Category: Stocks

There Is Always Enough Time To Panic, Redux

Posted on by David Merkel

Photo Credit: Gopal Vijayaraghavan || A stampede of wildebeest! Panic! Panic! MIndless panic!

Before I get started, dare I mention that Aleph Blog is a teenager now? 13 years old. Who knew it would last this long? Maybe it will outlast TheStreet.com where I got my start in business and investment writing.

Looking back at some of the posts from February and March of 2007, I find it interesting to see at least two posts about panicking. I think there were more.

The market was not as highly valued as it is now, but had structural deficiencies in the finance sector, which we don’t have now. Debt levels at nonfinancial firms were lower than what we have now, but for the most part, investment grade corporations have laddered their debt, and interest rates are indeed low, leaving ratios like EBITDA/Interest usually in good condition.

The main event at that point in 2007 was a sharp move down in the Shanghai stock market that gave many the jitters. Like the coronavirus, the effects on the markets are indirect, and not likely to be long lasting.

But what other similarities and differences are there? In early 2007, the Fed was tightening, en route to overtightening. Today, they are probably more likely to loosen than to stand pat, but they won’t tell you that openly now.

Areas of debt that are troublesome — margin debt, student loans, low end consumer credit, nonfinancial junk-rated corporate bonds and loans, and sovereign debts. Each of these have grown rapidly, while credit related to the housing markets is in decent shape.

Six business days ago, my estimate of future stock returns over the next ten years was 2.21%/year, the lowest I have ever seen it (and a new all-time high for the stock market). Today it is 4.40%/year. Quite a move. Also in the quite a move department is the 10-year Treasury note, whose yield went from 1.56% to 1.23%, a new all-time low.

Six business days ago, I would rather have owned investment grade corporates versus stocks. That has flipped. For some of my clients, near the end of the day, I did some small buying, moving from 79% stock to 81%. Nothing major, just some rebalancing trades.

I said two weeks ago: “As such, lighten up on risk assets, and prepare for the next drop in the stock market.” Now I don’t deserve any credit for that statement… I’ve been saying it for too long.

That said, the second-best strategy that you have the courage to follow is better than the best strategy that you are too scared to follow. As for me, if the market keeps falling, I will be buying *very slowly.* But if the current drop has you scared, well, maybe sell down to a level where you sleep well at night. I think mixes of risky assets to safe assets of between 80/20 and 50/50 are suitable for almost everyone, unless you are saving for a short-term need.

Best to do risk control when the market is not jumpy, slumpy, lumpy, or bumpy. Tell you what, if you are worried now, if the market retraces half the loss, take something off the table, and sleep well at night.

That said, there are no guarantees. Now is the only time you can act. Act wisely.

The Tail Can’t Wag the Dog

Posted on by David Merkel

Photo Credit: theilr || Cute dog, huh?

There are a pair of articles regarding the efforts of a few people posting at Reddit to make money in stocks as part of a perpetual motion machine. The articles are here: Businessweek, Matt Levine.

The idea is for a bunch of people to buy calls in the morning, which forces market makers to hedge by buying the underlying stock, which pushes the price up, giving automatic gains. Now, real hedgers hedge options using options, but the net effect should be the same regardless.

What the speculators mentioned in these articles don’t get is that they are violating rule XXXII:

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.? The process cannot work in reverse, except by accident.

The Rules, Part XXXII

The quick summary of this is that the tail can’t wag the dog. The amount of money in the options market is far smaller than the money in the stock market. As such, if speculators try to overwhelm the market for a given stock with call purchases, real money sellers will happily oblige them and provide them with stock. They will not win on average.

There are no simple magical money machines in the market. Those that think they have one have deceived themselves.

Focus on the Long-term

Posted on by David Merkel

Photo Credit: Sacha Chua || Planning is a good thing.

In any investment decisions, one must look at the long term. Don’t pay any attention to news that does not permanently change business conditions.

The thing that drew my attention here is the rather weak coronavirus. Stalin supposedly said, “A single death is a tragedy; a million deaths is a statistic.” My sympathies to the families of those who have died from the coronavirus. But to society as a whole, the coronavirus has done less damage than influenza does every year.

As such, I don’t pay attention to the coronavirus. Stocks are long-term assets, and if the coronavirus will have no impact on the economy past 2025, I don’t see why I need to pay attention to it.

The same applies to politics. Is there someone coming like Chavez or Maduro who will radically reshape business/industry? No? Well, don’t worry so much. Money votes for itself. Few genuinely want to slay the processes that make society well-off in aggregate, even if they are getting a lesser portion of the increase.

In healthy societies, there is a tendency to protect property rights. Property rights are an aspect of human rights, let the liberals note this. We can argue about the edges of the rights, but fundamentally property rights must be protected, or society falls apart.

Now, at present, I am not a bull on the stock markets, but it is not because of any event risk, but rather high valuations. We aren’t at the same valuations that we experienced at the top of the dot-com bubble, but we are in the range of valuations that only existed from 1998-2000. At present the S&P 500 is expecting gains of just 2.24%/year over the next ten years.

Even this is not the long term. Okay, bad returns for ten years, and after that, back to historic norms. Fine, that’s right. But how many will panic in the process of a crash, and not hang on for the long-term?

I think it is worth edging asset allocations toward caution as valuations are so high. We can’t predict when the disaster will happen, but when it does, there will be better opportunities to deploy free cash.

As such, lighten up on risk assets, and prepare for the next drop in the stock market.

On War Risk

Posted on by David Merkel

Photo Credit: Vitor D’Agnoluzzo || Politicians should think more carefully before using violence to achieve foreign policy goals — it is rare that it is ethically justified

Ten years ago, I wrote a short piece called In Defense of Home Bias. International investing is generally a good idea for diversification purposes, though it will work varyingly well over time. The last decade has not been kind to the concept for US investors, but perhaps it has been extra good for foreign investors in US companies.

The first bullet point I wrote with respect to difficulties with international investing was:

There will be no war that changes the amount or terms of commerce.

In Defense of Home Bias

This is one case where being an economic historian will help more than studying market statistics. Most market statistics studied today come from the post-WWII era where no conflict has materially affected the markets for a long time, or done lasting damage.

Contrast that with Italy, Japan and Germany in WWII (this applies to West Germany, not East Germany) — their markets were pounded to the degree where people lost a lot in real terms if they were invested in bonds or paper money, and lost significant value in stocks for a decade, but made it all back. Thos invested in short-term government debt coasted along as did those that held gold.

Though some productive capacity was destroyed, stocks recovered rapidly because they could improve profitability to keep up with post-war inflation. Gold and short debt could tread water, but bonds and non-interest bearing deposits lost value.

But looking back in history, not many wars end with a merciful victor like the US was at that time. After WWI, the demand for reparations and bad monetary policy killed German bonds and paper money. After the Civil War, the South was economically ruined — it too a long time to recover.

So, what to think about war risk?

  • If its not on your home soil, it is not likely to be too damaging, though government policy could lead to inflation, as happened in the Vietnam War era.
  • As Sun Tzu said, “Where the army is, prices are high; when prices rise the wealth of the people is exhausted.” (Quoting from this article here.) Yes, measured inflation is scarce today, but if we had to redirect the economy for a major war, it would be different, particularly when currencies are mere fiat currencies. Think of what happened to the currency of the South during/after the Civil War, or the value of the Continental Dollar during/after the Revolutionary War.
  • Stocks a given society tend to do okay unless a society is wiped out, or taken over by Communism.
  • A balanced portfolio that contains short-term debt and gold, as well as stock and bonds should do okay so long as the society itself is not destroyed… where existing property rights get extinguished.
  • Don’t invest in places where a hot war is going on. Even if speculating on when the war will end, that is a gamblers’ game.

For the most part I would say don’t worry too much about war. As the 34th Ferengi Rule of Acquisition says, “War is good for business.” To which Quark added, “…only from a distance, the closer to the front lines, the less profitable it gets.” Though fictional and humorous, it is for the most part true. If your assets and your society are not destroyed, you have your capital intact to speculate on the rebuilding of places that are destroyed.

Now all that said, there is the risk that a small conflict becomes a big one. Though WWI was inevitable in many ways, no one predicted the chain of events that led to the conflict.

My advice is threefold then. 1) Don’t worry — diversify across asset classes, including hard assets. 2) If you want to remove most of the remaining risk stick to places that have the “rule of law” and are unlikely to be dragged into armed conflict on their home soil. 3) Even if not on home soil, be wary of inflation if a conflict drags on.

Limits

Posted on by David Merkel

Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are

I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”

Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”

Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.

These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.

I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.

In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).

It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.

Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.

Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.

Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.

One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.

Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.

Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.

As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.

One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.

Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.

Summary

Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.

Another Way to Deal with the Rare Problem of Closed-end Fund Premiums

Posted on by David Merkel

Photo Credit: Matt M. || Some things are just too big for their own good.

Three years ago, I wrote an unusual piece called “How do you Manage a Company when the Stock is Considerably Overvalued?” Part of it dealt with the simpler case of dealing with closed-end funds that trade at a consistent premium to NAV. Quoting that portion of the article:

…what should a the managers/board of a closed end fund do if it persistently trades at a large premium to its net asset value [NAV]? ?I can think of three ideas:

1) Conclude that the best course of action is to?minimize the eventual price crash that will happen. ?Therefore issue stock as near the current price level as possible, and use it to buy non-inflated assets, bringing down the discount. ?What?s that, you say? ?The act of announcing a stock offering will crater the price? ?Okay, good point, which brings us to:

2) Merge with another closed end fund, trading at a discount, but offering them a premium to their NAV, hopefully a closed end fund?related to the type of closed end fund that you are. ?What?s that, you say? ?Those that manage other closed end funds are financial experts, and would never agree to that? ?Uhh, maybe. ?Let me say that not all financial experts are equal, and who knows what you might be able to do. ?Also, they do have a duty to their investors to maximize value, and for those that?sell above net asset value this is a big win. ?In the meantime, you have reduced your effective economic discount for those that continue to hold your fund.

3) Issue bonds or preferred stock convertible into common stock at a level that virtually guarantees conversion. ?Use the proceeds to invest in your ordinary investment strategy, bringing down the effective discount as dilution slowly takes place.

Of all the ideas, I think 3 might work best, because it would have the best chance of allowing you to issue equity near the overvalued level. ?If the overvaluation was 50%, maybe you could get it down to 25% by doubling the asset base, in which case you did your holders a big favor. ?If it works, maybe repeat it in two years if the premium persists.

How do you Manage a Company when the Stock is Considerably Overvalued?

Tonight, I want to suggest a fourth method, which would work and for the most part not upset existing holders. It would also benefit the fund manager. Do a rights offering.

A rights offering would give each shareholder a certain number of rights per original share held, allowing them to buy shares of stock at a price lower than the current price at the time of the announcement. The rights are typically tradeable, so someone not wanting to put more money in can trade their rights away — to them it is like a dividend. Others can buy the rights traded away, and buy shares in the offering. There are sometimes “oversubscription rights” which allow those subscribing in the rights offering to get additional shares at the offering price pro-rata to their subscriptions, if there are shares not purchased in the rights offering. Finally, rights not exercised expire worthless on the closing date of the offering.

Sound like a fun game? I participated in a number of these in the ’90s, particularly with some small-cap mortgage REITs that were busted from playing around with interest only securities using borrowed money. Messy stuff, but they had tax losses that were worth more than the price of the stock. The rights offerings were a means of raising capital to give them breathing room so that they could wind up their operations on more favorable terms than a forced sale that would endanger the value of the tax losses. But I digress…

Rights offerings are typically a small-cap phenomenon. They are one of the financing methods of last resort. But they could play a meaningful role in bringing down the premium over NAV of a closed-end fund.

Picture Credit: Aleph Blog

In this case, every old share receives one right, and it takes $15 plus four rights to buy a new share. The above assumes that all rights are used, and all the additional 2.5 million shares are subscribed.

Two things happen: the closed-end fund gets bigger, and the premium to NAV drops. Now, there is no guarantee that the price would not be affected by the rights offering — some people might mistakenly sell out in a panic, or the shareholders might bid up the price back to $21, illogical as that might seem. But if everyone behaved rationally in an offer like this, the premium over NAV would fall, and more so if fewer rights were needed to buy a share.

Now the managers of the fund would have more assets to manage, but might find that they can’t absolutely replicate the prior composition of the fund — many funds that trade at a premium are relatively high yielding bond funds. It’s possible that as a result of the additional money to put to work that the yield of the fund might fall, inducing some people to sell, and the premium to NAV would drop further.

It would be in the interests of the managers to try something like this to monetize the premium of the fund. If fund investors are rational, they wouldn’t lose any money in the process. But would the managers ever try doing it? Time will tell.

The Sirens’ Call

Posted on by David Merkel

Photo Credit: Miles Nicholls || Actually, the bells get rung at the top, and quite frequently for the duration of the process. People hear it and they decide not to listen. Too many false alarms.

The stock market model is projecting a 3.06%/year return over the next ten years as of the close on 11/15/2019. That’s near where a 10-year mid-single-A rated bond would trade. That’s not offering a lot of compensation for putting your money at risk.

I’m planning on reducing my total risk level by 15% or so, moving my equity allocation from around 70% to 55%. That will be the lowest it has been in two decades. I’m not running to do this. I am still working out the details.

The Fundamentals of Equity Market Tops

You might recall an old piece of mine that I wrote for RealMoney back in January 2004 — The Fundamentals of Market Tops. In it, I gave a non-technical analysis approach to analyzing whether we might be near a market top. In 2004, I concluded that we were NOT near a market top. (This article also served as a partial template for the article at RealMoney in May 2005, which said that YES we were near a market top for Residential Real Estate. Two good calls.)

The article is longer than most, should not fit in the TL;DR bucket for most investors. I’m not going to reconstruct the article here, but just give some brief points that fit the frame of the article. Here I go:

  • Value investors have been sidelined. Growth is winning handily.
  • Valuation-sensitive investors are raising cash. Buffett sitting on $130 billion is quite statement. He’s not alone. More on that below.
  • Momentum is working.
  • There has been a decline in IPO quality.
  • Lots of money is getting attracted to private equity.
  • Corporate leverage is high, and covenants are weak.
  • Non-GAAP accounting gets more attention than it deserves.
  • Defined benefit plans are net sellers of stock, but not for the reasons I posit in my article — they are doing it to move to private equity and alternatives, and bonds as a part of liability-driven investing.

Cutting against my thesis:

  • More companies are committing to paying dividends, and growing them. I’m impressed with the degree that corporations are thinking through their use of free cash flow, even as they lever up.
  • Actual volatility isn’t that high.
  • The Fed is supportive.

On net, these conditions give some confirmation to what my quantitative model is saying… the market is near a top. Could it go higher still? You bet, with an emphasis on the word “bet.” The S&P 500 at 4500 would be where valuations were during the dot-com bubble.

Asset-Liability Management and Market Tops

I want to emphasize one point, and then I am done. I wrote another article called Look to the Liabilities to Understand the Assets. There are a few more like it at this blog.

The main idea as applied to the present is this: when you have “strong hands” (those with long time horizons and strong balance sheets) raising cash levels and those with “weak hands” (those with shorter time horizons and weaker balance sheets) staying highly invested in risk assets, it is a situation that is unstable. Those that have capability to “buy and hold” are sitting on their hands, whereas those who have to get returns or they will suffer (typically municipal defined benefit plans and older retail investor who didn’t save enough) are risking a great deal, and have little additional buying power.

This is unstable. This situation typically exists at market tops. Remember, it is what investors DO that is the consensus, not what they SAY.

With that, consider your risk positions, and if you think you should act, do so. If you are uncertain, you could ask an intelligent friend or do half.

Dissent on Triple-S Management II

Posted on by David Merkel

Photo Credit: Morris Zawada || Looked at many dissent pictures, and they did not represent my views. A Pro-life march, in its principled and relatively quiet nature, with people who are mostly otherwise apolitical, fits.

I’ll give the big news up front, then I will explain. I decided to put Triple-S Management in the “too hard” pile, to use a phrase of Buffett’s. I am flat the stock for my clients and me. I don’t short, but if the price drops severely if/when Propiedad (the P&C subsidiary) goes into insolvency, I will buy in again.

Here’s my overall thesis: 1) I find it difficult to believe that Propiedad is solvent on a current basis. I do think there are reasons for the PR insurance department to play along as if they are solvent, giving them time to become solvent… but that’s a gambit that might not work if enough policyholder lawsuits succeed and get payments significantly higher than the amounts at which they are reserved. If that happens, and claims incurred from prior years goes significantly positive, there will be a lot of disbelief about the solvency of Propiedad.

2) If Propiedad goes insolvent there may be an effort to allege or force the parent company to stand behind all claims. That may take a number of forms, some of which are informal and messy, and are not likely to work. The formal methods of trying to do it are also not likely to work. That said, who can tell how a judge might rule on some marginal things that Triple-S did.

3) The stock is not going to zero. My base case is around $30/share if Propiedad is allowed to fail without additional cost to Triple-S.

Why Propiedad might Fail

I spent a decent amount of time thinking about the reserving issues, and it is possible for a P&C insurer to estimate values considerably lower in the short-run than what the company might ultimately pay. This is particularly true with long-tail coverages like asbestos and environmental, but less true with home and property claims.

In the 1980s, it was alleged by some industry observers that the entirety of long-tail P&C reinsurers that were active at that time were effectively broke. They were under severe stress. They delayed paying claims. They played for time hoping that they would earn enough on new business that they could stay afloat. Like the old joke, they hoped to eat the whole elephant “one bite at a time.” And for many of them with forbearing regulators and insureds, it worked. In similar situations, if regulators or insureds don’t play along, they can be forced into insolvency.

That may end up being the case with Propiedad. Insureds may win in court cases, and the initial winners will deplete the claims paying ability of Propiedad, leading the PR insurance department to take over to preserve value for the remaining claimants.

We are now more than two years past the Maria hurricane, and much of Puerto Rico is still a mess. Part of that stems from slowness in the US Government in giving aid. Some of its stems from insurers being slow to pay, and the courts of PR possibly being clogged as a result of all of the lawsuits being filed.

It seems that Propiedad has saved the worst for last in its effort at paying its claims. Thus comparisons to what has been paid already may be less than valid. It’s unusual to have so many claims hanging out past two years. Part of this is due to the size of the disaster relative to the size of Puerto Rico. Part of it also is that claims contested in court will take longer, and the courts may have their hands full.

But another aspect could be the insurance department trying to maximize claim payments to commercial insureds. If Propiedad survives, claimants have the opportunity to get a full payment. If Propiedad fails, and goes into liquidation, claimants will be limited a share of the assets in Propiedad, and whatever can be assessed by the PR Insurance Department on the premiums of surviving P&C insurers serving the state, up to a limit of $300,000/claim and $1,000,000 to any given entity.

In other words, you can sue Propiedad for what you would like, but the maximum you can recover if it is insolvent rests on:

  • the maximums as specified by the guaranty fund, or if there is more money from the insolvent estate of Propiedad
  • pro-rata reimbursement of claims over the maximums of the guarantee fund.

If Propiedad is afloat and earning money, and not paying dividends to Triple-S, the recovery levels of all claimants above the guaranty fund limits get higher. Also note that the PR Insurance department may not want to assess the remaining insurers. With the limited supply of insurers active in PR, it would likely mean higher premiums for all who are insured, in order for the companies to pay the assessments.

(As an aside, the P&C guaranty funds have a nice website with lots of data. I’ve cited some here already. It would have been more interesting if a means of contacting the PR guaranty fund were there, or how many claims their guaranty fund has had, and the assessments needed to fund them. But alas, PR has not reported financial data to them since 2010.)

But that brings us to the next point which will be:

Will Triple-S Pay the Claims of Propiedad?

I don’t think so. First, such an obligation is not listed in the 10-K or the statutory statements. A. M. Best rates them that way also. Propiedad has made statements like Triple-S stands behind Propiedad, but those are far short of a “full faith and credit guarantee” from the parent company. I should know: for four years I wrote GICs [guaranteed investment contracts] from a bankruptcy-remote subsidiary of the parent company. When my credit rating was no longer good enough to sell GICs because of buyers insisting on higher ratings, I could not get the parent company to agree to guarantee the GICs, and so I closed down the line of business.

It’s not impossible, though, that a judge would look at the vague statements and conclude otherwise. I think Triple-S would have meritorious arguments that other companies have said things like that, and they were not used to create a “full faith and credit guarantee.”

It is more likely that implicit pressure against the health subsidiary could be used to have Triple-S pay a limited amount to help with claims as they send Propiedad into insolvency.

If Triple-S Avoids Claims Due to Propiedad

The tangible book value of Triple-S excluding their equity in Propiedad is a little more than $34/share. Imagine Triple-S closing down operations because PR takes away their ability to write more health business. There would be a minor panic as many people and companies would have to go to the remaining health insurers in PR for coverage, and insurance rates would certainly rise. Triple-S would keep a skeleton staff for one year, and a smaller one for the next year as they pay out terminal dividends to the shareholders of at least $30/share.

But I could be wrong. Clever lawyers could find a way to charge Triple-S with the full value of claims owed by Propiedad, and those claims would have to be over $1.2 billion to drive the stock to zero. Those are the two victory criteria for the shorts. If Maria claims against Propiedad end up less than $300 million or Triple-S can send Propiedad into insolvency, then it is worth more than the current price.

But for now I will sit back and watch. There are too many jolts and bumps here, and I have safer ideas to invest in.

PS — I think the shorts would do better if they laid off the sensationalism of certain events associated with the management of Triple-S, and focus on the main question: can Triple-S be charged with the claims that Propiedad can’t pay? That is the key question.

Full disclosure: no positions in any companies mentioned in this article, for clients or me. This updates my views since the last article.

No es ESG

Posted on by David Merkel

Picture Credit: David Merkel || E & S are hollow, G is solid

There are fads in investing. They eventually go away. Remember ARM funds? The Americus Trusts? (Neat idea, killed by a legal change). The nifty fifty? Hot industries that produce a lot of IPOs?

I also think cryptocurrencies are a fad, and also factor and volatility investing, at least in terms of the ETFs that are offered to retail investors.

And, I think ESG is a fad, at least in terms of the way it is being deployed today. My main point is that E (environmental) & S (social) are mostly subjective, and not related to investment returns or risk control. G (governance) is mostly objective and related to investment returns and risk control.

Now some will say “But wait, there are all these journal articles showing that ESG produces better volatility-adjusted returns.” Quantitative finance has a laundry list of problems:

  • We have only one world, one history, one data set. We’ve gone over the data set numerous times, knowing its proclivities. It’s not hard to tease “alpha” out in a study, but it is difficult to realize alpha in real life.
  • Researchers often take multiple passes over the data set as they do their analyses. Only the ones with results supporting the expected conclusions get a paper published.
  • Neutral observers don’t exist — their pay and social standing get determined by producing a series of statistically significant results, regardless of whether they tortured the data to get there or not. (Aside: when I read some of the macroeconomic crud out of the Federal Reserve, and I see the abstruse technique employed to get a result, I know the data has been tortured, and of course the model does not predict well.)
  • And more — you can read this for the rest of the problems. I don’t think I even get all of the issues with academic-style research in that article.

As such, I don’t trust the research on ESG. The limited history that we have for general inquiries is even shorter for ESG analyses. The likelihood of picking up spurious correlation is high. As such, unless I have a good mental model for how environmental or social issues affect long-term growth in value, I can’t use them as a fiduciary. I have those mental models for governance, so I use them — just not the same way as some of the quantitative governance models do.

Governance issues are perennial; they are not a fad. The agency problem, where corporate managements pursue goals that are in their interests, but not in the interests of shareholders never goes away. It can be reduced by a variety of measures, like splitting the CEO and Chairman positions. removing management influence over the audit and compensation committees, end things like that.

That said, there are exceptions to the rules, and certain strong managers running companies with highly focused and ethical cultures might be allowed more running room. Berkshire Hathaway doesn’t fit most of the rules, and in general it has done well. One size fits most, but not all.

It’s similar to the way I view management use of free cash flow. With a talented and honest management team, I want the management to have the freedom to retain all of the cash flow for growth if they see the opportunities. But most managements aren’t that good, and they should pay a dividend. Buybacks should only be done when the stock is notably cheap compared to the private market value of the firm, and the balance sheet remains solid.

That’s why I think many simple governance scores are mistaken. You have to take a look at the management team and culture in order to do a broader evaluation of the governance. I for one a comfortable buying stakes in a company where there is a control investor if the control investor is known for treating the outside passive minority investors fairly, and does not scrape too much off the top.

I expect companies that I own to follow the laws of the countries that they work in, and engage in ethical behavior. My rule is simple: if a company tries to cheat one set of stakeholders, the odds are higher that they will cheat shareholders at some point. Most of my significant losses have stemmed from some sort of fraud issue… this is etched in my mind.

But many of the details of environmental and social factors seem utterly tangential to me — I don’t see how they drive value. Let the government press its claims on corporations to avoid discrimination and limit pollution. That is the proper locus for these issues, particularly if you are a fiduciary. What is in the best financial interests of your clients should be your guiding principle.

Note as well that the implementation of E, S, and G are nowhere near standardized. G is probably the closest. (This also applies to factor investing as well, which is constantly engaging in new specification searches sharpening their statistical analyses.) Even if I wanted to do E & S, how would I know that I have the right figures? How would I know that they weren’t a product of backtest biases?

Also, as Matt Levine points out, many applications of ESG don’t make a lot of sense, even if these were desirable goals. As such, I look at many of the ESG products being put out there are marketing fads to take the attention of retail away from earning returns… after all, it is tough to beat the market, and ESG will give you many ways to have have a built-in excuse.

Do I know that I am in a minority for my views here? Yes. But I am often in a minority, and I would argue that the degree of agreement with ESG is paper-thin. It’s good while it brings in assets to manage, but the moment it doesn’t bring home the bacon, it will be jettisoned.

I’m in the minority for now. I expect the majority to come my way, not vice-versa. No illusions — it will take time for that to happen.

Neither a Borrower nor a Lender be

Posted on by David Merkel

Photo Credit: Ben Schumin || Looks like a place where you may get a fast deal, but not the best deal.

Remember 125% LTV loans on houses prior to the financial crisis? Well, auto loans now are their twin separated at birth. The Wall Street Journal wrote an article recently about those who lend more than 100% on automobiles.

Now, in the old days, auto loans were short. They were shorter than five years, and never more than 80% of the value of the car. This meant that the balance of auto loan would always be less than the depreciated value of the car under ordinary circumstances.

But as has been common in American history, we always test the limits in lending. Maturities have been lengthened and loan-to-value ratios expanded. If you need a car, and your current loan is more than the value of the car you want to trade in, some lender will be willing to roll the loss into the value of the loan to purchase the next car, with a higher interest rate to compensate for the added risk.

Why is the risk higher? Auto loans are collateralized by the car. If you don’t pay, the repo man comes and takes the car. If the car is worth less than the loan, the borrower is liable for the difference. When the difference is big, the lender will pursue the borrower for payment, and either get the payment, or send the borrower into bankruptcy. The costs of bankruptcy to the borrower means losing the car and not being able to borrow for seven years or so.

But there will be costs to the lender as well. In a financial crisis, most of them will go bankrupt themselves. They aren’t thickly capitalized, and can’t afford a lot of losses. That’s part of the price of making low quality loans.

What to do

The first step in doing well here is to buy a cheap car that is of reasonable quality, even if it isn’t fashionable. I have only once paid more than $11,000 for a car, and that was for a 15-seat Ford XLT Van that last 14 years for me. Typically these days, I buy refurbished cars that have been through a wreck, and carry a salvage title. I would say, “You don’t need to look good,” but I look just fine. I pay very little for cars, and they last well.

Part of the challenge is finding honest auto dealers who charge a reasonable markup over their costs. Ask your smart friends for advice. (If you don’t have smart friends, get some.) Part of the price of the method that I use is that few lenders will lend on “salvage title” vehicles, so I have to pay cash. It is better to borrow unsecured at a high rate and buy a cheap but quality salvage title car than to buy an expensive vehicle from a regular dealer.

There is a hidden cost to buying salvage title cars though. If there is an accident and it is totaled, the insurer will pay you far less than for a similar non-salvage title vehicle.

Don’t Borrow to Buy a Car

This is the simplest advice. When I was 27, my parents came to visit me in California. My Father looked at the two used cars that my wife and I owned, and praised me — “You haven’t bought a lot of fancy rolling stock.”

I have never taken out an auto loan. I never will. Borrowing should only be for things that don’t depreciate, like a house.

People need to get over the idea that their car has to be powerful or pretty, and focus on buying cars that are reliable. Paying less for a car is one of the easiest ways to save money, so long as you get a quality car.

Avoid Owning Shares in Auto Lenders

I don’t know who you have to avoid here. I can’t think of a pure play. If you know of one, please mention it in the comments. I simply know that those who lend without adequate security eventually get hosed.

You would think we would have learned from the Financial Crisis, but the more I look at current conditions, the more I think we are short-sighted.

We are not facing a banking crisis now, but maybe we might around 2030. The banks are mostly in good shape now, but perhaps we might see the failure of some non-bank lenders in the next recession who have lent too much on autos.

In summary, try to avoid borrowing on a car, and don’t own companies who lend more than 100% on a car.

PS — three articles that I have written on buying cars:

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