Category: Value Investing

Investing in a Stagflationary Environment

Investing in a Stagflationary Environment

Posted on by David Merkel

I intend to get back to answering more reader questions, and doing it through posts.? I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.? Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.? There is always something to learn.

I was too young to appreciate the last stagflationary period.? Yet, I need to manage my portfolio.? My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.? I’m a Canadian based investor.? The simple solution is to pull in my exposure and be more Canada centric.? This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).? I also do not subscribe to the excessive weighting in gold as a major investment theme.? To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.? Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.? During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.? That said, I have read a lot on economic history, so I understand the era reasonably.? I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.? (Hi, Mom! 🙂 )? Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”? I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.? No way that project saved money on a net present value basis.? (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.?? It paid to have your fixed income assets as short as possible.? Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.? Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.? Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.? You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.? Who can raise prices more than the cost of their inputs?? Producers of global commodities like oil, metals, etc., typically do well here.? Financial companies with short duration assets or exposure to hard assets should do better here.? Staples should do better versus durables.? Growth investing should beat value investing (uh, oh, what do I do?? All of my processes are geared toward value investing).?? Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.? I occasionally like gold, but it’s not a panacea.? I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?? That’s why we diversify.? I don’t tie my whole portfolio to one macroeconomic view.? Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.? I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.? Diversify into foreign currency bonds.? Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.

More on Fair Value Accounting

More on Fair Value Accounting

Posted on by David Merkel

Earlier today at RealMoney, I responded to a question in the Columnist Conversation. It was a longish post that tried to be complete, so I reprint it here:


 David Merkel
Mark-to-Management Assumptions
9/18/2007 1:50 PM EDT

Bob, Joe is essentially correct, but I’d like to add a little. From the Office of Thrift Supervision Examination Handbook (pages 137 & 138):

Observable Inputs – market participant assumptions developed based on market data obtained from sources independent of the reporting entity

Level 1 Inputs – Unadjusted quoted prices in active markets for the identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Examples: Treasury bonds and exchange traded securities.

Level 2 Inputs – Other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active. Examples: loans traded within the secondary market and plain vanilla interest rate swaps.

Unobservable Inputs

Level 3 Inputs – Entity specific inputs to the extent that observable inputs are unavailable. Because there is little to no market activity, these inputs reflect the entity’s supposition about the assumptions of market participants based on the best information available in the circumstances. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Examples: credit enhancing I/O strips and private equity securities.

Another way to phrase it is this:

  • Level 1 – publicly observable data
  • Level 2 – derived almost entirely from publicly observable data, and a commonly-used model
  • Level 3 – significant use of private firm-specific data, or public data not derived from the markets (think of a life insurance industry standard mortality table)

    • Now, I’m not a fan of SFASs 157 & 159, or any of the current statements dealing with intangibles. Even level 1 is subject to problems when markets are less liquid. I’ve known of situations where a bond manager found himself holding a disproportionate share of the market of a publicly tradable bond, where it almost never trades because he owns so much of the issue. Where do you mark that? That’s just level one!

    Aside from AAA securities, most asset backed bonds never trade. Level 2 comes into play here, because the dealers estimate a pricing grid from what few transactions take place. with “fair value” accounting, there is no way to avoid mark-to-model, but there are significant possibilities for error.

    The classic case of level 3 is how one estimates the changing value of private equity investments over time. Discounted cash flow anyone?

    As a result of the changes, we have to be a lot more careful in how we interpret the financial statements of financial companies. The game just got a lot more complex given the new fair value accounting rules.

    Position: none

    After I wrote that, a friend of mine e-mailed me saying that Private Equity accounting was for the most part conservative at present, but that there was some pressure to use fair value accounting to smooth results. He also thought the use of these methods wouldn’t make private equity correlate more closely with public equities. I think he is onto something there, and that could affect that amount allocated by pensions and endowments to private equity. On the flip side, if the returns are smoothed through these accounting methods, the standard deviation of returns would drop, which is a bigger effect than the correlation effect. So allocations might go up, and some Private Equity managers, believing the smoother returns, might be tempted to lever up more.

    One other note: I expect that companies with high percentages of level 3 assets will trade at discounts to relative to their peers. Accounting complexity and opaqueness always have valuation discounts. I see it in insurance for financial insurers, reinsurers, and long-tailed commercial lines. Uncertain assets and liabilities should always get lower valuations. Thus, aggressive users of fair value will wonder why their P/Es and P/Bs are so low. It’s because of the lack of ability of investors to verify the asset and liability figures used.

    Eight Notes on a Distinctive Day

    Eight Notes on a Distinctive Day

    Posted on by David Merkel
    1. My broad market portfolio trailed the market a little today. I’ve been a little out of favor over the past three months; I’m not worried, because this happens every now and then. That said, we are coming up on another portfolio rebalancing, where I will swap out 2-3 stocks, and swap in 2-3 others. Watch for that in the next few weeks.
    2. Every group in the S&P 1500 was up today. I can’t remember when I have seen breadth like that before. Financials and Energy led the pace. Names like Deerfield Triarc flew on the Fed cut. They will benefit from cheaper repo rates, and the excess liquidity injected the system should eventually ease repo collateral terms.
    3. If the US dollar LIBOR fix at 6AM (Eastern) tomorrow follows the move in the US futures markets today, then we should see LIBOR drop by 27 basis points or so. Given the smaller move down in T-bill yields, 14 basis points, that would leave the TED spread at 132 basis points, which is still quite high, and higher than the 10-year swap spread. (LIBOR would still be higher than the 10 year swap yield.) This indicates that there is still a lack of confidence among banks to lend to each other on an unsecured basis. Things are better than they were two weeks ago, but still not good.
    4. The short term crunch from the rollover of CP, especially ABCP is largely over. The good programs have refinanced, the bad programs have found new ways to finance their assets, or have sold them, or used backup guarantors, etc.
    5. Watch the slope of the yield curve. It is my contention that the slope of the yield curve changes relatively consistently through loosening and tightening cycles. In the last tightening cycle, the curve flattened dramatically through the cycle, making the word “conundrum” popular. This is only one day, but the yield curve slope, measured by the difference in yields between 10-year and 2-year Treasuries, widened 10 basis points today. (The curve pivoted around the 7-year today.) If I were managing bonds at present, I would be giving up yield at present by selling my speculative long bond positions that served me well over the past few months in my model portfolio. I would be upping my yen and Swiss Franc positions.
    6. We learned some new things about the FOMC today: a) They don’t talk their book publicly, so don’t take their public comments too seriously. b) They are willing to risk more inflation for the sake of the non-bank financial system (which is under threat), or economic growth (which may not be under threat). c) They are flagging the Fed funds rate changes any more by letting rates drift nearer the new target in the days before the meeting. d) Beyond that, we really can’t say yet whether this is a “one and done” or not yet. We just don’t have enough data. e) The FOMC really isn’t interested in transparency.
    7. It would be historically unusual for this to be a “one and done.” Fed loosenings are like potato chips. It’s hard to stop at one. Just as there is a delay in the body saying, “that’s enough,” with the potato chips, the in the economy in reacting to monetary policy is slow as well, often leading policy to overshoot, as the FOMC reacts to political complaints to do more because things aren’t immediately getting better. It’s hard to sit in front of the short-term oriented Congress, or listen to the manic media, and say, “But the FOMC has done enough for the economy. It doesn’t look good now, but in 18 months, our policy will take effect and things will be better. Just trust us and wait.” That will not fly rhetorically; it will take a strong-headed man to not overshoot policy. On that Bernanke is an unknown.
    8. To me, it’s a fair assumption then that this cut will not be the last. Investment implications: in fixed income stay in the short to intermediate range, and remain high quality. Buy some TIPS, and have some foreign bonds as well. I like the Yen, Canadian Dollar, and the Swiss Franc. In equities, think of high quality sectors that can use cheap short-term credit, and sectors that benefit from inflation and a weaker dollar. So, what do I like? High quality insurers, mortgage REITs that have survived, (maybe trust banks?), basic materials, energy, goods transportation, staples, some areas in healthcare and (yes) information technology (if I can find any more cheap names there that I like).

    Full disclosure: long DFR

    The Longer View, Part 4

    The Longer View, Part 4

    Posted on by David Merkel

    In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

     

    1) Asset Allocation

     

    • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
    • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
    • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
    • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

     

    2) Insurance

     

     

    3) Investment Abuse of the Elderly

     

    It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

     

    Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

     

    The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

     

    4) Accounting

     

    • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
    • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
    • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

     

    5) Volatility

     

    • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
    • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
    • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

     

    That’s all for now.? More coming in the next part of this series.

    Triage, Part 2

    Triage, Part 2

    Posted on by David Merkel

    In the first round of triage I went through the first third of my portfolio. Now is the time for the second third; definitely a more positive experience, together with my changes on the first third, after further reflection.
    The Dead ? Companies with bad balance sheets, but have been whacked so bad that it is still worth playing

    • Jones Apparel
    • Deerfield Capital

    If they rally a lot more, I am out.

    Walking Wounded ? Companies with okay balance sheets that we feed more cash to

    • Lafarge
    • Industrias Bachoco
    • YRC Worldwide [moved from The Dead]

    Seemingly healthy that might have financing problems ? Sold

    • Lithia Automotive
    • Group 1 Automotive

    Uncertain as of yet

    Sara Lee

    Don’t know what to do here. Balance sheet has issues but profitability is improving as the turnaround progresses.

    Healthy companies that we leave alone

    • Barclays plc (Moved from Uncertain as of yet — Capital levels are seemingly adequate.)
    • Deutsche Bank
    • Mylan Labs
    • Cimarex Energy
    • Nam Tai
    • Arkansas Best
    • Bronco Drilling
    • Vishay Intertechnology
    • Aspen Holdings
    • Safety Insurance
    • Lincoln National
    • Assurant

    Safe New Names Bought

    • PartnerRe
    • National Atlantic [Did not get a full position on, was too stubborn about levels… not buying here.]

    So, there’s the triage with one third to go — I have not done the companies with my largest gains, which I presume to be in better shape. At this point, I’m relatively happy with what I have.

    PS — As to my methods, the main parts are reviews of the balance sheets and cash flow statements. It’s basic bond analysis, asking how likely it is that future cash flows will be able to cover the debts in question. At present, I am looking to hold companies that can survive a crisis. With the reservations noted above, most of this portfolio can do so.
    Full Disclosure: Long JNY DFR LR IBA YRCW SLE BCS DB MYL XEC NTE ABFS BRNC VSH AHL AIZ LNC SAFT PRE NAHC

    The Longer View, Part 1

    The Longer View, Part 1

    Posted on by David Merkel

    Here are some posts that have caught my attention over the last month, but I never commented on because of the increase in volatility placed more of a premium on covering current events.

    1. Will we ditch GAAP accounting for IFRS?? Personally, I don’t want to learn a new set of rules, but if it improves our ability to invest in a more global era, then maybe it will be a good thing.
    2. Do we care if we have auditors or not?? BDO Seidman recently got hit for damages of $521 million.? If this damage amount stands, it will bankrupt them, and possibly eliminate the #5 auditor in the US.? My argument here is not over guilt, but merely the size of the award.? That said, if the damage amount stands my solution would be to award 30% of the ownership of BDO Seidman to the plaintiffs.? Let them earn it through shared profits.
    3. Peter Bernstein takes my side in the understating inflation debate.? As I have said before, if you want to smooth inflation, use the median or the trimmed mean, which is more statistically robust than excluding food and energy.
    4. Jeff Matthews comments on how many companies that paid large special dividends, or bought back too much stock are regretting it in this environment.? What should they say to shareholders, but won’t?? I’ve said that for years at RealMoney, but during a boom phase, who listens?
    5. I found it fascinating that private issuances of equity via 144A are exceeding IPOs at present.? Only the big institutions get to invest, and they can only trade it to each other.? I experienced that as a bond manager, but for equities, this is new, and a growing thing.? Question: most trading will then be negotiated block trades as in the bond market.? If a mutual or hedge fund buys one of these 144A issues, how do they price it?? With bonds, it doesn’t usually matter as much, because things usually move slowly, but with equities?
    6. Can we time the value premium?? (I.e., when do we invest in growth versus value?)? The answer seems to be no.? Value strategies work about two-thirds of the time, which makes them dominant, but not so much so as to overcome the more sexy growth investing.? This allows the anomaly to continue.? The end of the article concludes: The bottom line for investors is that the prudent strategy is to ignore the calls to action you hear from Wall Street and the media and adhere to your investment plan. The only actions you should be taking are to rebalance your portfolio and to harvest losses when that can be done in a tax-efficient manner.? I like it.
    7. I’ll say it again.? Be careful with ETNs.? They may have tax advantages versus ETFs, but the hidden risk is that the sponsor of the ETN goes bankrupt, in which case you are a general creditor.? With an ETF, bankruptcy of the sponsor should pose little risk.
    8. Hit me again, please.? If financials didn’t hurt me recently, then it was cyclicals.? Ouch.? Both are at risk, but for different reasons.? Financials, because of a fear of systemic risk.? Cyclicals, because of a fear of a slowdown stemming from an impaired financial system being unwilling/unable to lend.

    I’ll try to post on the other half of this on Monday.? Have a great Sunday.

    One Dozen Items That Characterize The Market Now

    One Dozen Items That Characterize The Market Now

    Posted on by David Merkel

    I’m going to write this post backwards tonight, partly because going from specific to general may make more money for my readers tomorrow. Let’s go:

    1. Did you know that there has been panic in closed-end loan participation funds? No? Well look here. Or look at this Excel file. Here’s the skinny: the average loan fund has only lost 0.47% of its net asset value since 8/10, but the average price has fallen by 6.30%. You can pick up a little less than 6% here, with modest risk, or a little more, if you are clever. Remember that the grand majority of loans here are senior and secured.
    2. The Title insurers have gotten crushed. Here’s to the activists who bought a ton of LandAmerica in the 90s, something I advised against. Title volumes will slow. Wait for the home inventories to crest, and decline a little, then buy a basket of the Title companies.
    3. I have a decent amount of exposure to Latin America in the portfolio. That Brazil and Mexico have been whacked has cost me, even though my companies are conservative.
    4. The winds are blowing. Hurricane Dean is in the Gulf, and may do damage to Yucatan, and after that, oil infrastructure and Texas. Given the late start of the season, I would not begin to suggest that this will be a heavy loss year. Damages from Dean are still uncertain as well.
    5. From the excellent Aaron Pressman, I offer you his insights off of Nicholas Taleb’s book The Black Swan: The Impact of the Highly Improbable. What I would point out here is that when times are unusual, a lot of things tend to be unusual. Credit events tend to be correlated, so when things go bad as in 2000-2002, many seemingly unrelated things go wrong at the same time, often due to correlations in the portfolios of the holders, particularly leveraged ones.
    6. Having seen a decent amount in prime brokerage relationships at a medium-sized firm, I can only say that they are needed but overrated, and the conflicts of interest are significant.
    7. I wish i were managing structured securities again. Buying AAA CMBS at LIBOR + 0.60%. That’s the best since LTCM! Pile it on! Hey, maybe we can lever it?! 😉
    8. Onto credit issues. Fed funds futures are rising in price (down in yield) over the current credit woes. Canadian ABCP participants may have a good solution to their troubles. Convert the claims to longer dated floating rate paper, which can still be held by money market funds. Countrywide cut to BBB+, which effectively boots them from the CP market. Rescap goes to junk, but it should have been there already. If Countrywide survives you can make a lot of money in their unsecured debt. I’ll pass, thank you. I’d rather hold the equity. Anworth is also getting smashed in this environment.
    9. Have you seen the credit summary in the Wall Street Journal?
    10. I had argued at RealMoney that home equity loans would eventually get hit. A non-consensus opinion. Well, now they are getting hit.
    11. DealBreaker.com has chutzpah, particularly on this list of hedge funds that might have blown up.
    12. You can look at it on the serious side or the funny side. Either way, losing money for clients stinks. That’s why I focus on risk control.
    Triage

    Triage

    Posted on by David Merkel

    I’m still working through my portfolio, but I have categorized some stocks:

    The Dead — Companies with bad balance sheets, but have been whacked so bad that it is still worth playing

    • Jones Apparel
    • Deerfield Capital
    • YRC Worldwide

    Walking Wounded — Companies with okay balance sheets that we feed more cash to

    • Lafarge
    • Industrias Bachoco

    Seemingly healthy that might have financing problems — Sold

    • Lithia Automotive
    • Group 1 Automotive

    Uncertain as of yet

    Barclays plc

    Safe New Names Bought

    • PartnerRe
    • Microcap yet to be named when I have my full position on.

    More tomorrow. As you can tell, I am positioning my broad market fund more conservatively. I am not optimistic on how we work through the amalgam of debts that might not get paid.

    Full disclosure: long PRE IBA DFR JNY YRCW BCS LR

    Morning Actions

    Morning Actions

    Posted on by David Merkel

    Bought a little Lafarge and Industrias Bachoco in to the morning’s decline. Eliminated Group 1 Automotive, and began the acquisition of a little microcap trading below book value with no debt. The integrating theme here is holding onto businesses that don’t need external financing, and selling businesses that require external financing, starting with companies that haven’t been hit that badly yet.

    Could the existing financing troubles spill over into auto financing and auto floorplan financing? That’s possible, though I don’t see the transmission mechanism now. The potential trouble with Group 1 (aside from a balance sheet with high intangibles), is that changes in financing terms could dent their earnings stream. Now, I know that the automakers are highly motivated to move the metal, and will aid the financing process, but I don’t think they can be relied on in entire, unless they only selling for Honda and Toyota, which have superior balance sheets.

    The moves so far this morning are cash neutral. We will see how that changes as the day progresses.

    Full disclosure: long LR IBA

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