Accounting is esoteric.  :(  I say this as one who has never taken an accounting course in his life, but has written papers on accounting standards, and has had to implement them in the life insurance industry, which is possibly the industry with the most complex accounting of any industry.  (Okay, if we did the investment banks properly, they would be more complex.)

My post is prompted by Barry’s post.  I have known for a while, and commented here that the SEC is planning on abandoning GAAP for IFRS.  Why are they suggesting this?

• IFRS is not that much different from GAAP.
• They want to have every company in the developed world on a similar accounting basis, even if the basis is slightly worse than the existing standards.
• Then perhaps, foreign companies will once again list their equities in the US.

You can get the same information in different ways from:

• The Wall Street Journal
• The New York Times
• FEI financial reporting
• The Accounting Observer
• The Accounting Onion

The latter two links do not directly address the issue, but they write intelligently about accounting.

This download is big, but it summarizes the differences between FAS and IFRS (in 77 pages).

My short take is this:

• IFRS is a more liberal accounting standard.  Not by a lot, but significantly.
• There will be a ton of retraining for accountants in the US, and financial analysts (ouch).
• Earnings will rise, but P/E multiples will fall.  The intial net effect should be small.
• Value investors will fare relatively better, as they spend more time on the balance sheet, income statement, and other earnings quality issues.
• Exchanges in the US might get more foreign listings, if Sarbox were repealed.  Moving to IFRS is not enough.
• If I were on the SEC, I would not care about global comparability, I would stick with GAAP, and stand alone if necessary, among the nations of the world.  Why move to a less informative, and more rubbery standard?  I don’t see a good reason.

IFRS is more flexible, which means that companies under it are less comparable.  I don’t see the advantage in our moving away from GAAP, which has its problems, but less than IFRS.  When I get the web address to post complaints, I will post it here, and I will be writing the SEC to stop this foolishness.

My post last night attracted a number of intelligent comments.  I want to expand on what I said.

1) The Baby Boomers are different that other US generations.  They are less provident, willing to sacrifice the future for the present.  Not only do they save less, but they raid existing savings to fund current needs.  They are also more prone to investment scams.  When will Boomers realize that the amount that they can expect from investments with safety is not much higher than what long Treasuries yield?

2) My comment from last night, “The US is bad off demographically, but most of the rest of the world is worse off.  The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.” needs more explanation.

• The US has its birth rate at replacement rate, which is unique among developed nations, and is largely due to the influence of Mormons, Muslims, Orthodox Jews, Evangelicals, recent immigrants (legal or not), and homeschoolers.  (Personal observation: even non-religious homeschoolers tend to have more kids on average.)
• The rest of the world is worse off — China’s demographic problem is huge, but at least they save to compensate for it.  Europe is not quite as bad off, but nothing kills fertility quite so well as peace, moderate prosperity (meaning well-off with two working, not one working) and a decline in religious faith.

3) From a reader:

Can you please reconcile these two seemingly conflicting statements:

“[Boomers] will need to labor longer, and they should do so” and “To the extent that this causes labor shortages, the US will see greater employment prospects for its people”

Sorry that I wrote it that way.  There will be a balancing act that occurs in the economy around 2025 — wealthy Boomers retire, poor Boomers continue work.  The relative size of each cohort will determine what the effect is on the economy as a whole.  Beyond that, there is a third factor, immigration.  The US is more friendly than most places to legal and illegal immigration.  That helps solve our demographic problems, but it insures that my children learn Spanish.  If wages rise too much, immigration (and offshoring) will rise as well.  (It is akin to wealthy retired Boomers saying to their children, “You don’t have to care for us, we’ve found people who will do it more cheaply.”

4) Another reader comment:

Jeremy Siegel (Stocks for the Long Run) offers a pretty thorough and generally optimistic take on the Baby Boomer retirement issue in his latest book “The Future for Investors.” At the risk of oversimplifying a complex analysis, Siegel’s bottom line is that while there are not enough younger generation Americans to absorb the Boomers stock and bond assets at current prices, investors in emerging countries, like China and India, will more than make up for that and will end up buying the Baby Boomer’s paper assets as the Boomers sell them off to fund their retirements. The upshot is that foreigners will end up owning a lot of our companies by the year 2050. A potential snag, says Siegel, is whether America will be willing to let this happen, or will pass laws or adopt polices to discourage the transfer of US assets to foreign countries. This remains to be seen, but he is optimistic. On the other hand, the implications for the typical Baby Boomer’s most important asset, his or her house, is rather dire, because homes can’t be sold as readily  to foreigners, for obvious reasons. Siegel doesn’t provide an answer for the housing market, which is outside the scope of a book on stock investing in any event.

There is the political question around how much US corporations we would allow to be owned by foreigners.  I don’t know where the breaking point is there, but the answer will have an impact on the value of the US dollar.  As for homes, if we slow down the growth of the housing stock, and condemn more of the existing housing stock, we will eventually solve the excess housing problem.  As it is now, we have foreigners speculating on the value of residential US real estate.

5) One final note that I omitted last night.  Medicare is the big issue here, and we will begin to feel it over the next five years.  At least one election in the next decade will have Medicare as its top issue.  The Social Security problem is one-quarter the size of the Medicare problem.  No wonder Bush, Jr. did not try to deal with Medicare, but made the problem worse by adding the drug benefit.

6) I don’t see the emerging markets getting rich enough, fast enough, to do the wealth exchange necessary for the developed world on favorable terms for the developed world.

That’s all for now.  More comments, send them on.

Three notes on the blog itself.  1) I will be guest-blogging for one post at another site on Thursday.  Won’t say where, but watch for “The Fundamentals of Real Estate Market Bottoms.”  It will be reposted here Thursday evening.  2) I can’t paste certain bits of code in my blog because of a WordPress limitation introduced in version 2.5.  As of now, that won’t be remedied until version 2.9, which as far as I can tell, is a huge update, and is at least half a year off.  3) I have not left RealMoney, though I have not posted there in a while.  I started this blog so that I would have a site with my own distinct voice, and so that I could have greater creative freedom to write about things dearer to me that I felt would not fit the RM audience.  Also, I felt that I had run out of articles to write, simply because I held myself to a higher standard, and didn’t want to write articles just for the sake of putting something into print.  RM readers deserve better.  I will come back to posting at RM, I just don’t know when, amid my current busy-ness.

I last mentioned portfolio moves a little more than a month ago.  Here are my moves since then:

Rebalancing Buys:

• Ensco International
• Nam Tai Electronics
• Cemex
• Assurant
• Industrias Bachoco
• Charlotte Russe
• Valero
• Cimarex

Rebalancing Sells:

• Universal American
• OfficeMax
• International Rectifier
• Jones Apparel
• Smithfield Foods
• Group 1 Automotive
• Shoe Carnival

For a six-week period, that ’s a decent number of trades, at least for me.  My methods are designed to try to not trade frequently, but to trade to minimize risk and maximize return in a majority of situations.  For those not familiar with my rebalancing trades, I keep a fixed set of target weights in a largely equally-weighted portfolio.  When a security gets more than 20% away from its target weight, I buy (after review) to bring it back to target weight, or sell to bring it back to target weight (take some money off the table).

There have been three other actions during this time. 1) National Atlantic’s merger went through.  A loss for me, but I ain’t missing them at all.  2) After the buyback announcement, I traded my holdings in Anadarko for holdings in Devon Energy.  I like the valuation, and the Natural Gas exposure better at Devon.  3) I tendered all my MetLife shares for shares in RGA.  I like RGA a lot here and am willing to make it a double-weight in my portfolio. In the current tender offer, I should get approximately 10% more value in RGA shares for my MetLife shares, subject to a number of conditions listed in the prospectus.  Also, RGA is a unique company that makes its profit mainly from mortality, which is not correlated with other financials.  It is a well-run company, and deserves to be valued at a significant premium to book value.

Full disclosure: long RGA MET DVN SCVL GPI SFD JNY IRF OMX UAM XEC VLO CHIC AIZ IBA CX NTE ESV

That said, my question is: do I buy the property reinsurers here?  My initial guess is yes, because it has been a weak hurricane season so far, and the beginning and end of the seasons tend to be correlated.  But, it is too early to take action.  What I am more likely to do is wait until my next reshaping at the end of September, and make some shifts then.  Perhaps Gustav and some other hurricanes will prove my thesis wrong by then.

So, how are valuations for the reinsurers?  Cheap, but pricing is weak, because capital is plentiful.

Source: Yahoo Finance, Bloomberg

If I were looking to move tomorrow, I would consider IPC, Flagstone, and Validus among the “pure play” property reinsurers. Among the diversified players, I would consider PartnerRe, Endurance, Allied World, and Aspen. Note that the book value of PartnerRe is understated because they don’t discount their loss reserves. For conservative players, PartnerRe is compelling because of their strong balance sheet, very diversified book of business, and strong management. PartnerRe, Endurance, Flagstone, IPC and Allied World score some extra points in my book because of their conservative cultures.

I’m not doing this trade tomorrow, but with good weather, and continued pessimism over financials, this trade could look very good near the end of September.

Full disclosure: no positions

“Get financing when you can, not when you have to.”  Warren Buffett said something like that, and it is true.  My biggest early investment loss was Caldor, which Michael Price lost a cool billion on.  A retailer that could not hold up to Wal-Mart, Target, and Sears, Caldor expanded in the early 90s by scrimping on working capital.  Eventually a cash shortfall hit, and their Investor Relations guy said something to the effect of, “We have no financing problems at all!”  The vehemence cause the factors that financed their investory to blink, and they pulled their financing, sending Caldor into bankruptcy, and eventually, liquidation.

Caldor had two opportunities to avoid the crisis.  It could have merged with Bradlees and recapitalized, leaving it stronger in the Northeastern US.  It also could have done a junk bond issue, which was pitched to them eight months before the crisis, but they didn’t do it.  In the first case, the deal terms weren’t favorable enough.  In the second case, they thought they could finance expansion on the cheap.

Caldor is forgotten, but the lessons are forgotten today as well.  Today, overleveraged financial companies wish they had raised equity or long-term debt one year ago, when the markets were relatively friendly and P/Es were higher, and credit spreads were lower.

I know I am unusual in my dislike for leverage in companies, but on average less levered companies do better than those with more debt.  Caldor went out with a zero for the equity.  A few zeroes can really mess up performance.

Capital flexibility has real value to good management teams.  I don’t mind exess cash hanging out on the balance sheets of good firms.  Hang onto some of it, and maybe during a crisis you can buy a competitor at a bargain price.

But for the financials today, who has the wherewithal to be a consolidator?  Most of the industry played their capital to the limit, and are now paying the price.  Either the door is shut for new capital, or they are paying through the nose.

I don’t see anyone large who fits that bill of being a consolidator.  Maybe some of the large energy companies that have been paying down debt would like to diversify, and buy a bank.  Hey, feeling lucky?!  Lehman Brothers!

Look, I’m being a little whimsical here, but the point remains — run your companies with a provision against adverse deviation.  Be conservative.  For those that invest, avoid companies that play it to the limit, unless you are an investor with enough of a stake that you can control the company.

I’m going to be reviewing a few books on quantitative investing.  Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.  For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.  Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.  It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.  Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.  I have one of the few signed copies.  When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.  He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.  What do I mean by liability driven investing?  Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.  Instead, it has many models to share from different situations in the market.  There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

• Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.  Many strategies are competing for scarce returns.  Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
• Why do value methods tend to work?
• How do you avoid traps in calculating models?
• How do investors with different goals and expectations affect the market?  What happens when you get too many momentum investors?  Too many growth investors?
• Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
• If the market tends toward equilibrium, the forces guiding it are weak.
• Behavioral finance as a means of bridging investment theory and reality.
• Market microstructure: how do we minimize total trading cost?  Minimize taxes?
• How is the P/B-ROE model derived?
• How to model market anomalies?
• When do different valuation methods pay off well?
• How does international diversification help?  (Bold in 1999, but a bit dated now.)
• How to manage foreign currency risk in an equity portfolio?
• How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.  This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

Just a quick post to give a mid-quarter view of my main industry rotation model.  The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).  I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.  That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.

industry-ranks-8-21-08

Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).  I spend most of my time in the green zone, looking at industries where I think pricing power will return.  For me, the red zone is more useful for sale decisions.  When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.

Buffett said something to the effect of: “I would rather be approximately right than precisely wrong.”  Everyone should agree with that maxim, but in the business world, many processes don’t work that way.

Take auditing as an example.  I’ve only experienced it as an actuary working in financial reporting, and it amazed me to see the detail work that they went through of checking cash flows (which should be done — how else do we detect fraud?), but with little to no attention on reserving assumptions.  Spending time on the “bigger picture” questions is important, and shouldn’t be neglected.

Or, consider earnings spreadsheets that analysts do.  They can be valuable, but I find it more valuable to look at the broader industry picture to see if an industry as a whole has a favorable economic picture, or, might be close to a turning point.

Then again, I think more like a portfolio manager, and less like an analyst.  That makes me better for some tasks, and not others.  My boss at Provident Mutual taught me the you need to identify the main 2-3 drivers of future profitability, and focus on them, because they will drive 80-90% of the results.  (I call this Cioffi’s Rule.)  If you get the main factors right, you will make more money than most investors.

Sometimes, I get labeled a lightweight because I don’t dig deep on certain issues.  I’m just trying to stay focused on the important issues.  Now, on financial stocks today, I own a bunch of insurers that put me over market weight for financials, but I own no credit-sensitive companies.  Even high-quality names are under stress.  (Consider the rate American Express had to pay to borrow money recently.  And I thought MetLife had it bad.  Ah, to be a corporate bond manager again… there are bargains to be had if one has an adequate balance sheet.)

What we don’t know is a significant factor.  I need to see some significant failures before the financial sector will be interesting.  I’m not investing to be courageous.  I’m here to make money over the cycle on a risk-adjusted basis.  It’s not that I avoid risk, it’s that I avoid taking it when I don’t see that I am paid to take it.

Also, even though my portfolio is concentrated, with 35 almost-equally-weighted companies, I avoid going “socks-and-underwear” (as my Dad would say playing Sheepshead) on any single company.  Even on industries, I try to be measured in my overweight positions.  But the objective is to take risk when you are being paid to do it, and avoid it otherwise.  Focusing is a popular strategy, and those who do well at it do very well.  Those who fail at it fail big.  On average, the strategy of focusing doesn’t of itself add value.

My eight rules help me be approximately right.  That doesn’t mean that I don’t make mistakes.  I make mistakes, and sometimes they are big.  But, my mistakes haven’t been frequent and big.

Consider this as you invest.  Focus on the big factors that affect profitability, and look for positive industry trends that are underdiscounted, and negative industry trends that are overdiscounted.  And, in the process, only buy companies that you know will survive.  More money is lost buying marginal companies than is gained.  Remember the margin of safety concept.  Your first job is not to lose money, so choose wisely.

Full disclosure: long MET

I’ve been mulling over whether I should write about insurance M&A.  Ugh, yes, I should say something.  What pushed me over the edge was a piecein the WSJ on the purchase of Philadelphia Consolidated.  When I first heard about the deal, I blinked, and said, “Foreign acquirer overpays to enter the US.”  Is Philly a good company?  It’s a great company, but it may not be so under foreign ownership.  And, the price was well in excess of what it would have taken to create/attract the talent for a new venture.  Paying 2.7x book is not a winner.

But, the have been other missteps as well recently.  Liberty Mutual buys Safeco and Ohio Casualty for 1.8x and 1.6x book.  High prices for the assets obtained, and Liberty Mutual can’t lever that much as a mutual company.  It feels like the current management is going for growth at all costs, and the only losers will be the participating policyholders, who will eventually get a lower dividend stream.

I’m also not into funky holding company structures, for example, where a mutual company sells off a piece of a subsidiary to be publicly traded.  In that sense, it was good of ALFA to buy in their stock subsidiary (2.0x book), and now Nationwide is doing it as well (1.6x book).  Someone buying Nationwide Financial Services at the IPO earned an 8.7% annualized returnto the buyout.  ALFA shareholders did better, but I am not sure how much better, because I can’t tell how many times the stock split.  Both beat the returns on the S&P 500.  (I won’t mention the details of how Provident Mutual took Nationwide to the cleaners when they sold themselves; that had an effect on the returns.)

But, think about it from the perspective of the participating policyholders, who nominally own the mutual insurance companies.  That was expensive capital that diluted the dividends that they would have received.  But, mutual policyholders are sleepy, and mutual company managements take advantage of them.

I will mention three more deals before I close.

• Commerce Group sold itself to Mapfre SA (1.6x book).  Another foreign company overpaying for a US presence.  I like the deal, because Safety Insurance will out-compete Commerce/Mapfre.
• Midland Companies was bought by Munich Re for 2.0x book.  Midland was well-run, but I don’t see the fit with Munich Re.
• Castlepoint Holdings was bought by Tower Group at 1.0x book value.  Perhaps a little incestuous, because it was Tower Group’s main reinsurer, but Tower helped bring th IPO to market, and I can’t tell whether this is a bright or dumb idea.

Insurance accounting is opaque to outside experts, and sometimes even to those doing the figures inside the companies.  Management often see marketing or cost synergies in doing deals, but my experience says those aren’t common.  Also, diversification benefits have to be weighed against lack of focus.  It is very difficult to manage disparate business lines.

To those are getting bought out, or who have been bought out, I encourage you to be grateful for the gift that you have received.  For those who own the acquiring company, I must say that the return performance for acquiring companies has been poor.  Consider investing in companies pursuing organic growth, which is often a better idea.

Full Disclosure: long SAFT

When I review books, I don’t just review new books.  I try to share with my readers the books that have helped me become a better thinker on investments.  Fortunately, in this case, the 1984 book Super Stocks was reprinted in 2007.  Perhaps that validates my opinion that this is a valuable book.

Ken Fisher focuses on the concept of Price to Sales [P/S] ratios as a means of analyzing cheapness in companies.  Cheapness, yes, but predicated on the concept that a new product, process improvements, or better management will make more profits from the sales, or improve sales volumes and perhaps profit margins.

Though the examples are from the early 80s, the writing is clear enough that one can get the idea of how it might apply today.  You would get the same feeling from Ben Graham’s classic The Intelligent Investor, where the examples were from the 50s and 60s, but the truths are timeless.

Why choose this book to review now?  Profit margins are artificially high, and will come down somewhat from here, even if they remain above average.  How can we find cheap stocks when profit margins are so high?  Use P/S, or Price-to-Book [P/B].

My own investing looks at a wide number of valuation figures, but across an economic cycle, I give more or less weight to each variable.  When things are bad, I give more weight to P/S and P/B.  During the recovery, I emphasize P/E on a forward basis.  When the bull market is in full swing, I let industry selection dominate, which gives me more market sensitivity. As another example, I play up EV/EBITDA when buyouts are becoming common, and drop it as a criterion when buyouts are not being funded.

So, unlike Peter Lynch, paying attention to the macroeconomic environment can positively affect your performance, if you do it intelligently.

Super Stocks is very consistent with my eight rules, particularly the rules:

• Stick with higher quality companies for a given industry.
• Purchase companies appropriately sized to serve their market niches.
• 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.

Fisher spends a decent amount of time on balance sheets, market share, competitive advantage, and use of cash flow for future investment.  Though I don’t endorse everything in the book, like his price-to-research ratios, there are a lot of good concepts for the average investor to consider, and benefit from.

Full Disclosure: If you enter Amazon through any of the links on my site (mainly on the leftbar) and buy anything, I get a small commission.  This is my version of the tip jar, and it doesn’t increase your costs at all.