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 recent case of JP Morgan’s hedging activities bring to light an observation that should be clear to all but isn’t.  Hedging only works when you are small relative to the markets in which you hedge.

Let’s consider tranched credit index default swaps.  We can create models where the prices of each tranche can be calculated given default frequency and severity.  But default is not a constant beast.  Defaults come in waves, and when incidence is high, so is severity of loss.  Vice-versa when incidence is low, leaving aside fraud.

We might have a good idea of where credit default should trade for a basket of corporate debtors “credits” so long as we look at the thing as a whole,  and don’t carve it up.  In general, a basket of borrowers is easier to predict than individual borrowers.

But the basket gets difficult when we split it up into first loss, second loss, third loss, etc. claims where different parties lose their capital at differing levels of total loss.  Yes, in theory, we can come up with prices.  We can even come up with hedge ratios  that show the theoretical tradeoff between tranches as losses increase or decrease, which might work, might, if you are a small player in that market.

Woe betide you, if you do anything too fancy, and you are big relative to the market.  Because you are big, you have affected the prices of the market.  Price relationships that were normal before you arrived have shifted and reflect your interests, which in the short-run makes your accounting look better.  As the bubble grows, those investing in the bubble look better.  But as the bubble expands, those that have invested in it find a wave of cash fighting against them, but it doesn’t matter, because momentum investors are still buying.

At the end, the large investor amid the bubble finds himself stranded.  The market knows his positions, and he can’t make trades to extricate himself, because the terms are onerous.

Look, I used to trade small-issue lesser-known bonds.  I only bought stuff that I knew would be money-good, i.e. pay off.  In that case, you have the option of speculating when spreads are wide, and selling when they get tight.  But if you do that with bonds that you don’t know whether they will likely pay in full, the ability to hedge is meaningless, because your hedge could break in a default.

And so it was for JP Morgan.  When you get too big relative to the market, it had better be when you are the buyer or seller of last resort, and you are catching the turn.  But in normal markets, bigs are pigs, and are likely to be slaughtered.

It doesn’t matter what your model says is the right tradeoff if you are too big relative to the market.  Your own actions have poisoned the signals that your models receive.

Amaranth fell into this same bucket, with a talented energy trader who understood how the market generally worked.  As his success grew, so did his size, and he didn’t realize that the size of the fund was distorting market prices.  At the end there was one unlikely scenario that was unhedged, and that was the scenario that occurred, and the results led to the collapse of the fund.

If Amaranth had been smaller they could have traded out of it.  At their size, they were “elephants in an elevator.”

Size matters, and for investment purposes, smaller is better.  And for the most part, less complex is better too.  Don’t demand liquidity from markets, or you will lose.  If liquidity comes to your door, and it seems to be a good deal, wave it in.

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.  I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.  Also, how to make money in the bond market when you reach the risk limits.

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.  Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.   Also, the end of my time as a bond manager, and the parties that came as a result.   Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.  Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

-==-=-=-=-=–=-=

That’s all for now.  Never thought I would do so many long series when I started blogging.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

Then there was the continuation of “The Rules” series:

The Rules, Part XIII, subpart A

On the biases the come from yield-seeking.

The Rules, Part XIII, subpart B

Repeat after me, “Yield is not free.”

The Rules, Part XIII, subpart C

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.  It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

The Rules, Part XV

Securitization segments a security into liquid and illiquid components.

The Rules, Part XVI

“Governments are smaller than markets; markets are smaller than cultures.“

A fundamental rule of mine, but one with a lot of punch.

The Rules, Part XVII

On the differences between panics and booms.

The Journal of Failed Finance Research

Much research fails quietly, but other researchers don’t learn about the dead ends.  Better that they should learn of the failures, and avoid the dead ends.

How I Minimize Taxes on my Stock Investing

Sell low tax cost lots and donate appreciated stock to charities.

Place Political Limits on Overly Compliant Central Banks

Gives a simple rule to control central banks so that they avoid the present troubles.

Yield, the Oldest Scam in the Books

Yes, offering yield is the oldest way to trick people into handing over their money.

A Summary of my Writings on Analyzing Insurance Stocks

A good place to get started if one wants to get up to speed on insurance stocks, but there is a lot there.

Economics is Hard; the Bad Assumptions of Economists Makes it Harder

Going over Kartik Athreya’s letter criticizing nonprofessional economics bloggers.  Why the math behind macroeconomics and microeconomics doesn’t work.

Why Are We The Lucky Ones?

When you are a part of a small broker-dealer, all manner of harebrained deals get offered to you.  This explores three of them.  Note: management did not ask my opinion on the fourth deal, and that is a large part of why they no longer exist.

One more note: the guy who was going to pledge $5 million of stock in example 2 for a $1 million loan?  The stock is worth $7,000 today.

Watch the State of the States

The economics of the states tells us a lot more about the national health because they can’t print money to buy national debts.  (Though they can can raid accrual accounts…)

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

My view is that neoclassical economists are wrong.  Aggregate demand has failed for four reasons:

1. Overleveraged consumers will not readily buy.
2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
3. Aggregate demand is mean-reverting.  It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.  The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
4. When the financial system is in trouble, people get skittish.

The Market Goes to the Dogs, Which Chase Their Tail Risk

Complex and expensive hedging solutions, many of which embed some credit risk, can be less effective than lowering leverage, and (horrors) holding some cash.

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

This one had its detractors, because I believe the paradox of thrift is wrong.  Too much aggregation, and it does not allow the dynamism of the economy to adjust over time, even from severe conditions.

Probably the biggest new thing I did at the blog was start “The Rules” series.  Personally, I think all of them are best articles, because they proceed from deeply held beliefs of mine.  So I start with those:

The Rules, Part I

There is no net hedging in the market.  At the end of the day, the world is 100% net long with itself.  Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

The Rules, Part II

Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

The Rules, Part III

The assumption of normality for asset price changes is wrong in virtually every financial market setting.  The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

The Rules, Part IV

Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.  (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)  The five stages of grieving apply here.

The Rules, Part V

Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

The Rules, Part VI

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.  Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

The Rules, Part VII

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

The Rules, Part VIII

Illiquidity is a function of total transaction costs, which can be considered barriers to entry.

The Rules, Part IX

Attempting to control a system changes it.

The Rules, Part X

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.  This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

The Rules, Part XI

Could an investment bank go to junk status?

The Rules, Part XII

Growth in total factor outputs must equal the growth in payment to inputs.  The equity market cannot forever outgrow the real economy.

And that’s the end of the “rules” posts for now.  They express deeply held beliefs of mine.

My next group of posts dealt with banking reform:

• A Few Notes From the Fordham Conference
• Dumb Regulation is Good Regulation — How to Regulate the Banks
• A Summary of What Bank Reform Should Be

Most of it comes down to getting the risk-based capital formulas right, raising capital levels, and most of all avoiding borrowing short to lend long.  The asset-liability mismatch is the core of why banking crises happen, because the liabilities run when asset levels are depressed.

The next group deals with debts and liabilities of nations and other lesser governments:

• Default, Inflation, Higher Taxes — Choose One
• Ignore anyone who tells you that debt levels don’t matter.
• A Question of Cultural Failure
• A Question of Cultural Failure (II)
• Of Credit Ratings, Sovereign Risk and Semi-Sovereign Risk
• More on Sovereign Risk and Semi-Sovereign Risk
• The Virtue of a Big Bang
• The Logic of Shared Pain
• Promises, Promises (Deals with the huge entitlement promises all over the world)
• The Whole Earth is Owned; Debts Net Out to Zero

Debt-based economic systems are inherently inflexible.  Governments that make long-term promises without pre-funding them scam their taxpayers, and those to whom they make promises.  All solutions are ugly once the willingness of a government to pay on its promises is questioned.

What is Liquidity? (IV)

My point is that you can’t take illiquid assets and make them liquid.

Moat, Float, Growth

Warren Buffett labors to preserve the company he has built, so that it can last far longer than he will.  An impossible task, but what is Buffett if not one that does things far beyond what most of us can do?

In Defense of the Rating Agencies – V (summary, and hopefully final)

I never did go on CNBC for this.  They figured out what I told them: “This wouldn’t make for good television.  It’s too complex.”  But it does come down to my five realities:

• Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
• Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
• New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
• There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
• Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

In the recent run-up, there was talk of the infallibility of equities.  This led to a higher level of variable compensation in the economy through option and share issuance and low pressure to raise fixed wages.  This was yet another form of hidden leverage, which hid the unprofitability of enterprises through share dilution.

That was written in 2001, after the flop of the Nasdaq.  I have sometimes said that bubbles are financing phenomena.  That’s true, but we can phrase it more generally: bubbles occur because of an asset-liability mismatch.  People go long a long-duration asset with short-duration funding.  The short duration funding can be borrowing, or vendor finance, or it can be a labor commitment in order to get equity or option awards.

People chase the long-term asset that seems so valuable, and give up time and interest (money’s version of time) to get it.  They give up more than they imagine for something of uncertain value.  In other words, a mania.  Give up something relatively certain in the short run for something with uncertain long run potential.

The attitude could be summed up with a conversation I heard in early 1998 between my boss and his best salesman, where the salesman said, “It’s a no-brainer, have the market pay your employees.”  His idea was that a constantly rising stock market would provide compensation to employees through stock awards, options, 401(k)s, etc., even as the market was straining at valuation limits.  It is probably a sign that the market is overheated, when market-based rewards become common.

Startups by their nature require that employees be flexible, and give up a lot of fixed guarantees.  What payments they receive at the beginning are small, and less than their work might deserve in most established contexts.  But there is the possibility of the big payoff, and the possibility of total loss.  The asset in question has a lot of variability, but the liability, the work that must be put in, is big, and may not vary much for success or failure.

In the tech bubble, many parties extended vendor credit because there were big profits to be made in the future.  Alas, but they lent to those with very uncertain prospects, and in March of 2000, the chain of leverage started to collapse, both for vendors, and for those that worked in the industries.  Just as hedge funds have a hard time holding onto good employees when performance goes bad, so it is for tech companies when financing dries up, and the stock price craters.  Rats desert the sinking ship.

“Free money” brings out the worst in people.  Do something small in the present and reap a huge future.  Sadly, it rarely works that way, except at the very beginning of a boom.  At the end of the boom, it is a maelstrom, with many people demanding to throw their money away in search of riches that will never be.

From a dated piece:

Crowd-following is common to humanity.  It takes a lot to stand apart from highly correlated behavior.  I’ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.  I said to her, “They don’t know anything about investing!”  My mom replied, “Oh, David.  You’re such a fuddy-duddy.  I just bought some Inktomi!”

Now, to set the record straight, that was just 1% (or less) of my mom’s assets, so an occasional flyer is acceptable.  Call it “Mad Money.”    For my cousins, it was most of their investable assets.  My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I am close to concluding that it is impossible to teach the average person how to do well in investing.  They don’t have the patience or the willingness to learn. (Few want to be called “fuddy-duddy” by their mothers.)

Getting rich quick is very rare, but it entrances some people several times in their lives, and rarely does it end well.  It is far better for most people to work hard in areas of the economy that are being rewarded, and invest excess cash in a mix of  stocks, long-dated investment grade bonds, money markets, and a little gold.

After all, it’s not what you make, it’s what you keep.

Risk premiums should never be capitalized, they should only be taken into income as earned.

This may end up being another odd post of mine.  I’m going to start writing about bank regulation, but I will end up talking about monetary policy.

There are many people who hate the rating agencies. They hate them because they are a convenient target, and most people don’t understand what they do. Rating agencies provide opinions. Nothing more, nothing less.

Many people would like to get rid of the rating agencies. But it’s not that easy. Regulators outsource their credit rating function to the rating agencies because they don’t want to do that work.

There is a way to eliminate the rating agencies, and I have written about that before. But the idea is so radical, that the banks would rather have the rating agencies exist, than use my idea.

So what’s my idea? Simple. If you were setting up a portfolio, what would you assume would be the minimum that you could earn on the portfolio? My minimum would be buying Treasury bonds and earning interest on them.

So if I am looking at a portfolio of risky assets, I would split each asset into two. I would mirror the cash flow pattern of each asset, and construct an equivalent Treasury portfolio to mimic the cash flows. All of the cash flows above that amount from the risky asset are the risky cash flows. The amount of capital that banks hold as reserve against losses should be proportionate to the present value of risky cash flows.

Unlike my last piece on this, I am not saying that the whole present value of risky cash flows should be held as capital against losses. But the regulators should use this, if we are not using rating agencies, as a proxy for credit risk in bank asset portfolios.

Why is this a good measure of credit risk inside banks? The market for lending is fairly efficient. Debts that have more risk have higher interest rates.

This measure of risk benefits from the concept of simplicity. It can be applied everywhere. And, there is good theoretical justification for it. Any return that is upon the government bonds is subject to question.

But suppose we decided to use this as a major portion of our formula for regulating bank capital. What would happen to monetary policy?

Well, if the Fed tries to do something similar to “operation twist” it would require banks to hold more capital against their positions, because the safe interest rate falls, it causes the risky portion of each loan to rise. As such, any sort of “operation twist” would fail, because the rise in capital levels, would blunt any advantage from over Treasury interest rates.

From my vantage point, it would be a real plus to have monetary policy neutered in that way. The Fed, should it deserve to exist, should be concerned with the banking system and its solvency. It should not be concerned with the overall level of interest rates. If lowering interest rates lowers the judgment of solvency, then that would restrain the Fed from being too aggressive in lowering rates. And that would be good. The Fed has generally not succeeded with monetary policy. They have been too loose in the past, leading to the problems of the present.

And, as I have said before, we should not have unelected bureaucrats driving our economy, rather, we should have Congress do it because we can vote them out.

That’s all for now. Thanks for reading me. I appreciate all of my readers.

Rebalancing of any sort in investing presumes an underlying stability to the economic system, and thus, market returns.  Rebalancing will not protect against socialism, war, or an overleveraged position.

The concept of rebalancing requires the idea of reversion to mean.  It will not protect you when profound shifts are happening, where the market are moving to a new equilibrium different from the old one.

Many shifts in the markets are precipitous; they don’t allow for slow adjustment.  That’s why many lose out when sharp shifts occur.  Especially in leveraged positions, the question comes: “Do I take my loss, invest more, or just let it ride?”

The best answer is forward-looking, only asking what is most likely.  The best preparation is also forward-looking, but with a glance to the past, asking what could happen at worst, which is worse than the worst of the past.

There are times when it seems that stability is no more, or that the boundaries for stability are far larger than normal, such as now.   At such a time, it may pay to follow market trends, realizing that there many participants like you that are struggling to figure out the situation that everyone is in.

The point is to be forward-looking.  Ignore the past.  Ask what is most promising over your favored time-horizon.

So when it makes sense, add to a position that has lost money.  When it doesn’t make sense, sell the whole position and realize the loss.  Could this be simpler?

The market takes action against firms that carry positions bigger than their funding base can handle.  Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.  After that happens, valuation-motivated sellers appear to offer more at those prices.  The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.  As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”  The short-term proclivities of investors usually have no effect on the long run value of companies.  Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.  One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.  And often, they invested in financials that looked cheap, but took too much credit risk.  Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.  Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.  Every time I read something by him or see a video with him, I think, “Bright guy.”  But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.  Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.  From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.  And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.  Are the assets and liabilities properly stated?  Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

• Company size (the ability of management to make sure values are accurate or conservative declines with size)
• Rapidity of the company’s growth
• Length of the asset or liability
• Uncertainty over when the asset will pay out, or when the liability will require cash
• Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”  It is also a question of whether the company will have adequate financing to hold those assets in all environments.  For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”  All financial asset values are relative to the financing environment that they are in.  Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.  Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.  Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.  (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.  Do they try to grow rapidly?  That’s a danger sign.  There is always the tradeoff between quality, quantity, and price.  In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.  Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?  How much do they explain away one-time events?  Are they raising leverage to boost ROE, or are they trying to improve operations?  Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?  Even with good financial companies there are disappointments.  With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.  They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.  What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.  Even the others of his top 10 have not done well, and the fund as  a whole has suffered.  Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.  And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

• A 9.9% return from inception to 5/31/2011 is hot stuff, and,
• A 6.0% dollar-weighted return is very good as well.  Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”  Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

• It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
• Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
• When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.  The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.  It can be a negative self-reinforcing cycle for some time.  My one bit of advice would be: focus on margin of safety.  If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

Every excess eventually unwinds.  When an excess unwinds, the fall gets exacerbated by trend-followers blowing out of mutual and other pooled funds with lousy relative performance.

If you had a list of who owned a given publicly-traded asset, and when they bought it, you would know a lot about how patient, intelligent, indebted, etc., the holders of the assets are.  That would give some insight into how they might behave if the asset’s price began to fall.  Would they buy more as it went down, or would they sell in a panic?

Now no one has this data, but some approximate the data by a variety of measures.  Dollar volume traded as a fraction of market capitalization is a measure of speculative activity, though truly, I suspect that the holders of most stocks fall into two camps — long-term (years), and short-term (days to months).  Short-term has gotten shorter as computer power has democratized trading.

We can also read the lists of holders from 13F data.  Managers are pretty consistent.  If they are low turnover, they tend to stay that way.  The same for high turnover.

The holders of mutual funds tend to be late to the news.  There are two reasons for this:

1. They aren’t paying close attention because the results of mutual funds give slow and unclear signals, which only become clear when the quarterly statement arrives.
2. Because of loads, and brokers who sold the investors on the funds, regret causes reactions to be slow.

But these holders are late liquidators, and cause funds with bad investment strategies to sell some of their favorite wrong investments, which drives the prices of the investments down further.  This can cause assets to overshoot below their fair value, which value investors quietly accumulate.

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Long horizon investors tend to resist momentum.  Short horizon investors tend to follow momentum.  Long horizon investors tend to have little short-term need for results.  Short-horizon investors want/need results soon.  At bottoms, long-term investors dominate.  At tops, short-term investors dominate.

Mutual funds are in general short term investors, but the few that try to educate their investors that they are long term value investors do get more patient holders, which gets reinforced if the returns are good over a long period.

A Ponzi scheme needs an ever-increasing flow of money to survive.  Same for a market bubble.  When the flow’s growth begins to slow, the bubble will wobble.  When it stops, it will pop.  When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)  – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.  But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.  Also, at very high levels, the authorities take interest.  At very low levels, the Ponzi dies.  Part of the evil genius of Madoff was striking the balance.  He also did four other things:

• Soft-peddled the marketing so that it was like joining an exclusive club.
• Discouraged withdrawals by saying you would not get back in (for some).
• Deluding regulators into thinking that it was a front-running scam.
• He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.  All Ponzi schemes eventually fail. So how does this relate to market bubbles?  With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.  This could be due to a number of factors:

• Players see that borrowing to chase a rising asset is a winner.
• Promoters make it easy to do for inexperienced investors.
• An easy monetary policy lowers financing costs, aiding bubble financing.
• Players seek stock gains, and disdain debt claims.
• At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.  Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the  investment environment is.