnist Conversation, but they wished that I could give it a greater title. Titles are meant to give a common theme. Often with my “Miscellaneous Notes” posts, there is no common theme. Unlike other writers at RealMoney, I cover a lot more ground. I like to think of myself as a generalist in investing. I know at least a little about most topics.

Now, I have to be careful not to overestimate what I know, but the advantage that I have in being a generalist is that I can sometimes see interlinkages among the markets that generalists miss. Anyway, onto my unrelated comments…

1) So many arguments over at RealMoney over what market capitalization is better, small or large? Personally, I like midcaps, but market capitalization is largely a fallout of my processes. If one group of capitalizations looks cheap, I’ll will predominantly be buying them, subject to my rule #4, “Purchase companies appropriately sized to serve their market niches.” Analyze the competitive position. Sometimes scale matters, and sometimes it doesn’t.

2) My oscillator says to me that the market is now overbought. We can rise further from here, but the market needs to digest its gains. We should not see a rapid rise from here over the next two weeks, and we might see a pullback.

3) My, but the dollar has been weak. Good thing I have enough international bonds to support my balanced mandates. I am long the Yen, Swissie, and Loony.

4) Sold a little Tsakos today, just to rebalance after the nice run. Cleared out of Fresh Del Monte. Cash flow looks weak. Suggestions for a replacement candidate are solicited.
5) Roger Nusbaum is an underrated columnist at RealMoney in my opinion. Today, he had a great article dealing with understanding strategy. He asked the following two questions:

  • If you had to pick one overriding philosophy for your investment management, what would it be?
  • If you had to pick four of your strategies or tactics to accomplish this philosophy, what would they be?

Good questions that will focus anyone’s investment efforts.

6) In the “Good News is Bad News” department, there is an article from the WSJ describing how the SEC may eliminate the FASB by allowing US companies to ditch GAAP, and optionally use international accounting standards [IFRS]. If it happens, this is just the first move. Eventually all companies will follow an international standard, that is, if Congress in its infinite wisdom can restrain itself from meddling in the management of accounting. The private sector does well enough, thank you. Please limit your scope to tax accounting (or not).

7) Also from the WSJ, an article on how employers are grabbing back control of 401(k) plans. Good idea, since most people don’t know how to save or invest. But why not go all the way, and set up a defined benefit plan or a trustee-directed defined contribution plan? The latter idea is cheap to do; we have one at my current employer. Expenses are close to nil, because I mange the money in-house. Even with an external manager, it would be cheap.Would there be people who complain, saying they want more freedom? Of course, but they are the exception, not the rule, and of those who complain, maybe one in five can do better than an index fund over the long haul. I am for paternalism here; most ordinary people can’t save and invest wisely. Someone must do it for them.

8) Finally, the “hooey alert.” The concept of using custom indexes to analyze outperformance smacks of the inanity of “returns-based style analysis.” I wrote extensively on this topic in the mid-90s. Anytime one uses constrained optimization to calculate a benchmark using a bunch of equity indexes, the result is often spurious, because the indexes are highly correlated. Most differentiation between them is typically the overinterpretation of a random difference between the indexes. Typically, these calculations predict well in the past, but predict the future badly.

That’s all for now.

Full Disclosure: long TNP FXY FXF FXC

Current Industry Model

Current Industry Model

Here are my current industry ratings. Unfortunately, the current list does not diversify me much. I might look at trucking, shoes, coal, restaurants, or specialty retail, but nothing much grabs me on the list. Most industries don’t feel trashed at this point.

When I find my model to be thin in what it is offering me, I sometimes run another model that looks at bad relative price performance by industry. If I’m still uninspired at the next portfolio reshaping, due for late June (or so), I’ll run that model to see if it gives me any fresh ideas.

Update on Indicators, Part 2

Update on Indicators, Part 2

I should mention that Assurant has been added to the S&P 500. Could not happen to a more deserving company; they are truly innovators in the insurance industry.

And now, more on indicators, bullish, bearish, and otherwise:

Bullish

  1. Low quality stocks outperformed in the first quarter, according to Merrill Lynch. That’s bullish in the short run, but not the intermediate term.
  2. LBO volume and private equity volume continue unabated.

Bearish

  1. Economy feels like stagflation-lite. Low positive growth, and rising inflation.
  2. Inflation is rising globally, particularly in India and China.
  3. Mortgage interest payments in the US are a record high (since 1989) compared to Disposable Personal Income.
  4. Corporate credit metrics are deteriorating for both junk and high grade corporate debt, but are not critical yet.
  5. Equity REITs seem to be rolling over.

That’s all for now. Tomorrow is another day.
Full Disclosure: long AIZ

Update on Indicators

Update on Indicators

Usually I look at my indicators at the beginning of a month. If I look at them more frequently, the changes are too small, and I don’t get the signal. In no particular order, here are my thoughts, both Bullish and Bearish:

Bullish

  1. Contrary to what the bear in Barron’s said this weekend, the chart for the Merger Fund is bullish. They paid a dividend at year end, and the current chart shows that arbs are making money, which is bullish.
  2. ECRI’s indicators are forecasting growth up, and inflation down.
  3. Both emerging market stocks an bonds have bounced back well.
  4. Earnings yields are still high relative to Treasuries, though if profit margins mean-revert, this argument is hooey.
  5. ISI Group’s broadline retailer’s survey is showing some life.
  6. Securitization of subprime loans, and CDOs containing tranches of subprime deals rated less than AA, are not getting done. These assets are getting sold to financial intermediaries that have adequate balance sheets to fund them.

Bearish

  1. From Alan Abelson’s column in Barron’s this weekend, Henry Kauffman uses a concept akin to my “bicycle stability versus table stability” to discuss liquidity. The former is access to credit, while the latter is excess high quality assets that are readily salable.
  2. Imposing tariffs on China is a real dumbkopf move. Eventually that will bite into the capital flow that keeps our interest rates so low, in addition to decreasing the benefits from the global division of labor.
  3. M3 is falling, and significantly. The banks are pulling back from landing, and credit availability is shrinking. My M3 proxy is the total liabilities of the banking system. Works very well.
  4. Fed funds continues to miss on the high side, since the FOMC meeting. The monetary base has gone flat, and there has been only one permanent open market operation this year, on 2/26.
  5. Financial stocks are lagging the market.
  6. The yield curve is still flat.
  7. Equity REITs don’t yield enough relative to Treasuries.
  8. Housing prices are falling nationwide.
  9. Asset price changes are increasingly in two camps: safe and risky. Correlations within the two camps are high and positive. Correlations of the two camps are very negative.
  10. Inflation remains high over the Fed’s comfort zone.

Neutral, or You Call It

  1. Implied volatilities have bounced up, but are still low.
  2. Corporate bond spreads have bounced up, but are still low.
  3. Implied 5 year inflation, five years forward, has been in a channel between 2.2% and 2.8% for the last four years.
  4. TED spreads are higher, but still low.
  5. The swap curve gained slope after the recent mini-crisis.
  6. The FOMC tightened less this time relative to prior times, if the measure is inflation versus the Fed funds rate.

That’s all for now. The two biggest bits of news are the tariffs on Chinese goods, and the decline in my M3 proxy. Bearish items both.

Around the Web, and then Some

Around the Web, and then Some

  1. There were two articles on reinsurers this morning suggesting that there should be a lot of consolidation via M&A. I’m not so sure. First, most players there want to acquire, not be acquired. Second, most of them don’t trust the underwriting and reserving of their competitors to the degree that they trust their own. To the extent that current players want to diversify, it is cheaper to do it organically than by acquisition. With the high degree of ease of entry into the market, the franchise value of a reinsurer is low. Now, maybe the property-centric reinsurers want to diversify (a smart idea, but they are stubborn), or the new reinsurers want to buy in a reverse merger one of the class of 2001 to eliminate the capital haircut from the ratings agencies (but they don’t have the cash for it). Those ideas make sense, but scale isn’t that much of a virtue here, and with P&C reinsurers the reserving is opaque as mud. I can see a deal or two getting done, but not a lot of them.
  2. With all the hand-wringing in the Wall Street Journal this morning on free trade, just watch, we impose some series of tariffs or restrictions that reduce the current account deficit, only to see the capital account surplus shrink also, leading to higher interest rates and a lower dollar, breaking the current cycle giving the US cheap imported goods in exchange for dollar denominated bonds.
  3. Throw a rock, hit a commentator who says that the Bank of China (or other major central bank with large dollar holdings) would never sell their positions because it would work against their interests, driving the value of the dollar down. That’s a half truth at best. Here’s why: the central bank will eventually focus on the future, realizing that sunk costs are sunk. Just because you have a big dollar position, does that mean you have to add to it to preserve its current value. Ignore the past, and let the dollar denominated securities mature. Use fresh cash and maturity proceeds to buy assets in the currencies that you like. It won’t cause a panic, but the dollar will still adjust down. Recognize from the start that the dollar assets are worth less than current exchange rates, and maximize value from there. (Large holders of any asset under pressure have to think this way to maximize value.)
  4. Buyer Beware. Or maybe, it should be borrower beware. People are generally less competent at making rational choices when they are borrowing rather than paying cash. So it is no surprise that when Beazer finances homes that they sold, buyers might have gotten less than an optimal deal. This is true with many financial transactions. In general, the more moving parts in a transaction, the worse off the average person is in evaluating a deal. Better to line up your financing separate from the decision to purchase an asset, or you could end up up with a bop on your beezer, figuratively speaking.
  5. So FASB might have a tighter leash on its neck from the SEC? Not sure whether that is good or bad. Neither organization gets high marks in my book. FASB desperately needs a more coherent overarching approach to accounting, rather than the piecemeal addjustments that they are doing. The SEC, if anything, is more beholden to political pressure, and the idiocy that that brings into accounting.
  6. Then there’s Texas, basically invalidating the GASB on reporting the liability for long term government employee benefits. You might remember my piece at RealMoney, Pensions: Things Can Always Be Worse. Well, this is an example of that, and it is not limited to Texas. Though the Texas argument may have merits, governments all over the country are finding that they have to finally recognize the present value of the pension promises that they have made, and disclose it to the citizenry. It will be a mess, because a large amount of these promises are totally unfunded, much like Social Security, Medicare, and most other programs of our Federal Government.
  7. It takes a week, but finally the market comes around to my view of the FOMC, though it takes Bernanke before Congress to correct the view of the markets. Inflation is not on hold, but the FOMC is, for now.
Around the Web

Around the Web

  1. There was an article in Forbes interviewing Jeremy Grantham that made me think. He suggests that value investing might be heading for a period where it will underperform. I.e., value stocks are not as relatively undervalued as they normally are. If he is correct, what should I do? I could shut off the value discipline, and run my industry models in GARP [growth at a reasonable price] or even momentum mode. That cuts against my grain; perhaps what I would do is give a little more weight to the industry models as I make my selections. That would tilt me away from hard value measures. My methods are eclectic, so I have to adapt to what the market is likely to reward 2-4 years from now.
  2. “Minsky moment.” Ah, cute phrase. Well, I loved Edward Chancellor’s, “Devil Take the Hindmost,” and he has an interesting article at Institutional Investor. The themes he talks about are dear to me. My only quibble is that we aren’t yet there for a collapse. There is enough cash available to mop up problems at present. Whether that will continue to be true is another question.
  3. My biggest concern is the dollar, and the carry trade. If the dollar dips below 112 yen, I suspect that there will be a self-reinforcing panic as short yen positions get covered. The Economist had a piece on this recently that made a lot of sense. Eventually we will have an unwind here, but it will come with a lot of kicking and screaming in Asia.
  4. For wonks only, First American Corelogic posted a report called Mortgage Payment Reset 2007: The Issue and the Impact. Very informative on the effects of the loan reset features on hybrid loans, and what might happen to the real estate markets.
The Kelly Criterion

The Kelly Criterion

In an upcoming article at RealMoney, I will be writing an article on optimal position sizing. To do that, I use the Kelly Criterion, which says that a position size should be equal to (edge/odds). There is added complexity in applying this to stocks, because in gambling, each game is uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another, particularly for me, because I concentrate sectors.

The Kelly criterion applied to stock investing would recommend a fixed weight portfolio. Optimally, you would rebalance daily to those fixed weights, but there are two factors that interfere: first, there are costs to trading, and second, momentum tends to persist in the short-run. To me that implies that one has fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, like maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. How much are each of the rules worth? Well, that I will describe in the article at RealMoney, and that hopefully will explain why holding 35 or so positions is proper for me in running my strategy.

One more thing, I appreciate the work done at the CASTrader Blog on the Kelly criterion. We manage money very differently, but we both appreciate the value of the Kelly Criterion.

PS — As an aside, I get ribbed by some at RealMoney, whether contributors or readers about holding 35 positions as hyperdiversified. In general I agree with portfolio concentration, but given that I concentrate sectors and industies, that makes 35 a lot more like 20 in terms of total volatility. On the other hand, compared to most mutual fund managers, 35 names would be a tighter ship than 95% of them run.

Beat, but not Beaten

Beat, but not Beaten

Ugh. What a day. It’s 1:30AM as I begin to write this, and I have been going since 4AM after traveling to Manhattan to DC and back, with the usual difficulties. The two highlights of my day were meeting with the best operational management team in insurance, Assurant, and meeting up with my work colleagues for dinner to celebrate new members coming onto staff. The lowlight was not getting any time with my family.

Now, one of the nice things about my portfolio management style is that I can ignore the markets for short amounts of time, and 99% of the time, it doesn’t matter. I do 95-99% of all my trades through portfolio rebalancings and portfolio reshapings. Like Buffett, who I admire (though I don’t always agree with), I wouldn’t mind if the market were closed more frequently. So today my broad market portfolio was up 50 basis points in my absence. I am now ahead of where i was at 2/26, before the shock.? Maybe I should be absent more often. 🙂

While traveling, I put the finishing touches on six (yes) articles that will be published on RealMoney over the next month. One should be next week, and is a compilation of what I have written here on my recent portfolio reshaping, with a few bits taken out and another page of explanatory data added for greater clarity. The other five articles are a series that I have worked on for a while which I have informally entitled “The Excellent Analyst” series. It goes through the framework of questions that I ask when I have a management team all to myself. I don’t go for material nonpublic information; I also don’t go for earnings trivia, rather, I try to see how the management team thinks as businessmen. Another place where I agree with Buffett, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”

With insurance, that comes natively to me, having done pricing, reserving, reinsurance, and corporate work as an actuary, having managed a small division of a company, with underwriting, marketing, and investment risk control. And my time managing insurance assets, mortgage bonds and then corporates, together with the derivatives. Having done all that, understanding insurance managements is second nature to me. I can sense a bad management team, and I delight in a great management team.

This brings me full circle to Assurant. Why are they the top operational insurance management team to me? This is a non-exhaustive list:

  1. Few other companies in insurance have seriously thought about sustainable competitive advantage. Assurant does it well, being #1 or #2 in almost all of the businesses in which they choose to compete.
  2. They invest in IT and customer relationships to create barriers to entry that are difficult to reverse engineer.
  3. Few insurance companies figure out their core competencies so closely, and then look for adjacent markets to apply them to.
  4. Few insurance companies look for “blue ocean” markets, where there is an unmet need and no competitors.
  5. Excellent capital allocators.
  6. Excellent at M&A, doing small infill acquisitions and growing them organically.
  7. Understands the concepts in market segmentation, and applies it to pricing, reserving, customer service and risk control.
  8. Executes almost flawlessly. What a great culture.

And if that’s not enough, they earn an ROE that is solidly in the top quartile for insurers, and I have no doubt that they will do the same next year. Progressive and AFLAC, move over. There is a new growth insurance name in town, and their valuation metrics are inexpensive, compared to what we are likely to get.

 

Full Disclosure: Long AIZ

Second to Last Step

Second to Last Step

Here’s the file for my progress on the portfolio change so far. Because of the data license that I have from Bloomberg, no numeric data fields from Bloomberg are listed here; only fields that I have calculated.

The grand rank is a weighted average of the ranks of the other variables, where a low number indicates desirability. Rsi Px 52week rank is a measure of price level. 0 means a 52-week low, and 100 means a 52-week high. NOA is net operating accruals; 0 means a low level of accruals on the balance sheet. 100 means there are a lot of accruals on the balance sheet.

Rsi Px 52week rank, NOA, Price-to-Sales, and Price-to-Book get a double weight. Everything else gets a single weight. I vary the weights each period based on what concerns me. When I am more bearish, I overweight the things that I am overweighting now.

Tomorrow I should have my portfolio changes. I choose 2-4 companies in the top half of my portfolio to replace 2-4 companies in the bottom half. Why do I do it this way? It forces me to make trade-offs, tossing out appreciated positions, and adding in promising names.

Up On A Down Day

Up On A Down Day

Up about 1/4% today, against a lousy market. Giving extra help today were Valero Energy (though I sold a little), Helmerich & Payne, and ConocoPhillips. Hurting the cause were Royal Bank of Scotland and Lithia Automotive.

Is the recent panic over? Yes and no. No, because you can never tell what additional macroeconomic problems will crop up. Yes because CDOs [Collateralized Debt Obligations] are still getting funded. I have a saying that bubbles only pop when cash flow is insufficient to finance them. Well, the riskiest part of the debt markets, CDO equity, still has willing participants. That indicates that it is not bubble-pop time yet, and that has positive implications for the junk debt and equity markets. Party on!

Industry models tomorrow.


Full Disclosure: Long HP VLO COP RBSPF LAD

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