Category: Stocks

A Practical Reason to be Aware of ETF Activity

A Practical Reason to be Aware of ETF Activity

In investing, it is important to understand what industries the companies in which you invest are in.? There are several reasons for this:

  • Companies within an industry tend to face the same cost pressures.
  • Companies within an industry tend to face the same revenue drivers.
  • Companies within an industry tend to face the same regulators and political pressures.
  • Companies within an industry tend to face the same behavior from debt-financers and equity investors.

Now, some companies have competitive advantages that are difficult to replicate, but those are not plentiful.? It is no surprise then that equity performance within industries tends to be tightly correlated.

Now consider ETF activity.? The largest ETFs cover whole stock markets, or sectors containing many industries.? The trading can drive the prices of many stocks regardless of the fundamentals in the short run.? The ETFs allow for simple decisions to be made.? “Financials stink; sell the XLF.”? “Technology stinks; sell the XLK.”? “Energy and materials will do well here, buy the XLE and XLB.”

The thing is, in each of those sectors, there is a lot of variation.? Is there a reason to worry about financial companies that focus on mortgages?? Yes.? Does that have anything to do with insurers?? Aside from mortgage, financial and title insurers, no, it doesn’t.? What do chemicals have to do with base metals?? Not much.? Do refiners and E&P companies benefit similarly from a rise in the price of oil?? No, it is the opposite; one buys oil, the other sells.

ETF trading activity can be a benefit to the fundamental investor.? When your companies come under pressure from ETFs because ETF holders sell indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the selling, it is time to buy a little more.? When your companies rise because ETF buyers buy indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the buying, it is time to sell a little.

ETFs simplify decision-making for many investors.? Sophisticated investors will avoid the simplification and drill down the economics and the industries and companies that they own, leading to greater profits in the long run.

Getting an Initial Read on a Deal

Getting an Initial Read on a Deal

I wrote at RealMoney.com today:


David Merkel
What Would Make More Sense to Me, Redux
2/1/2008 10:14 AM EST

Nine months ago, I wrote this: Microsoft and Yahoo! are in several different businesses with modest synergies between them. Buried inside such a merger would be (at least):

  • An Internet advertising company
  • A web/(other media) content producing company
  • An operating system/applications software company
  • A consumer entertainment products company
  • A web search company, and
  • A web marketing company.
  • Going back to our discussion of GE earlier this week, Microsoft does not need more businesses in its portfolio. It needs to focus its activities on what it does best. Same for Yahoo! but their problems are less severe unless they do this merger.

    If I were Microsoft, I would accept defeat, and sell all web properties to Yahoo! If I were Yahoo!, I would spin off all content production in a new company to shareholders. You would end up with three focused companies that would be able to hit their markets with precision, in a business where scale matters inside your market, but not across markets. The ending configuration would be:

  • A software company for everything except the web — Microsoft, which would pay another huge special dividend with the proceeds from the sale.
  • A web search, advertising and marketing company — Yahoo!, which could focus on competing with Google, and
  • A web/(other media) content production company (would it make money?)
  • This to me would be rational, but corporate cash gets spent by self-aggrandizing folks with egos, so this is not likely to happen in the short run. But I think the eventual economic outcome will resemble something like this.

    Microsoft has not shown a lot of competence in the areas that Yahoo! has focused on, and because of their long history of growth, I’m not sure they get how to run a company that is transisting into maturity. I would be bearish on the total concept.

    The market has awarded an additional $3.7 billion to the combined valuations on Microsoft and Yahoo! off of this news. After some time, that premium should reverse, and it will come out of the valuation of Microsoft. But then, I only play in tech when it is trashed, so what do I know?

    Position: none

    =-=-=-=-=-=-=-=-=-

    By the end of the day, that initial valuation premium of $3.7 billion turned into a deficit of $1.2 billion, and that was against a rising market. I’m not that kind of trader, but some deals make sense, and some don’t. When you find one that doesn’t make sense, and the market value of the package rises, one can short both the acquirer and the target, and wait for rationality to arrive.

    That’s not to say that all deals are bad. Value can be added through synergies or improved management, or unlocked through expense savings and more leverage. Microsoft-Yahoo is unlikely to fit any of those descriptions in any major way.

    Seven Brief FOMC Notes

    Seven Brief FOMC Notes

    1) From an old post at RealMoney:


    David Merkel
    Nominate Fisher for the ‘FOMC Loose Cannon’ Award
    6/1/05 4:05 PM?ET

    It was pretty tough to dislodge William Poole, but if anyone could win the coveted “FOMC Loose Cannon” award in a single day, it would be Richard Fisher, after suggesting that the FOMC was “clearly in the eighth inning of a tightening cycle, we’ve been doing 25 basis points per inning, it’s been very transparent, and very well projected by the Federal Open Market Committee under the leadership of Chairman Greenspan,” and, “We’re in the eighth inning. We have the ninth inning coming up at the end of June.” [quoted from the CNBC Web site] Why don’t they have media classes for rookie Fed governors and Treasury secretaries? Even if he’s got the FOMC position correct, typically the Fed governors come out with a consistent message, and then, they cloak and hedge opinions, in order not to jolt the markets.

    Okay, so Fisher dissented.? So he hasn’t had a predictable tone since becoming a Fed Governor.? Big deal.? The Fed needs more disagreement, and more original thought generally, even if it is wrong original thought, just to challenge the prevailing orthodoxy, and force them to think through what are complex decisions that might have unpredictable second order effects.

    2) I hate the phrase “ahead of (behind) the curve,” because there is nothing all that clear about where the curve is.

    3) Watch the yield curve, and note the widening today.? That is a trend that should persist, regardless of FOMC policy.

    4) Rate cutting begets more cutting, for now.? The current cuts will not solve systemic risk problems embedded in residential real estate, and CDOs, anytime soon.? They will help inflate China (via their crawling dollar peg), and healthy areas of the US economy.

    5) Where is the logical bottom here?? How much below CPI inflation is the Fed willing to reduce rates before they have to stop, much less raise rates to reduce inflation?? My guess: they will err on lowering rates too far, and then will be dragged kicking and screaming to a rate rise, as inflation runs away from them.? The oversupply in residential housing will cause housing prices to lag behind the price rises in the remainder of the economy.

    6) Eventually the FOMC will resist Fed funds futures, but for now, the Fed continues to obey the futures market.

    7) The stock market loves FOMC cuts in the short run, but has not honored them in the intermediate-term.

    Completion of the Reshaping

    Completion of the Reshaping

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

    New Buys

    • Avnet
    • Ensco International
    • Alliance Data Systems

    New Sales

    • Bronco Drilling

    Rebalancing Sales

    • Valero Energy (that was fast)

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

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

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

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

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

     

    Full disclosure: long JOF NAHC AVT ADS ESV

    My Best Relative Value Week in a Long Time

    My Best Relative Value Week in a Long Time

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

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

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


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

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

    Position: long GMK

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

    Full disclosure: long GMK

    Miscellaneous Musings on Our Manic Markets

    Miscellaneous Musings on Our Manic Markets

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


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

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

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

    Position: long RGA BRNC

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

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

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

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

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

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

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

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

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

    Full disclosure: long RGA BRNC

    What a Day!

    What a Day!

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

    Sales:

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

    Purchases:

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

    Rebalancing Buys:

    • Valero
    • ConocoPhillips
    • Vishay Intertechnology

    Rebalancing Sale:

    • Deerfield Capital

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

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

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

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

    Full disclosure: long DFR RGA HMC VLO COP VSH

    A Bonus from <I data-src=

    A Bonus from MoneySense Magazine

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

    Notes on Stocks and the Fed

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

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

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

    Insurance Thoughts

    Insurance Thoughts

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


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

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

    Position: Long LNC

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


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

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

    Position: long HIG LNC

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


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

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

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

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

    Position: none

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

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

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

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

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

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

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

    Full disclosure: long LNC HIG

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

    Shrink Positions or Position Sizes?

    Shrink Positions or Position Sizes?

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

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

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

    Full disclosure: long NTE DFR

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