Value Investing – Page 82

Gone for Two Days

Posted on 9 November 2007 by David Merkel

Sorry, but off on church business for two days.? As a parting shot, this is what I wrote on RealMoney yesterday:

		David Merkel
		What Do You Say When You Are Wrong?
		11/8/2007 5:34 PM EST

Well, I say I was wrong, then. Wrong about National Atlantic. Ordinarily, reserving at short-tail insurers is hard to mess up, because the claim cash flows quickly reveal mistakes. This is one of the exceptions to the rule.I hate losing money; the only thing I hate more is losing money for others. My sympathies to anyone who has lost along with me. I am still playing on this one, because the company is valued as if it will never make money again, and my opinion is that they will make money again, or, there might be M&A activity.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: still long NAHC, longer even

		David Merkel
		How Do You Minimize The Costs Of Being Wrong?
		11/8/2007 6:40 PM EST

You diversify. Even with National Atlantic, my portfolio was even with the market today. Though it was my largest position, it was still only one of my positions, at less than 5% of the portfolio. Diversification is underrated, and we neglect it to our peril.Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long NAHC

Holding My Nose, Still

Posted on 8 November 20078 November 2007 by David Merkel

Three companies of mine reported after the bell, Flagstone, Deerfield, and National Atlantic. I’ll take them in that order.

Flagstone beat handily, as I would have expected a property-centric reinsurer to do in this environment. Let’s see what optimism tomorrow brings. At 96-97% of book value, it seems cheap, but I can’t imagine property reinsurance rates will be that robust next year.

Deerfield is a little more tricky. They took a loss due to mark-to-market events in their portfolio. REIT taxable income is reasonable at 50 cents/share, and much of the writedown is a GAAP anomaly that shaves $1.20 off of the current book value. Economic book value is $11.84, which provides some support to the stock. The dividend of 42 cents is still intact. There is reasonable excess liquidity, even after the increase in repo margins during the third quarter. Let’s see what the market thinks.

Now for the problem child, National Atlantic, which takes an 83 cent loss. Here’s the main offending paragraph from the press release:

“For the three months and nine months ended September 30, 2007, reserves have increased by $17.6 million and $9.4 million, respectively, principally as a result of the strengthening of the reserves for bodily injury claims. During the third quarter it was determined that the Company’s policy related to claims handling procedures and reserving practices were not applied consistently, primarily within the bodily injury claims unit. As part of the resolution of this matter, the Company retained an independent claims consulting firm.”

For a company the size of National Atlantic, these are huge reserve changes, particularly for a short-tail line like auto. What I am about to write here is only a guess, but this likely was building up since sometime in 2006. One of the reasons I am willing to be a little more bullish on short-tail insurers is that it is a lot harder to get the reserve wrong. Looks like I am getting one of the rare events that teaches greater caution. (That said, my average cost is $8.85, so I’m not that badly hurt.) Given the large reserve change this period, ordinarily, the decks are cleared for future periods, but who can tell for sure? Also, this places the combined ratio since 2002 at 103.7%. It makes me think that the company will do well to eke out any underwriting profit.

I’ll be listening to the call tomorrow. What’s the endgame here? Given the marginal ability to earn underwriting profits, perhaps the company would best be reconciled by merging with another firm. That wasn’t my opinion over the past three years, but it is my opinion now. There are many firms that could have an interest at the right price, which probably approximates the book value of $13.28. That said, many of them may have kicked the tires already and passed, some probably thinking that a bid at book value would not be honored. All I can say is, give it a shot. Rumor is that Commerce wasn’t offering more than book, so if you want a greater presence in NJ personal lines, it may be available at a reasonable price.

Full disclosure: long FSR DFR NAHC

Buying Cheap and Holding My Nose

Posted on 7 November 20077 November 2007 by David Merkel

How comfortable would you be buying National Atlantic Holdings?

Or Deerfield Triarc?

Or YRC Worldwide?

I could go on, after all, recently I bought some Redwood Trust, and a number of smaller cap value names that don’t seem to be getting much respect right now. Value as a strategy is lagging now, and I am feeling that in my performance. Financials that deal with mortgages are out of favor also.
So why mortgage REITs now? Take a look at this chart of the 10-year Treasury yield less that on mortgage REITs:

Yields are pretty high relative to “safe” Treasuries, comparable with 1990 and mid-2002 spreads. Only the bad old days of 1974 surpass the yield spreads of this era by a significant amount. As I recall, REITs had a really bad name in the late 1970s after the mid-decade shellacking. I remember technical terms like “fraud,” but then, I was an impressionable teenager with an active imagination. 🙂

Now consider this chart of the 10-year Treasury yield less that on equity REITs:

The result is closer to fair value. I certainly would not call equity REITs as a group cheap; future returns rely on property price appreciation, which doesn’t seem likely to me at present.
Now, I’m not endorsing all mortgage REITs. Review funding structures and excess liquidity; you want excess cash flow and conservatism at this point. Heroics offer more downside than upside here.

As for YRC Worldwide, trucking is needed in our economy, and even with some slowdown, YRC should still make money, just not as much. On National Atlantic, I would only say that it seems that there is a forced seller in the name now, and when he is exhausted, the stock will lift. It is difficult to destroy a personal lines insurer with a conservative balance sheet. At 60% of a conservative book value, I can live with adverse outcomes.

Remember, do you own due diligence here. Just because it looks cheap does not mean it can’t get cheaper.

Full disclosure: long RWT NAHC DFR YRCW

The Problems of Ruin, Near-Ruin, and Decay

Posted on 1 November 2007 by David Merkel

Many investors, both institutional and individual, take too much risk. Taking too much risk can take a number of forms:

Buying companies with weak balance sheets.
Buying companies with high valuations.
Inadequate diversification, whether by number of companies, number of industries, or some risk factor like buying only high-yielding stocks.
And more…

There are three ways that problems can manifest themselves.? The first way is ruin.? An investor is so certain of himself that he uses a large amount of leverage to express his position.? When the bet goes wrong, he loses it all; he is ruined.? The second manifestation is near-ruin.? As ruin is threatening, the investor sells everything to preserve some of his assets, often near the local bottom for that set of assets.

The third manifestation is decay.? In this case the investor says, I will never take losses greater than x% of my position.? Nice intention, but it raises the spectre of the death by a thousand cuts.? Many assets fall before a significant rise; why get stopped out?? Instead, use falls in price to re-evaluate positions, and consider adding if the original thesis is still valid.

To be a little more controversial here, I don’t trust the bold claims of most technicians who place stops on their positions, and claim to have good performance.? Once one places stop orders, the probability rises for multiple small losses that exceed the few larger gains in the portfolio.? Call me a skeptic, but I would rather re-evaluate my positions than automatically sell, which seems to me to be a recipe for decay.

For My Canadian Readers

Posted on 30 October 2007 by David Merkel

If you are looking for more of me to read, pick up a copy of the November 2007 MoneySense magazine for my article “Nerve Medicine.”? It describes five points on risk control for individual investors.? Thanks to MoneySense for publishing my article.? The magazine costs only C$5.50 at the newsstand.? That’s about $6.00 US, right? 😉

As an aside, to editors of publications that peruse my blog, I am available for other writing assignments.? I enjoyed writing a longer article for a retail audience, and would accept the challenge again.? E-mail me if you have interest.

Second Video on the Federal Reserve

Posted on 29 October 2007 by David Merkel

Here’s my second video from TheStreet.com on the Federal Reserve.? This one is on where to invest from an equity standpoint.? There are two areas to look at.? Companies that benefit from:

Lower borrowing rates
Higher inflation

In the first category are healthy financials, and companies with the flexibility to borrow short-tern and buy back stock.? I highlighted insurance companies in my video, but this could apply to other financials and yield-sensitive companies, so long as they don’t face any significant fallout from housing and housing finance.

In the second category are companies that are exporters, and companies where the global prices of their products will rise in dollar terms, while their inputs stay relatively fixed.? This would include energy and most commodities.

Bonds were not a topic of discussion, but I still favor foreign, high quality and short-to-intermediate bonds for now.

Momentum and Growth

Posted on 24 October 2007 by David Merkel

I make no pretense to being anything more than a value manager.? It’s what I’ve done for the past fifteen years, with pretty good results.? Granted, my new methods over the past seven years attempt to incorporate industry rotation in two ways:

Industries where pricing power is near there nadir, such that the only direction is up, given enough time.? Strong companies in weak industries survive weak pricing cycles, and do well when the cycle turns.
Industries where pricing power is underdiscounted, and it will pay just to wait for future earnings to validate a higher P/E.

But no, I don’t explicitly focus on earnings growth, though I do look at forecast earnings for next year, which embeds a future ROE forecast.? I ignore growth forecasts for several reasons:

Growth forecasts tend to mean-revert.? Low growth companies tend to surprise on the upside, and high growth on the downside.? With a little help from pricing power, I tend to get more good surprises.
ROEs also tend to mean-revert.? Competition enters spaces with high ROEs and exits spaces with low ROEs.
It’s rare for a high growth, high P/E company to grow into its multiple.
Low growth, low P/E companies can be treated like high-yield bonds.? A P/E of 10 implies an earnings yield of 10%; I may not capture all of that 10% in dividends and buybacks, but a modestly good management team will find ways to deploy excess cash into other organic growth opportunities which will grow earnings in the future.? With a little good management, I can see my company with a P/E of 10 grow its intrinsic value by more than 10% in a year.

As for momentum, my rule of thumb is that momentum persists in the short run, and mean-reverts in the intermediate term.? I have to size my trading to the rest of my strategies.? Value emerges over the intermediate term, not rapidly.? The same tends to be true of industry rotation; it works with a lag, but it works.? I have to become like Marty Whitman at that point and say that often the fundamentals and price action are lousy when I buy, and for me that’s fine, because:

I focus on balance sheet quality,
Accounting integrity, and
Cheapness.
I have my rebalancing discipline standing behind me, which often has me buy more before the turn occurs.
I also stay reasonably well-diversified.

The turns usually do occur.? I never make a ton of money on any trade, but typically 80% of my trades make money. And, my losses are typically small, so this method works well for me.

Anyway, that’s why I embrace negative momentum and don’t explicitly embrace growth.? It can place me in the “caricature” camp for value managers, because my valuation metrics are usually lower than most.? Given my longer holding period, I’m fine with that, because low valuations tend to produce their own catalysts for change, if one has done reasonable research on the shareholder-friendliness of the corporation, and the strength of its financials.? Besides, as intrinsic value grows with companies having low valuations, there is a strong tendency for the stock to rally.? Think of PartnerRe, which has never had a high valuation; as it puts up good earnings year after year, the price of the stock keeps running.? Just another example of an underdiscounted trend in the markets.

Full disclosure: long PRE

Eight Notes on Insurance, Economics, and Value Investing

Posted on 23 October 2007 by David Merkel

Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”? An interesting comment to be sure.? Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.? That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.? So who would be affected?? Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.? Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”? Now, we weren’t talking about credit card debt, which they paid off in full every month.? They did have a home equity loan at 8.5% fixed.? My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.? Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.? My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.? Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.? Shoe retailers and mortgage REITs have not done well of late.? Am I predicting no recession by buying the retailers?? No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.? I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
Does buying a mortgage REIT mean that I am betting on further FOMC loosening?? No.? The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.? While a FOMC loosening would probably help, I’m not counting on that.
My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.? The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.? There is only so much room for shorting, which is an artificial overlay on the system.? We aren’t at the limits of shorting yet, but we are getting closer to those limits.? It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).? It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
I’m thinking of doing a personal finance post on what insurance to buy.? Is that something that readers would like to read about?

October 2007 Portfolio Reshaping

Posted on 22 October 200723 October 2007 by David Merkel

The reshaping file can be found here. In order to stay in compliance with the Bloomberg data license, I only include numeric fields that I have calculated. My ranking method ranks the companies in my portfolio, and all replacement candidates by several variables:

Relative Strength (lower is better, double weight)
Trailing P/E
This year’s P/E
Next year’s P/E
Price-to-book (double weight)
Price-to-sales (double weight — financials are counted as average)
Dividend Yield
Net Operating Accruals (a measure of accounting integrity — double weight — financials are counted as average)

I rank the companies on all of the criteria, weight the ranks, and calculate a grand rank. I look for the company that I own that has the middle rank for all of my currently owned companies, and I sell a few companies that I own below that, and buy some new companies near the top of the list. Here are my actions:

Sales

Sara Lee
Dow Chemical
DTE Energy

Purchases

Redwood Trust [RWT]
Gehl Corp [GEHL]
Shoe Carnival [SCVL]
Charlotte Russe Holding [CHIC]

Future Sale

One reinsurer — could be Flagstone, PartnerRe, or Aspen Holdings.

Rationale

I have enough reinsurance names going into earnings. If you need more of an example of how well they will do this quarter, then look no further than PartnerRe’s solid earnings report this evening. On the other sales, DTE Energy and Dow Chemical were solely for valuation reasons. Sara Lee is another matter; my confidence that they can turn around the company is reduced, and valuation is not compelling.

As for purchases, on the shoe retailers, there were a bevy of cheap names, but Shoe Carnival and Charlotte Russe seemed to have the most consistent operations, and low debt. Gehl seems to be in a good industry, small agricultural machinery is in demand, and valuations are modest. Finally, Redwood Trust seems to be well-run as mortgage REITs go. Asset quality is good and leverage is moderate. Also, the debt is all from securitizations, so it is non-recourse to the company; the most that can happen is that the assets in the securitizations depreciate to the degree that their residual interests are worthless.

One other shift that is unintentional here, is that my portfolio becomes more small cap in nature. I am selling away larger companies, and buying smaller ones. That is an accident of the process, but occurring because there are some genuinely cheap companies to buy. Time will tell as to whether these are good purchases, but most of what I like in investments are lining up here.

Full disclosure: long PRE AHL FSR CHIC SCVL RWT GEHL

Crash Remembrances

Posted on 20 October 200721 October 2007 by David Merkel

On Friday over at RealMoney, I posted the following:

		David Merkel
		1987 Memories
		10/19/2007 5:20 PM EDT

I was a young actuary when the crash hit in 1987, one year and change into my career. I did not have any investments at that time, but I had just bought a house with my (then) new wife. Few today remember that the crash of 1987 was the culmination of three separate crashes. In late 1986, the US Dollar hit new lows, amid massive intervention by central banks. In February 2007, I came down with a bad cold that sidelined me for four days. Cuddled up with the WSJ while my wife was at work, I concluded that the bond market was about to fall apart, so we accelerated buying a small home. Two months after we completed the financing, mortgage yields rose by 2% during the bond market meltdown.

The stock market roared on, though. Through August, the market rose, and the earnings yield shrank. Bond yields remained stubbornly high; it was a great time to invest in high quality long bonds, particularly long zero coupon bonds.

The eventual crash in October is no surprise to me today. Equities could not stand the competition from bonds, so the market slumped from August to October, until the pressure of dynamic hedging took over starting on Friday the 16th, selling into a declining market in order to maintain the hedges, and spilling over in a self-reinforcing way on the 19th. For what it is worth, there was a humongous rally in long bonds as people sought safety.

Now, my Mom was buying the day after the crash. This is why she is more professional than most professionals I know. She bought solid companies that would survive bad times. I knew far more people who sold into the panic. As for me, I got a trial subscription to Value Line, and picked six stocks, which I sold too soon for a 20% gain, and didn’t return to direct investment in single equities until 1992. (I used mutual funds.)

Since then, I have been consistent in plying my advantage in picking cheap stocks where the fundamentals are under-discounted. It’s been a good niche for me, maybe it can be of value to you as well.

PS — no bounce today, kinda like October 16th, 1987.

Position: none

Now, should the crash have been bought? Yes, at least in the short run, even without knowing the verdict of history. The difference between stock and bond yields narrowed dramatically, and option implied volatility was making a bold effort to escape earth orbit. Beyond that, fast moves tend to mean revert; slow moves tend to persist.
Now, my knowledge of the markets was rather crude back in 1987, so I never would have caught those then; nor did most commentators at the time. People were too scared to be rational. Even the FOMC blinked, with a neophyte Greenspan, with no serious crisis imminent, thus beginning his career of throwing liquidity at small problems, and leaving the consequences for later.

Well, at least I bought the lows in 2002. That event was similar, but not nearly as short-run severe as 1987, though it had the “strength” of longer duration as a bear market.

Before I close for the evening, I would like to mention that I will have the portfolio reshaping complete on Monday, and watch for it here first. As an aside, there are a lot of cheap small cap shoe retailers, and a lot of cheap general and apparel retailers also. I don’t normally buy retailers, but this time things are too cheap. Expect to see me buy one.