Category: Stocks

Relying on the Kindness of Strangers as an Investment Strategy

Relying on the Kindness of Strangers as an Investment Strategy

In 2002, when many credits were troubled, I would look at some of troubled positions that we held and do a recovery analysis, to see what we might get if the company filed for insolvency. Often in that process, I would find that investors elsewhere in the capital structure had different motivations than we did. The bank might prefer to liquidate the stinker, while the bondholders, in a more junior position, would prefer it kept as a going concern. Or, the equity investors that have control of the company might pursue a unprofitable strategy that encumbers the assets of the firm, leaving the bondholders with a less valuable entity for their debt claims. Or, the company could issue secured debt, effectively subordinating bondholders, while providing cash that could be used to buy back stock. Another case is when you have a valuable company with a liquidity problem. The banks will be willing to lend against that trapped value so that the company can repay bondholders, right? Right?! (Sigh.) In most of these situations, a bond investor finds that he is implicitly relying on the kindness of strangers. That is rarely a good place to be. 🙁

Now, a few judicious debt covenants could partially level the playing field, but with investment grade bonds those are rare. (Covenants work a lot better than fraudulent conveyance lawsuits, etc….) My main point here is that it pays to analyze situations in advance to understand when your bargaining power is weak. Risk control is best done on the front end, not the back end. Equity/Management will always hold the “capital structure” option to some degree, and unsecured lenders will always have a weak hand there.

So when I read this article about ladies in Baltimore losing their homes because they didn’t do enough scrutiny of the mortgage documents, partly because they were deceived by people who were seemingly experts, who said that they would be able to refinance the rate when the reset date hit, I thought about relying on the kindness of strangers again. It would be one thing if guaranteed refinance terms were offered at the initial refinancing, but absent that, credit conditions are fickle, and it can be a short interval between loose credit and tight credit. Relying on the ability to refinance a debt is always risky.

Today, consumer credit terms are tight. A year ago, they were moderately loose. Two years ago, terms were stupid loose. Who knows, later this year, terms could become stupid tight, where even good quality borrowers with adequate security can’t get credit.

Again, in investing, and even in personal finance, strive to understand your bargaining position. Do you hold the options? If it’s not you or those with you in your position, then others hold the options to control the assets. Usually those are held by the equityholders (or management, who sometimes act in their own interest, not that of the shareholders), and senior or secured debtholders. Those with weak positions, like preferred stockholders, unsecured and junior debtholders must be compensated for the weak position with extra yield or covenant protections.

The same analysis applies to structured securities, whether the credit enhancement comes from a guarantor or a senior-subordinate structure. In the good times, the equity controls the deal. In the really bad times, control often slides to those who are most senior in the capital structure.

On a personal level, a house is controlled by the owner if he can stay current on the payments (if any). Absent that, the bank controls the situation, subject to the rights of other claimants (the taxman, home equity lenders, mortgage insurers, etc.)

If strangers are kind to you, that is a good thing. Be grateful for a society that encourages that kindness. But don’t rely on it in investing or personal finance.

PS — sometimes even a good analysis of your rights and options can go awry. The KMart bankruptcy was a good example of that, where KMart had assets worth more than their liabilities, and could have gotten financing to continue. But a bankruptcy judge allowed their petition, and they were able to give creditors and lessors the short end of the stick. Those that controlled KMart post-bankruptcy made out handsomely. It would be difficult to repeat that aspect of the success.

Thus, you might look at this good article on Sears Holdings (successor name for KMart) in a slightly different light. The financial engineering gains can’t be repeated. It now must make its money as a retailer. As the article gently points out, being a good investor and a good retailer don’t naturally go together.

Bringing this back to topic, does management of Sears act in the best interests of shareholders? Management has the incentives to do so, but sometimes the intellectual gratification of the CEO can get in the way of making good business decisions. Management has control, the outside passive minority investors do not. Their only options are to ride on the Sears bus, or get off. If an investor doesn’t think the management of Sears is doing it right, he would be foolish to trust them with his money.

How to Manage a Portfolio

How to Manage a Portfolio

Given the title above, I feel embarrassed to write, because the topic is too basic. I write because too few managers think clearly on the topic. The following analysis applies to long only funds and hedge funds; it also applies to equity and bond funds. The impetus to write this note arrived because the Fidelity Magellan Fund is reopening because cash inflows will make the life of the portfolio manager easier… not that he will get many inflows for now.

My view is that it should not be hard to manage a shrinking portfolio. It is much harder to manage a rapidly growing portfolio. (I have experienced that, and that is a topic for another day.) Here is the key concept: the portfolio manager must rank his portfolio by expected returns, adjusted for risk. This applies to both the longs and shorts. If there are cash inflows to a portfolio, assets should be allocated to the highest returning assets. If cash outflows, assets should be liquidated from the situations with the lowest expected returns. It is that simple, and I did that when I was a corporate bond manager. It worked well.

The reason why it will not be implemented at many asset management shops is that it takes work to do it, and we all avoid work if we can. But maintaining lists of long and short ideas ranked by likely risk-adjusted returns will yield better decision making, if one will do it.

What of the January Effect?

What of the January Effect?

I’m not feeling well this evening, so this will be a short post dealing with one simple issue.? (If I have strength, I may do one more.)

The January Effect is one of the best known calendar anomalies.? Stocks and high yield bonds tend to do well after the first day of the new year. This happens because these assets get oversold as some investors sell losing positions for tax reasons.? This tends to be more powerful for stocks that have done poorly over the past year, and for small companies, and value stocks.? This year it seemingly hasn’t happened.? Why?

First, all anomalies exist within a broader market environment.? When enough market players jump onto an anomaly, the anomaly outperforms in the short run, but peters out, because all interested parties have bought in.? If that were true of the January Effect, we would see the gains made in December, rather than January.? That’s not what happened this year.? (Anomalies tend to do best when they are ignored.)

Second, in a market where small value stocks may be overvalued, the January Effect could disappear for a year while small value stock valuations adjust back to normal, or below that.? That might be true this year.

We are in the winter season, not just for the calendar, but for small stocks and value investing. ? I feel the winter chill in all that I do at present, and no, I am not talking about the lack of insulation in my hovel.? I have the winter wind in my face now (much as I remember walking home from high school in Milwaukee), and yet I know that this is the time that my best purchases are likely to be made.? I have to focus on my core disciplines, and buy good long-term cash flow streams cheaply.

Before I close, I would say that a new favorite blog of mine is the CXO Advisory Group blog.? For quantitative investors, there is a wealth of knowledge there.

The Fed, Financial Guarantors, and Housing

The Fed, Financial Guarantors, and Housing

This post will be a little more disjointed than others. One housekeeping note before I start: I’m behind on my e-mail. I will catch up on it next week, DV.

Fed and Federal Government Policy

I don’t know; it seems like there are rumblings that the Fed will imminently take action, and that does not resonate with me. You can also read the stuff from Doug Kass at RealMoney, or consider the rebirth of the Plunge Protection Team. We are not so far from the next Fed meeting that waiting would make that much of a difference, particularly since the Fed tipped its hand when Bernanke spoke recently. There is a decent-sized cut coming, and the Treasury yield curve reflects it.

Now, I have my doubts as to the long-term efficacy of unusual measures from the Fed or the Treasury. You can’t get something by government fiat. Even a Fed Governor thinks we expect too much from the Fed, a sentiment with which I heartily agree, even though the Fed is partially responsible for creating that illusion. If the Fed took more of a “we do our best, but our powers are not that large in the long run” approach, market players might not give them so much credence.

Now, I’m not going so far as Anna Schwartz, who thinks the current Fed isn’t up to the task. That may or may not be true; what is hard to dispute is that Alan Greenspan dealt the existing FOMC a bad hand from a prior monetary policy that too easily responded to minor crises, rather than letting the economy take some pain. Moderate recessions are good for the economy; save the heroics for depression-like conditions.

Financial Guarantors

I may fail at it, but I try to be honest and self-critical here at my blog. For example, I did not suggest that Warren Buffett would buy Ambac, but I was misinterpreted as saying so. Now that Ajit Jain says that Berky might buy into one of the financial guarantors, I am not going to say that I predicted that, because I didn’t. It would be amusing if Buffett announced his new entry into the financial guaranty space to drive their prices down so he could buy a stake cheaper, but that is not his style. He values his reputation. That said, the NY regulator may not have thought enough steps ahead in pushing for Berky to set up a new guarantor. Good for new issues; perhaps not as good for old ones at legacy carriers.

Now, I admire Marty Whitman and Aldo Zucaro, but so far, their forays into the mortgage guaranty space have not worked out. I’m not counting them out, but it still may be early for that trade. Maybe we should wait for one of the companies to fail. The remaining companies should do well, once capacity drops out.

As for MBIA, they cut their dividend, which to me indicates a lower future level of profitability. Then they raise $1 Billion through surplus notes at their operating subsidiary, and pay 14% to do that. That has to be a record spread for a new-issue nominally AA-rated bond. Personally, I think I would pass on the notes, except for a flip. I would rather hold the common. Scenarios that would kill the common would most likely also kill the surplus notes. The common has more upside potential.

Residential Real Estate

I am fascinated by the willingness of some of the courts to insist on strict standards before they allow lenders to foreclose. Examples:

In general, I think there are legitimate flaws in the documentation that got ignored before the number of attempted foreclosures became so large. This is pointing out some stresses in the system. When this is done, securitization will not vanish; it will just be better managed.

Now as a final note, it is somewhat shameful that banks can’t follow FAS 114. The calculations aren’t hard; they just don’t want to recognize losses that they should recognize. That’s the real issue, so FASB and Congress should not give in here.

Industry Ranks and Additional Stocks

Industry Ranks and Additional Stocks

If I did not use a mechanical method for ranking replacement candidate stocks against my portfolio, I would not let so many stocks go onto my potential replacement list. Today I updated my industry model, and here it is:

Industry Groups January 2008

(If you have any difficulty downloading that, let me know. I’ve been having trouble with that.)

From that, I ran a bunch of screens, adding in some technology industries that have been hit of late. Here are the additional tickers that will be added to my candidates list: AMIE ASYT BBBY BC BELM BGFV BIG BNHN BRLC BWS CAB CBR CHRS CHUX CMRG CRH CTR CWTR DBRN DECK DFS DSPG DSW ESEA EXM EXP FHN FINL FRPT FSS GASS HGG HLYS HTCH HZO IDTI IKN IM IMOS JAS JNS KSWS KWD LF LIZ LNY LSI MIPS MRT NSIT NSTC NTY ODP OPMR OVTI OXM PERY PLAB POOL RCRC RENT ROCK RSC RT RUTH SAIA SHOO SIG SMRT SNA SNX SONC SSI TJX TOPS TUES VLTR VOXX ZQK

Now, the mechanical ranking system is supposed to be a simple way of prioritizing value stocks, and typically it does pretty well in directing my attention to the stocks that I should analyze, not necessarily the ones I should buy. That’s true of any screening method, no matter how simple or complex. You always find some companies that look really good initially, but got there because of data errors, accounting mis-characterizations, or a business situation that was vastly different when the accounting snapshot was taken.

Now, after all of this work, I’m only trading 3-4 stocks into and out of my portfolio of roughly 35 stocks. But the idea is to end up with a portfolio with better offensive and defensive characteristics, such that the relative performance will be good, and should the market turn, I will be in the industries and companies with a lot of potential to outperform.

Time for the Next Portfolio Reshaping

Time for the Next Portfolio Reshaping

I will admit, I don’t feel much like doing my portfolio reshaping now, even though it is a part of my management discipline, because the portfolio has been kicked around.? Not much worse than the rest of the market, though, and there are some stocks that look interesting that could be worth considerably more three years out.? As you look through my tickers list for candidates for addition, you’ll see a few commonalities:

  • Energy (still)
  • Industrials (still)
  • Retail (now, that’s new)
  • Insurers (many still cheap, particularly some stronger operators, also title names)
  • Technology (different for me)
  • ?A few odd real estate names (not likely, but there are some places where values are protected)

So, the process begins.? Within a few days, I’ll run my industry model, and do a few screens off of it, adding a few more tickers.? Beyond that, I invite you to send me ideas as well.? Last time, ideas suggested by readers made up two of the four new names that I bought.? So, send them in, and thanks as always for reading me.

The replacement candidate tickers:?? AA ABK ACIW AEO AES AIG AIT ALL APA APL ARM ARO ARW ASGN ATU ATW AVCA AVZA AZ BAC BCS BER BGP BKE BKS BRO BRY CACC CAE CAKE CALL CAMD CBL CCRT CHS CNQ CNX COF COST CQP CRI CRK CRZO CSCO CSG CSGS CSL CTLM DDS DFG DITC DLB DNR DRI DTLK DVN EAT EEP EFII EMC ENWV ESST ESV EXAR EXTR FLEX FNF FNM FRE FSII GCA GLW GPC GS GSIT GSK GW HAS HCC HCSG HD HIG HILL HMC HOC HOG HOLX HPQ IDTC INAP INFN INSP INT INTC IRE ISSI JCG JCP JEC JRT JWN KEM KFT KSS LINE LM LOOK LRW LUV LYG MAN MAS MDC MHK MHP MHS MMC MNST MTSC MTW MU MUR MVC MW MWA NOV? NSH NSR OII OMX ORI OXY PCZ PDC PDE PDII PDS PHLY PNCL PNRA POL PROS PTEN PVSW RAMR RAVN RGA RIG RNIN RNWK SCMR SGP SIMG SKS SKSWS SKX SLXP SNY SPN SSTI SSW STC STI SU SWK T TECH TECUA TEX TGI TLGD TMTA TM TNB TOT TRID TRLG TSO TWB UFS UNP URBN USG VFC VMC VNR VPHM WAG WCG WDC WHQ WLL WSM WSTL WU WWW XL XTEX XTO

PS — Though I don’t feel like doing it, I didn’t feel like doing it in the Fall of 2002 either,and some of my best picks came then.? So, discipline before feelings.

Make Money While You Sleep — II

Make Money While You Sleep — II

Thanks to Eddy Elfenbein for sending over the data on how the market does over multiple nights when the market is closed.? Unfortunately, the data is skewed because of 9/11, where the market was closed for seven days, and the change from the close to the open was -4.59%.? What should be done with that data point?? When the market closed on Monday 9/10/01, traders expected that the market would reopen as normal on Tuesday, but it didn’t.? The seven day hiatus was not planned, so traders treated it as a one night gap on Monday, but it opened as a seven night gap the next Monday, with negative results.

Now, if you throw out the 9/11 data point, the average price return over a one night gap is 0.005% over the last eight years.? For a multiple night gap, the return is higher — 0.012%.? If you include in 9/11, it is lower — 0.002%.

But what of dividends?? Where do they belong?? They belong to the nighttime returns, because on the morning that a stock goes ex-dividend, on average the price drops at the open to reflect that.? Now, assume a 1.5%/year dividend rate (rounding, the actual is a little higher).? Now the returns for a one night gap are 0.010%, and for a multiple night gap it is 0.024%.? Even counting in 9/11, the result is 0.014%, higher than the single night gap.

One commenter on last night’s post commented that it might not be the risk of holding stock overnight as much as the possibility or occurrence of news flow.? Before the fact, risk and potential news flow are similar concepts.? After all, how does risk shift, but often through news flow changing the opinions that people hold regarding assets?

For a long term investor like me, this all doesn’t matter much.? I’m not going to buy a bunch of futures contracts or ETFs near the close and sell them into the open.? Still, this could be another example of a market anomaly that stems from the perception of a risk which does not occur on average.

Make Money While You Sleep

Make Money While You Sleep

Eddy Elfenbein often comes up with cute ideas on how the market works, and this article is no exception.? Someone holding the stock market overnight, at least over the past decade, does better than someone owning stocks during the day.? (I assume that? Eddy has made the proper corrections for dividends, and things like that.)? Now, why might this be?? This is my theory: though daytraders are a part of this, it is not that we are all a bunch of daytraders, but that enough players in the market view the daylight hours as less risky than the night, because they can’t trade then.? Newsflow happens more often while the market is closed.? Thus, there is a tendency to clear out positions before the session closes.? (Now, no net position clearing occurs.? Someone has to hold the stock overnight; they receive a slight discount in the price to do it.)

Another way to think about it is that people get paid to take risk, and there is risk in holding stock overnight.? Now, if we wanted to test this hypothesis, there is even more risk holding stock over the weekend.? How do the overnight returns vary overnight, versus over multiple nights?? Perhaps Mr. Elfenbein can run that calculation as well.

Momentum, Schmomentum

Momentum, Schmomentum

My biggest insecurity when it comes to my investing comes from the concept of momentum.? For the past 7+ years, I’ve been leaning against the wind, buying companies with bad momentum, and for the most part, it worked.? In general, falling stocks have bounced back.? Over the last six months it has not seemed to work so well.? Now, I had a period that was much worse in the middle of 2002.? I even scraped excess money together to invest in late September of 2002.? I am less confident here.

I have a number of ideas that work with respect to momentum:

  • In the short run, momentum persists.
  • In the intermediate-term, momentum reverts.
  • Sharp moves tend to mean revert, slow moves tend to persist.

My own proprietary oscillator indicates that we are very close to a short-term bounce point.? The recent move down has been too rapid, and sellers should be tired.? One more hard down day, and a bounce should occur.

Back to my own portfolio management.? Since I am a value investor, I have leaned toward longer holding periods, which implies to me that I should be playing for the intermediate-term reversal of momentum phenomenon.? But the short-term momentum anomaly is probably stronger.? Consider these two pieces from Crossing Wall Street.? Eddy illustrates the point well.

So, as I head into my next portfolio reshaping, I am scratching my head, and wondering how I should use momentum in my investing.? Suggestions are welcome.

On Benchmarking

On Benchmarking

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”? Ergo, the commenters are always right, at least in terms of what they want to read about.? So, tonight I write about benchmarking.? (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.? The idea behind a benchmark is one of three things:

  1. A description of the non-controllable aspects of what a manager does.? It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
  2. A description of the non-controllable aspects of what an investor wants for a single asset class or style.? It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
  3. A description of what an investor wants, in a total asset allocation framework.? It reflects the risk-return tradeoff of the investor.? The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.? The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.? Should he buy it?? Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.? Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.? (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.? Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.? The greater the frequency of measurement, the more index-like performance becomes.? The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.? Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.? Give them the money, and check back in five years.? (The list is illustrative, I can think of more…)

What does that mean for me, though?? The first thing is that I am not for everybody.? I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.? Over a long period of time, I believe that I will beat those benchmarks.? Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.? I think I will beat those broad benchmarks for several reasons:

  • Value tends to win in the long haul.
  • By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
  • By not limiting picks to the US, I can find chedaper stocks that might outperform.
  • By rebalancing, I pick up incremental returns.
  • Industry analysis aids in finding companies that can outperform.
  • Avoiding companies with accounting issues allows for fewer big losses.
  • Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
  • I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.? In the short-term, I live with underperformance.? Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.? Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM

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