I’m still working through my portfolio, but I have categorized some stocks:
The Dead — Companies with bad balance sheets, but have been whacked so bad that it is still worth playing
Jones Apparel
Deerfield Capital
YRC Worldwide
Walking Wounded — Companies with okay balance sheets that we feed more cash to
Lafarge
Industrias Bachoco
Seemingly healthy that might have financing problems — Sold
Lithia Automotive
Group 1 Automotive
Uncertain as of yet
Barclays plc
Safe New Names Bought
PartnerRe
Microcap yet to be named when I have my full position on.
More tomorrow. As you can tell, I am positioning my broad market fund more conservatively. I am not optimistic on how we work through the amalgam of debts that might not get paid.
I sold Lithia Automotive in the late morning for the same reason as Group 1 Automotive.? Mid-afternoon, I replaced the position with PartnerRe.? As I commented at RealMoney:
Reserves are conservative even prior to the fact that they don’t discount their reserves.
Reasonable P/E multiple
Quality balance sheet
Quality management team.
Conservative asset policy
Not overexposed to southeastern property risks.
Position: long PRE
What I didn’t mention was how much not discounting their reserves is worth after-tax: nearly $20/share.? Take out a few other items, and you get an adjusted book value of around $85 on a very strong and diversified reinsurer.? I can live with that.
Bought a little Lafarge and Industrias Bachoco in to the morning’s decline. Eliminated Group 1 Automotive, and began the acquisition of a little microcap trading below book value with no debt. The integrating theme here is holding onto businesses that don’t need external financing, and selling businesses that require external financing, starting with companies that haven’t been hit that badly yet.
Could the existing financing troubles spill over into auto financing and auto floorplan financing? That’s possible, though I don’t see the transmission mechanism now. The potential trouble with Group 1 (aside from a balance sheet with high intangibles), is that changes in financing terms could dent their earnings stream. Now, I know that the automakers are highly motivated to move the metal, and will aid the financing process, but I don’t think they can be relied on in entire, unless they only selling for Honda and Toyota, which have superior balance sheets.
The moves so far this morning are cash neutral. We will see how that changes as the day progresses.
I’m going to try to put in two posts this evening — this one on recent activity, and one on the Fed, to try to address the commentary that my last post generated.
Central Banking in the Forefront?
Let’s start with the state of monetary policy.? Is it easy or tight?? It’s in-between.? The monetary base is growing at maybe a 3% rate yoy.? The Fed has not done a permanent injection of liquidity in over 3 months.? MZM and M2 are around 5%, and my M3 proxy is around 8%.? But FOMC policy is compromised by the willingness of foreigners to finance the US Current account deficit, and cheaply too.? The increase in foreign holdings of US debt is roughly equal to the increase in M2.? That provides a lot of additional stimulus that the Fed can’t undo.
So what have the Central Banks done lately? Barry does a good job of summarizing the actions, all of which are temporary injections of liquidity, together with statements of support for the markets.? So why did short-term lending rates to banks spike?? My guess is that there were a few institutions that felt the need to shore up their balance sheets by getting some short-term liquidity.? I’m a little skeptical of the breadth of this crisis, but if anything begins to make me more concerned, it is that some banks in the Federal Reserve System needed liquidity fast.? Also, some banks needed quick liquidity from the unregulated eurodollar markets.? But who?? Inquiring minds want to know… 😉
So, over at FT Alphaville they wonder, but in a different way.? What do central bankers know that we don’t?? My usual answer is not much, but I am wondering too.? Panicked calls from investment bank CEOs?? Timothy Geithner worrying about systemic risk?? Maybe, but not showing up in swap spreads, yet.? Calls from commercial bankers asking for a little help?? Maybe.? I don’t know.? I wonder whether we’ve really felt enough pain in order to deserve a FOMC cut.? We haven’t even had a 10% correction in the market yet.? Obviously, But some think we’ve had enough pain.? But inflation is higher than the statistics would indicate, and is slowly getting driven higher by higher inflation abroad, some of which is getting transmitted here.? Not a fun time to be a central banker, but hey, that’s why they pay them the big money, right? 🙂
More notable, perhaps, are the extreme swings in stock prices. Many market-neutral strategies are underperforming here.? (Stock market-neutral does not mean credit market-neutral.)? Statistical arbitrage strategies were crowded trades.? Truth is, to a first approximation, even though almost all of the quant models were proprietary, they were all pretty similar.? Academic research on anomalies is almost freely available to all.? Two good quants can bioth start fresh, but they will end up in about the same place.
Insider buying is growing in financial stocks, after the market declines.? I like it.? My next major investment direction is likely overweighting high quality financials, but the timing and direction are uncertain.
Finally, from the Epicurean Dealmaker (neat blog. cool name too.), how do catastrophic changes occur?? I love nonlinear dynamics, i.e., “chaos theory.”? I predicted much of what has been happening two years ago at RealMoney, but I stated the the timing was uncertain.? It could be next month, it could be a decade at most.? The thing is, you can’t tell which straw will break the camel’s back.? I like being sharp rather than fuzzy, but I hate making sharp predictions if I know that the probability of my being wrong is high.? In those cases, I would rather give a weak signal, than one that could likely be wrong.
Many Hedge Funds are Systematically Short Liquidity
8/9/2007 5:43 PM EDT
You can look at Cramer’s two pieces here and here that deal with the logjam in the bond markets. Now, there are problems that are severe, as in the exotic portions of the market. There are problems in investment grade corporate bonds in the cash market, but spreads haven’t moved anywhere nearly as much as they did in 2002. The synthetic (default swap) portion of the market is having greater problems. Oddly, though high yield cash spreads have moved out, they still aren’t that wide yet either compared to 2002. The problems there are in the CDS, and hung bridge loans.
Most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. If these funds are blowing up, like LTCM in 1998, then liquidity will be tight in the derivative markets, but the regular cash bond markets won’t be hurt so bad.
I agree with Michael Comeau with a twist… this may end up being good for the equity markets eventually, but in the short run, it is a negative.
Let me try to expand a little more here. A good place to start is Cramer’s last piece of the day. Part of what he said was:
But first you have to recognize that I am not talking about opportunity. We need the Fed simply to issue a statement like it did in 1987, that it would provide all of the liquidity necessary to get things moving in the credit markets.
All of those who think the Fed is helpless are as clueless as the Fed. A statement like that would eliminate the fear all over town that committing capital is going to wipe your firm out.
The European action seemed desperate today, but it’s a bit of a desperate time, and they did what is right.
If we had made the right call on Tuesday at the Fed, we would have maneuverability over the next month to help.
Now we can’t. Not for another couple of months, [sic]
Unfortunately, Cramer is wrong here. The ECB only did a temporary injection of funds, which will disappear. The Fed also did a similar temporary injection of funds today, which brought down where Fed funds were trading. It will disappear as well, but both the ECB and Fed can make adjustments as they see fit. There isn’t any significant difference between the actions.
There have been notable failures and impairments, for sure. Let’s run through the list: the funds at BNP Paribas, funds at AXA, Oddo, Sowood and IKB, Goldman Sachs, Tykhe Capital, and Highbridge (and more). With this help from DealBreaker (most of the comments are worth reading also), I would repeat that most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. Another way of saying it is that they have a hidden short in credit quality, and this short is biting bigtime.
Okay, I’ve listed a lot of the practical failures, but what classes of hedge fund investments are getting hurt? Primarily statistical arbitrage and event-driven. (Oh, and credit-based as well, but I don’t have any articles there.) The computer programs at many stat arb shops have not done well amid the volatility, and there have have been significant M&A deals that have come into question, like MGIC-Radian. Merger arbitrage had a bad July, and looking at the Merger Fund, August looks to be as bad. (Worrisome, because merger arb correlates highly with total market confidence.) As for statistical arb, I know a few people at Campbell & Company. They’re bright people. Unfortunately, when regimes shift, often statistical models are bad at turning points. Higher volatility, bad credit, and the illiquidity that they engender doom many statistical models of the market.
So, how bad is credit now? If you are talking about securitized products and derivatives, the answer is extremely bad. If you are talking about high yield loans to fund LBOs, very bad, and my won’t some the investment banks take some losses there (but they won’t get killed). High yield bonds, merely bad — spreads have widened, but not nearly as much as in 2002. Same for investment grade corporates, except less so. Now the future, like say out to 2010, may prove to be even worse in terms of aggregate default rates of corporates, because more of the total issuance is high yield. This is just something to watch, because it may imply a stretched-out scenario for corporate credit losses.
The Dreaded Subprime
Subprime mortgage lending has had poor results. I would even argue that early 2007 originations could be worse than the 2006 vintage. This has spilled over into many places, but who would have expected money market funds? The asset-backed commercial paper [ABCP] market is a small slice of the total commercial paper market, and those financing subprime mortgage receivables are smaller still. The conduits that do this financing have a number of structural protections, so it should not be a big issue. The only thing that might emerge is if some money market fund overdosed on subprime ABCP. I’m not expecting any fund to “break the buck,” but it’s not impossible.
I generally like the writings of Dan Gross. He is partially right when he says that the effects of subprime lending are not contained. Many different institutions are getting nipped by the problem. But I think what government officials mean by contained is different. They are saying that they see no systemic risk from the problem, which may be correct, so long as the aggregate reduction in housing prices does not cause a cascade of failure in the mortgage market, which I view as unlikely.
Perhaps we should look at a bull on subprime lending? Not a big bull, though. Wilbur Ross has lent $50 million to American Home Mortgage on the most senior level possible. That’s not a very big risk, but he does see a future for subprime lending, if one is patient, and can survive the present slump.
A note on Alt-A lending. There’s going to be a bifurcation here; not all Alt-A lending is the same. As S&P and the other rating agencies evaluate loan performance, they will downgrade the deals with bad performance, and leave the good ones alone. The troubles here will likely be as big as those in subprime. Perhaps the lack of information on lending is the crucial issue. Colloquially, never buy a blind pool, or a pig in a poke. Information is supremely valuable in lending, and often incremental yield can’t compensate.
In a situation like this, simplicity is rewarded. Complexity is always punished in a liquidity crisis. Bidders have better thing sto do in a crisis than to figure out fair value for complex instruments when simpler ones are under question.
Another aspect of liquidity is the investment banks. As prime brokers, their own risk control mechanisms cause them to liquidate marginal borrowers whose margin has gotten thin. This protects them at the risk of making the crisis worse for everyone else as the prices of risky asset declines after liquidations. Other investors might then face their own margin calls. The cycle eventually burns out, but only after many insolvencies. My guess: none of the investment banks go under.
Finally, let’s end on an optimistic note, and who to do that better than Jim Griffin? As I said before, simplicity is valued in a situation like this, and stocks in aggregate are simple. As he asks at the end of his piece, “What are you going to buy if you sell stocks?” I agree; there will be continued problems in the synthetic and securitized debt markets, but if you want to be rewarded for risk here, equities offer reasonable compensation for the risks taken. Just avoid the areas in financials and hombuilders/etc, that are being taken apart here. The world is a much larger place than the US & European synthetic and securitized debt markets, and there are places to invest today. Just insist on a strong balance sheet.
There’s a lot of talk about the superiority of yield-based strategies, and that has been true in hindsight, particularly since interest rates have fallen for pretty much the last 25 years, while corporate profits and free cash flow have generally grown, allowing for greater dividend capacity.? A potent mix that has favored yield, but what if the environment changes?
I don’t go looking for yield, but stocks with some yield tend to find their way into my portfolio.? Why?? Companies with stable business models, strong balance sheets, and good earnings quality tend to produce free cash flows in excess of their reinvestment needs.? That cash can be given to shareholders as dividends, or used to buy back stock.
But there is something positive about what a dividend does to a company’s management team, which in the American context, is viewed as a pseudo-obligation.? This makes the cost of capital tangible to the management team, which will be more careful about how they use their cash.? After all, they have a dividend to maintain.
Now, yield in itself can be manipulated.? Leverage can be increased to pay dividends, and with low quality companies that often happens.? Smart investors look to see how well a company’s dividend yield is covered by the earnings.? Avoid the shares of a company that isn’t likely to earn its dividend, particularly if the have to compromise the balance sheet to do it.
A yield in itself does not make a company more safe; if the yield is high enough such that there are naive yield investors in the stock, that yield can actually make the stock more risky, if a disappointing earnings report puts the dividend in jeopardy.
Finally, as an aside, a quick note on intelligent vs. dumb buybacks.? Intelligent management teams have an estimate of what they think their firm is worth, and they don’t buy back stock, unless the stock is trading below that level.? The management team won’t tell you that level, but they might tell you if they follow such a strategy, if you ask them.
After that, you can find out where they are buying stock back.? If you look in the cash flow statement, under cash flows from financing, you can see how much they spent buying back stock, and in the statement of shareholders equity you can see how many shares they bought back.? Those two figures will enable you to calculate the average buyback price.? This figure can be important even for traders, because it can indicate a level where a management team is willing to buy buy shares when they have free cash, and as a result, can become a support level for the stock.
Good fundamental investing means looking at more than just a few summary variables, like yield.? You have to dig through the financial statements to see how the business adds value.? If that means that your stock gives you a yield, like most of my stocks do, that is icing on the cake.
Over the past seven years, my broad market strategy done well against the S&P 500. I reach the seven year anniversary at the end of August, and should business prospects require it, I will get the results audited. But since the start of the quarter, the strategy has not done so well, trailing the S&P by a little less than 4%. Why have the results been so bad?
My portfolio has concentrations in a number of areas. I have a slight overweight in financials (though only one company affected by the current crises), a large overweight in energy, and an overweight in cyclicals, though cyclicals targeted at foreign demand, not US demand. These areas have underperformed, and so have I. Industries are 60% of the performance of the market in my opinion, so when you run a portfolio that concentrates industries, there will be periods of underperformance.
Value is out of favor at present as well. My approach is “all cap” value; I don’t care about the size of companies that I buy. I’m only 2% or so behind the Russell 1000 Value, but I am more than 4% ahead of the Russell 2000 Value. Small cap value has gotten smashed, and I am a partial casualty along with it.
So, maybe I’m not doing that badly. What I do at times like this is to try to identify the factors leading to underperformance and ask whether those factors are likely to persist for a year or more. Let me go through my major exposures, updating what I wrote previously:
Energy ? Integrated, Refining, E&P, Services, Synfuels. I am still a bull here; we aren’t finding enough energy supplies to meet the needs of our growing world. (15%)
Light Cyclicals ? Cement, Trucking, Chemicals, Shipping, Auto Parts. These areas are undervalued, given the way our world is growing. (20%)
Odd financials ? European banks, an odd mortgage REIT [DFR]. Largely insulated from the credit crises, and cheap. (10%)
Insurance — AHL, AIZ, SAFT, and LNC. All of them cheap, and with good earnings prospects. (10%)
Latin America ? SBS, IBA, GMK. All are plays on the growing buying power in Latin America. (8%)
Turnarounds ? SLE, JNY. Give them time; Rome wasn?t burnt in a day. (5%)
Technology ? NTE, VSH. Stuff that is not easily obsoleted. (5%)
Auto Retail ? LAD, GPI. Out of favor. (5%)
Cash (15%) — 5.25%/year is not bad.
That’s 93% of my broad market portfolio. Three other miscellaneous companies make up the rest. You can find the complete portfolio here.
After writing this, my tentative conclusion is that my methods still work, but that I am fighting temporary setbacks from value being out of favor, and from financials getting taken out and shot, even if there is no connection to the current credit crises. Therefore I soldier on, trusting the methods that have brought me this far.
Full disclosure: long LAD GPI NTE VSH SLE JNY SBS IBA GMK AHL AIZ SAFT LNC DFR
When I do a review of links, I try not to do a linkfest, as much try to share my ideas, while annotating places where you can get more data.? I keep topical clipping folders.? Today’s review is on the Great Substitution of Equity for Debt, Formerly Led by Private Equity.? Usually I organize by subtopic when I write, but tonight I will do it by time, because it took me seven weeks to get back to this, and a lot has happened over those weeks.
Go back to mid-June.? 10-year Treasury rates were challenging 5.25%.? Rates all over the world had risen, and some predicted they would go higher, and choke off the private equity boom.? In hindsight, not a good argument, not because Treasury yields fell, but because junk credit spreads are more critical to private equity than treasury and high-grade yields.? In the short run, junk debt yields don’t react much to Treasury yields.? So most didn’t worry at the time.
Give Andy Kessler credit for timing. He expresses skepticism for private equity before Blackstone comes public, suggesting that all they do is borrow money against the assets of the target companies, and then foist them on the retail public later.? Well, that’s not all of what private equity does, but to a first approximation, that’s 90% of the deal.? He takes both sides of the issue, suggesting that conditions are stretched from a valuation standpoint, but suggesting that the insanity could go on for a while longer.
Failed deals often represent turning points, and by the end of June, both Thomson Learning and US Foodservice pulled their debt deals. The appetite for yield had diminished considerably, versus the need to protect capital.
In the short run though, the market is bouncy, and more deals piled up into early July, even as junk spreads began to widen.? I love the closing quote in this WSJ article: “It’s all worth keeping in mind as the market hits its rough spots. Roger Altman, chairman of Evercore Partners points out, for instance, that by any historical measure, the interest rates for junk bonds remain very cheap.? Barring a very steep climb in rates, Mr. Altman says, private equity ‘is a permanent feature of the capital markets. Nothing foreseeable can change that.'”? Mr. Altman is a bright man, no doubt, but turning points are only clear in hindsight.
Now, 2007 had already surpassed 2006 for private equity deals. Maybe completed deals are another issue.? Going to something more mundane, Mark Hulbert points out some research showing that companies that buyback their stock outperform the market.
By mid-July sentiment was definitely shifting in the debt markets, even as the equity markets rose.? More deals were having trouble getting done.? The willingness of lenders to take risk was declining, particularly on PIK bonds and Toggle notes.? Personally, I find it amazing that high yield investors buy instruments that may not pay interest in cash, given the dismal credit experience of such structures.? What would you expect from a company that doesn’t have enough money to make interest payments in cash?
The next article is a vision of the future. Five or so years from now, who will buy all of the new IPOs generated from today’s flood of private equity?? Then again, with the over-borrowing to make deals work, maybe not so many will come to market in the future, at least, not at the size that they left.
Take a look at the seven bad times to buy equities from John Hussman.? The last five of them came at times when the “Fed Model” would have told you to be in bonds.? The first two were close, but in the long haul, one was better off holding common stock through the declines.
By mid-July, we are a little past the recent peak, and buybacks are taking the place of LBOs in the market for shrinkage of the supply of equity.? With investment grade bond yields falling from mid-June, it seems like a reasonable thing to do.
I would never want to be a dedicated short investor.? Shorts are perpetually short the capital structure option, which the equity holders can exercise to lever up, when it is to their advantage to do so.? In this article, the difficulties of being short are explained, with the risks of private equity buyouts, and getting crowded out by naive shorts running 130/30 funds.? Jim Griffin at RealMoney takes an allied approach, suggesting that with equity getting replaced by debt, that equities are possibly a good deal here.
So private equity is dead now, right?? I see it more as a sorting process.? Deals that make economic sense at higher lending rates will get done, and those that don’t make sense will be funded by the investment banks, or shelved for now, depending on the bridge lending deal terms.? It won’t be as big of a force in the market, but buybacks among investment grade corporations will continue to shrink the overall equity supply of the market for now.? I am still a moderate bull on the equity market.
As I write this, I am listening to a replay of the RAM Holdings Conference Call that happened on Monday.? RAM Holdings did not have a good day in the market yesterday, losing 44.5%? of their market value.? What went wrong?
Investors are more attuned to subprime, and so the merest hint of trouble sends them running for the exits.
They are more attuned to CDOs, and so the merest hint of trouble sends them running for the exits.
They commented that premium volume might decline over the remainder of the year.
They only met the earnings estimate.
The cost of their soft capital facility has risen to LIBOR+200, the maximum, leading them to question whether they can’t replace the facility with something better.?? (My guess? No.)
The conference call focused on subprime, CDOs, and the more shadowy bits of their guarantees.
So what does RAM Holdings do?? They reinsure the primary AAA financial guarantors.? They are the only AAA reinsurer that does not compete with the primary insurers.? Typically, they try to take an equal slice of all of the business that MBIA, Ambac, FGIC, FSA, and the three others produce each year.? In that sense, you can think of them as a small version of what the average of the financial guarantee industry would be like if it were a single company.? Unlike a P&C reinsurer, losses kick in only after a threshold is met, and then a lot of losses get paid, with RAM Holdings, the losses are pro-rata from the first dollar.? The primary insurers would have no advantage passing them bad business, because they would be more affected by the bad business.
I’m reviewing RAM Holdings as a possible purchase candidate.? If I were running a small cap fund, I would definitely start tossing some in now.? Why?? It’s trading at less than 35% of adjusted book value, and the balance sheet is good in my opinion, and the opinions of S&P and Moody’s.?? If I were running a hedge fund, I would buy RAM and short equal amounts of MBI, ABK, SCA and AGO.? Why?? If RAM is really in this much trouble, it is likely that MBIA, Ambac, Security Capital and Assured Guaranty are in the same trouble.
Aside from that, their subprime exposure is small-ish and seasoned.? Their CDO exposure is almost all AAA, with super-senior attachment points (i.e. non-guaranteed AAA bonds would have to lose it all before thet pay dollar one of guarantees).? Honestly, I’m probably more concerned about the BBB HELOC and closed-end second lien mortgage exposure.? I would need more data on that before I could act.
Then there’s Safety Insurance, which was up 12.0% on Monday.? What went right?
Unlike Commerce Group, which missed, they beat estimates handily.
They raised their dividend by 60%, from $1.00 to $1.60.
They announced a $30 million buyback (and they have the money to do it).
The asset side of their balance sheet carries little credit risk.
Now, Safety faces its challenges as the Massachusetts auto insurance market possibly partially deregulates, but Safety has successfully competed in a variety of different market regimes in the state.? The current management team has shown itself to be very adept at adjusting to changing conditions.
Even with change, Massachusetts will still be the most heavy handed state in the US with auto insurance.? It won’t attract a lot of new entrants.? And, it is possible that no change will happen… previous deregulatory plans have come and gone, though this one has more political clout behind it.
Safety is still cheap to me at 1.0x book value, and 7.6x 2008 estimated earnings.? I’m hanging around for more.
It was not a great week for my portfolio, but I still like my stocks. Is global growth slackening? I don’t think so. Are the financials that I own under threat? With the possible exception of Deerfield [DFR], no, not at all. Four quality US insurers, three quality European banks, and DFR. Hey, Deutsche Bank actually profited from the crisis. And Safety Insurance, unlike Commerce Group which missed estimates, beat estimates by a dime after the close. Bright management team there, and it trades at 97% of book, 5.7x 2007 earnings, and 6.8x 2008 earnings. (Did I mention that the reserves look conservative?)
Today’s action makes me think that there is some mindless “sell financials” program out there, and not caring about what is inside the financials. I will be adding to my names that were the worst hit recently, and perhaps, giving a higher weight to some of the insurers that I recently purchased. Assurant at 8.7x 2008 earnings, and Lincoln National at 9.2x 2008 earnings? It doesn’t make sense; these are two high quality companies with excellent growth prospects.
I am a value investor. Scanning my portfolio, I see a median 2008 P/E between 9-10x, and a median P/B in the 1.1x area. My portfolio will find support, even if the market falls further.
