Category: Value Investing

The Collapse of Fixed Commitments

The Collapse of Fixed Commitments

I’ve begun portfolio triage here, and am debating what to sell, and buy, if anything.? More in my next post, if I have the strength tonight.? I’m feeling a little better, though the market is not helping.

Why the collapse of fixed commitments?? Consider what I wrote In RealMoney’s columnist conversation today:


David Merkel
Yielding Illiquidity
8/15/2007 4:02 PM EDT

Liquidity is the willingness of two parties to enter into fixed commitments, which can be measured by yield spreads, option prices, and bid-ask spreads. At present, the willingness to be on the giving liquidity side of the trade is declining. Even the willingness to do repos, which is pretty vanilla, has dried up. Roughly double the margin needs to be put up now to hold the same position. That dents the total buying power for what are arguably high quality assets — agency RMBS and the AAA portions of prime whole loans. This means that prices fall until balance sheet players with unencumbered cash find it sufficiently attractive to take on the mortgage assets.

I thought this era of unwinding leverage would arrive, and arrive it has. (That said, I did not expect that mortgage repo funding would be affected. That was a surprise.) I could never predict the time of the unwind, though, and though I have a decent amount of cash on hand, it can never be enough at the time.

One of the few bright sides here is that most of the real risk is concentrated in hedge funds, and hedge fund-of-funds. (Some pension plans are going to miss their actuarial funding targets dramatically.) Hopefully the investment banks with their swap books have done their counterparty analyses correctly, and didn’t cross hedge too much.

I’m still up for this year, but not by much. Perhaps I liked being intellectually wrong better while I made money on the broad market portfolio. Sigh.

Position: none

Could Countrywide fail?? It’s not impossible.? I had an excellent banking/financials analyst when I was a corporate bond manager, and she taught me that if you are a finance company, your ratings must allow you to issue commercial paper on an advantageous basis in order to be properly profitable.? If not, the optimistic outcome is a sale of the company to a stronger party.? The pessimistic outcome is failure.? We last tested this late in 2002 when we accumulated a boatload of Household International debt on weakness after they lost access to the CP markets, but had announced the merger with HSBC.? If you can make 12% in two months on bonds, you are doing well.? Paid for a lot of other errors that year.

But if Countrywide fails, the mortgage market is dead temporarily.? It would be a help after a year because of reduction in new mortgages, but in the short run, the rest of the market would have to digest the remains of Countrywide’s balance sheet.

Shall we briefly consult with the optimists?? Exhibit A is William Poole, who is more willing to speak his mind than most Fed Governors, for good and for ill.? He doesn’t see any effect on the “real economy” from the difficulties in the lending markets.? At the beginning of any lending crisis, that is true.? Difficulties happen in the “real economy” when current assets have a difficult time getting financed, and consumer durable purchases and capital investments get delayed because financing is not available at reasonable prices.? By year end, Poole will change his tune.

Now, I half agree with the Lex column in the Financial Times.? The level of screaming is far too loud for a decline of this magnitude. ? But that’s just looking at the stock price action.? The action in the debt markets in relative terms is more severe, and bodes ill for the equity markets eventually.? Remember, the debt markets are bigger than the equity markets.? Problems in the debt markets show up in the equity markets with a lag, as companies need financing.

One more optimist: private equity funds buying back LBO debt.? The steps of the dance have changed, gentlemen.? It is time to conserve liquidity, not deploy it.? The time to deploy is near the end of a credit bust, not near its beginning.

How about the pessimists?? Start with Veryan Allen at Hedge Fund.? He tells us that volatility is normal, and that it often drags the good down with the bad.? The difference is risk control, and the good don’t die, and bounce back after the bad die.? Now let’s look at the rogues’ gallery du jour. Who is getting killed?? Pirate Capital, Basic Capital, and let’s mention the Goldman Sachs funds again because the leverage was higher than expected.? Toss in an Austrialian mortgage lender for fun, not.? Consider those that are trying to remove money from hedge funds.? It may not be as severe as possible, but it could really be severe.? Investors, even most institutional investors, are trend followers.

Five unrelated notes to end this post:

  1. Could this be the end of the credit ratings agencies?? I don’t think so.? It might broaden the oligopoly, and weaken it, but ratings are an inescapable facet of finance.? Ratings go through cycles of being good and bad, but people need opinions that are standardized about the riskiness of securities.? Go ahead, ban all of the existing ratings agencies now.? Within five years, debt buyers and regulators will have recreated them.
  2. What is funny about this article from the Wall Street Journal is that they mix some residential mortgage REITs into an article on commercial mortgage REITs.? DFR and FBR both are residential mortgage REITs.? There may be more there too, but I haven’t checked.
  3. If you can’t trust your money market funds, what can you trust?? I was always a little skeptical about asset backed commercial paper [ABCP] when it first arrived, but it survived 2000-2003, and I forgot about it.? Now it comes back to bite.? Some programs will extend maturities.? Some backup payers will pay, and some won’t.? Fortunately, it is not ubiquitous in money market funds, but it is worth looking for, if you have a lot in money market funds.
  4. How rapid has this 1,000 point decline in the Dow been?? Pretty fast, though 1,000 points is smaller in percentage terms than it used to be.
  5. Sorry to end on a sour note, but the Asian markets are having a rough go of it, and will make tomorrow tough in the US as well.

It’s late, so I’m going to post on my portfolio tomorrow.? I’ll give you the skinny now.? I’m evaluating the balance sheets and cash flow statements of stocks in my portfolio, and I am starting with those I have lost the most on, and evaluating their survivability under rough conditions.? I have some good ideas already, but I fear that I am too late; some names are so cheap, though leveraged (DFR is a good example), that it is hard to tell what the right decision is.? I will be making some trades, though, no doubt.

Full Disclosure: long DFR

The Value of Having a Deposit Franchise (or a Printing Press)

The Value of Having a Deposit Franchise (or a Printing Press)

I’m worried.? That doesn’t happen often.? Over the years, I have trained myself to avoid both worry and euphoria.? That has been tested on a number of occasions, most recently 2002, when I ran a lot of corporate bonds.? Ordinary risk control disciplines will solve most problems eventually, absent war on your home soil, rampant socialism, and depression.? I like my methods, and so I like my stocks that come from my methods, even when the short term performance is bad.? Could this be the first year in seven that I don’t beat the S&P 500?? Sure could, though I am still ahead by a few percentage points.

Let’s start with the central banks.? I don’t shift my views often, so my change on the Fed is meaningful.? But how much impact have the temporary injections of liquidity had?? Precious little so far.? Yes, last I looked, Fed funds were trading below 5%; banks can get liquidity if they need it, but credit conditions are deteriorating outside of that.? (more to come.)? I don’t believe in the all-encompassing view of central banking espoused by this paper (I’d rather have a gold standard, at least it is neutral), but how much will full employment suffer if most non-bank lenders go away?

Why am I concerned? Short-term lending on relatively high quality collateral is getting gummed up.? You can start with the summary from Liz Rappaport at RealMoney, and this summary at the Wall Street Journal’s blog.? The problems are threefold.? You have Sentinel Management Group, a company that manages short term cash for entities that trade futures saying their assets are illiquid enough that they can’t meet client demands for liquidity.? Why?? The repurchase (repo) market has dried up.? The repurchase market is a part of the financial plumbing that you don’t typically think about, because it always operates, silently and quietly.? Well, from what I have heard, the amount of capital to participate in the repo market for agency securities, and prime AAA whole loan MBS has doubled.? 1.5% -> 3%, and 5% -> 10%, respectively.? Half of the levered buying power goes away.? No surprise that the market has been whacked.

Second, away from A1/P1 non-asset-backed commercial paper, conditions on the short end have deteriorated.? As? I have said before, complexity is being punished and simplicity rewarded.? High-quality companies borrowing to meet short-term needs are fine, for now.? But not lower-rated borrowers, and asset-backed borrowers.? Third, our friends in Canada have their own problems with asset-backed CP.? Interesting how Deutsche Bank did not comply with the demand for backup funding.? Could that be a harbinger of things to come in the US?

On to Mortgage REITs.? Thornburg gets whacked.? Analyst downgrades.? Ratings agency downgrades.? Book value declines.? Dividends postponed.? It all boils down to the increase in margin and decrease in demand for mortgage securities (forced asset sales?).

It’s a mess.? I’ve done the math for my holdings of Deerfield Capital, and they seem to have enough capital to meet the increased margin requirements.? But who can tell?? Truth is, a mortgage REIT is a lot less stable than a depositary institution.? Repo funding is not as stable as depositary funding.? There will come a point in the market where it will rationalize when companies with balance sheets find the mortgage securities so compelling, that the market clears. After that, the total mortgage market will rationalize, in order of increasing risk.? Fannie and Freddie will help here.? They support the agency repo market, but the AAA whole loan stuff is another matter.? Everyone in the mortgage business except the agencies is cutting back their risk here.

By now, you’ve probably heard of mark-to-model, versus mark-to market.? The problem is that mark-to-model is inescapable for illiquid securities.? They trade by appointment at best, and so someone has to estimate value via a model of some sort.? The alternative is that since there are no bids, you mark them at zero, but that will cause equity problems for those buying and selling hedge fund shares.? This is a problem with no solution, unless you want to ban illiquid securities from hedge funds.? (Then where do they go?)

There’s always a bull market somewhere, a friend of mine would say (perhaps it is in cash? that is, vanilla cash), but parties dealing with volatility are doing increasing volumes of business, which is straining the poor underpaid folks in the back office.

Why am I underperforming now?? Value temporarily is doing badly because stocks with low price-to-cash-flow are getting whacked, because the private equity bid has dried up.? That’s the stuff I traffic in, so, yeah, I’m guilty.? That doesn’t dissuade me from the value of my methods in the long run.

Might there be further liquidity troubles in asset classes favored by hedge funds?? Investors tend to be trend followers, so? yes, as redemptions pile up at hedge funds, risky assets will get liquidated.? Equilibrium will return when investors with balance sheets tuck the depreciated assets away.

Finally, to end on a positive note.? Someone has to be doing well here, right?? Yes, the Chinese.? Given the inflation happening there, and the general boom that they are experiencing, perhaps it is not so much of a surprise.

With that, that’s all for the evening.? I have more to say, but I am still not feeling well, and am a little depressed over the performance of my portfolio, and a few other things.? I hope that things are going better for you; may God bless you.

Full disclosure: long DB DFR

Buybacks and Yield Should be Byproducts of Free Cash Flow

Buybacks and Yield Should be Byproducts of Free Cash Flow

There’s a lot of talk about the superiority of yield-based strategies, and that has been true in hindsight, particularly since interest rates have fallen for pretty much the last 25 years, while corporate profits and free cash flow have generally grown, allowing for greater dividend capacity.? A potent mix that has favored yield, but what if the environment changes?

I don’t go looking for yield, but stocks with some yield tend to find their way into my portfolio.? Why?? Companies with stable business models, strong balance sheets, and good earnings quality tend to produce free cash flows in excess of their reinvestment needs.? That cash can be given to shareholders as dividends, or used to buy back stock.


But there is something positive about what a dividend does to a company’s management team, which in the American context, is viewed as a pseudo-obligation.? This makes the cost of capital tangible to the management team, which will be more careful about how they use their cash.? After all, they have a dividend to maintain.


Now, yield in itself can be manipulated.? Leverage can be increased to pay dividends, and with low quality companies that often happens.? Smart investors look to see how well a company’s dividend yield is covered by the earnings.? Avoid the shares of a company that isn’t likely to earn its dividend, particularly if the have to compromise the balance sheet to do it.


A yield in itself does not make a company more safe; if the yield is high enough such that there are naive yield investors in the stock, that yield can actually make the stock more risky, if a disappointing earnings report puts the dividend in jeopardy.


Finally, as an aside, a quick note on intelligent vs. dumb buybacks.? Intelligent management teams have an estimate of what they think their firm is worth, and they don’t buy back stock, unless the stock is trading below that level.? The management team won’t tell you that level, but they might tell you if they follow such a strategy, if you ask them.


After that, you can find out where they are buying stock back.? If you look in the cash flow statement, under cash flows from financing, you can see how much they spent buying back stock, and in the statement of shareholders equity you can see how many shares they bought back.? Those two figures will enable you to calculate the average buyback price.? This figure can be important even for traders, because it can indicate a level where a management team is willing to buy buy shares when they have free cash, and as a result, can become a support level for the stock.

Good fundamental investing means looking at more than just a few summary variables, like yield.? You have to dig through the financial statements to see how the business adds value.? If that means that your stock gives you a yield, like most of my stocks do, that is icing on the cake.

Dealing with Underperformance

Dealing with Underperformance

Over the past seven years, my broad market strategy done well against the S&P 500. I reach the seven year anniversary at the end of August, and should business prospects require it, I will get the results audited. But since the start of the quarter, the strategy has not done so well, trailing the S&P by a little less than 4%. Why have the results been so bad?

My portfolio has concentrations in a number of areas. I have a slight overweight in financials (though only one company affected by the current crises), a large overweight in energy, and an overweight in cyclicals, though cyclicals targeted at foreign demand, not US demand. These areas have underperformed, and so have I. Industries are 60% of the performance of the market in my opinion, so when you run a portfolio that concentrates industries, there will be periods of underperformance.

Value is out of favor at present as well. My approach is “all cap” value; I don’t care about the size of companies that I buy. I’m only 2% or so behind the Russell 1000 Value, but I am more than 4% ahead of the Russell 2000 Value. Small cap value has gotten smashed, and I am a partial casualty along with it.
So, maybe I’m not doing that badly. What I do at times like this is to try to identify the factors leading to underperformance and ask whether those factors are likely to persist for a year or more. Let me go through my major exposures, updating what I wrote previously:

  1. Energy ? Integrated, Refining, E&P, Services, Synfuels. I am still a bull here; we aren’t finding enough energy supplies to meet the needs of our growing world. (15%)
  2. Light Cyclicals ? Cement, Trucking, Chemicals, Shipping, Auto Parts. These areas are undervalued, given the way our world is growing. (20%)
  3. Odd financials ? European banks, an odd mortgage REIT [DFR]. Largely insulated from the credit crises, and cheap. (10%)
  4. Insurance — AHL, AIZ, SAFT, and LNC. All of them cheap, and with good earnings prospects. (10%)
  5. Latin America ? SBS, IBA, GMK. All are plays on the growing buying power in Latin America. (8%)
  6. Turnarounds ? SLE, JNY. Give them time; Rome wasn?t burnt in a day. (5%)
  7. Technology ? NTE, VSH. Stuff that is not easily obsoleted. (5%)
  8. Auto Retail ? LAD, GPI. Out of favor. (5%)
  9. Cash (15%) — 5.25%/year is not bad.

That’s 93% of my broad market portfolio. Three other miscellaneous companies make up the rest. You can find the complete portfolio here.
After writing this, my tentative conclusion is that my methods still work, but that I am fighting temporary setbacks from value being out of favor, and from financials getting taken out and shot, even if there is no connection to the current credit crises. Therefore I soldier on, trusting the methods that have brought me this far.

Full disclosure: long LAD GPI NTE VSH SLE JNY SBS IBA GMK AHL AIZ SAFT LNC DFR

A Tale of Two Insurance Companies

A Tale of Two Insurance Companies

RAMR 8-6As I write this, I am listening to a replay of the RAM Holdings Conference Call that happened on Monday.? RAM Holdings did not have a good day in the market yesterday, losing 44.5%? of their market value.? What went wrong?

  • Investors are more attuned to subprime, and so the merest hint of trouble sends them running for the exits.
  • They are more attuned to CDOs, and so the merest hint of trouble sends them running for the exits.
  • They commented that premium volume might decline over the remainder of the year.
  • They only met the earnings estimate.
  • The cost of their soft capital facility has risen to LIBOR+200, the maximum, leading them to question whether they can’t replace the facility with something better.?? (My guess? No.)
  • The conference call focused on subprime, CDOs, and the more shadowy bits of their guarantees.

So what does RAM Holdings do?? They reinsure the primary AAA financial guarantors.? They are the only AAA reinsurer that does not compete with the primary insurers.? Typically, they try to take an equal slice of all of the business that MBIA, Ambac, FGIC, FSA, and the three others produce each year.? In that sense, you can think of them as a small version of what the average of the financial guarantee industry would be like if it were a single company.? Unlike a P&C reinsurer, losses kick in only after a threshold is met, and then a lot of losses get paid, with RAM Holdings, the losses are pro-rata from the first dollar.? The primary insurers would have no advantage passing them bad business, because they would be more affected by the bad business.

I’m reviewing RAM Holdings as a possible purchase candidate.? If I were running a small cap fund, I would definitely start tossing some in now.? Why?? It’s trading at less than 35% of adjusted book value, and the balance sheet is good in my opinion, and the opinions of S&P and Moody’s.?? If I were running a hedge fund, I would buy RAM and short equal amounts of MBI, ABK, SCA and AGO.? Why?? If RAM is really in this much trouble, it is likely that MBIA, Ambac, Security Capital and Assured Guaranty are in the same trouble.

Aside from that, their subprime exposure is small-ish and seasoned.? Their CDO exposure is almost all AAA, with super-senior attachment points (i.e. non-guaranteed AAA bonds would have to lose it all before thet pay dollar one of guarantees).? Honestly, I’m probably more concerned about the BBB HELOC and closed-end second lien mortgage exposure.? I would need more data on that before I could act.

SAFT 8-6 Then there’s Safety Insurance, which was up 12.0% on Monday.? What went right?

  • Unlike Commerce Group, which missed, they beat estimates handily.
  • They raised their dividend by 60%, from $1.00 to $1.60.
  • They announced a $30 million buyback (and they have the money to do it).
  • The asset side of their balance sheet carries little credit risk.

Now, Safety faces its challenges as the Massachusetts auto insurance market possibly partially deregulates, but Safety has successfully competed in a variety of different market regimes in the state.? The current management team has shown itself to be very adept at adjusting to changing conditions.

Even with change, Massachusetts will still be the most heavy handed state in the US with auto insurance.? It won’t attract a lot of new entrants.? And, it is possible that no change will happen… previous deregulatory plans have come and gone, though this one has more political clout behind it.

Safety is still cheap to me at 1.0x book value, and 7.6x 2008 estimated earnings.? I’m hanging around for more.

Full Disclosure: long SAFT

I Like My Stocks

I Like My Stocks

It was not a great week for my portfolio, but I still like my stocks. Is global growth slackening? I don’t think so. Are the financials that I own under threat? With the possible exception of Deerfield [DFR], no, not at all. Four quality US insurers, three quality European banks, and DFR. Hey, Deutsche Bank actually profited from the crisis. And Safety Insurance, unlike Commerce Group which missed estimates, beat estimates by a dime after the close. Bright management team there, and it trades at 97% of book, 5.7x 2007 earnings, and 6.8x 2008 earnings. (Did I mention that the reserves look conservative?)

 

Today’s action makes me think that there is some mindless “sell financials” program out there, and not caring about what is inside the financials. I will be adding to my names that were the worst hit recently, and perhaps, giving a higher weight to some of the insurers that I recently purchased. Assurant at 8.7x 2008 earnings, and Lincoln National at 9.2x 2008 earnings? It doesn’t make sense; these are two high quality companies with excellent growth prospects.

I am a value investor. Scanning my portfolio, I see a median 2008 P/E between 9-10x, and a median P/B in the 1.1x area. My portfolio will find support, even if the market falls further.

Full disclosure: long DFR DB AIZ LNC SAFT

Speculation Away From Subprime, Compendium

Speculation Away From Subprime, Compendium

Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.

  1. I have grown to like the blog Accrued Interest.? There aren?t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google ?Ohio Mattress,? and you can see the danger here.? Deals where the debt interests don?t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a ?bridge to nowhere.?? Maybe the investment bankers should visit Milwaukee, because the ?bridge to nowhere? eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
  2. Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, ?The markets are offered without bid.? We?ve never seen it this bad.? What do you want to do??? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
  3. I?ve seen a number of reviews of Dr. Bookstaber?s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
  4. I?m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren?t easy money.
  5. From the ?Too Many Vultures? file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
  6. Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
  7. Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
  8. Becoming more proactive on ratings?? I?m not holding my breath but Fitch may be heading that way on CMBS.? Don?t hold your breath, though.
  9. When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
  10. We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can?t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don?t), volatility is reduced, and panics are more slow to occur.
  11. Perhaps Babak at Trader?s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
  12. The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here?s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
  13. Shhhhh. I?m not sure I should say this, but maybe the investment banks are cheap here. I?ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
  14. Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
  15. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
  16. Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
  17. Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
  18. Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.
  19. How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
  20. There is a tendency with hedge funds to hedge away ?vanilla risks? (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber?s new book that makes this point.? Let?s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
  21. Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
  22. I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are ?side bets? that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
  23. I?ve said it before, and I?ll say it again, there are too many vulture investors in the present environment.? It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.? That said, Sowood benefits from the liquidity of Citadel.
  24. Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
  25. Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those?)? At present the key factors are these? does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
  26. There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn?t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky?s attempts to close out Gen Re?s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
  27. If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn?t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
  28. If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.
  29. Regarding 130/30 funds, particularly in an era of record shorting, I don?t see how they can add a lot of value.? For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn?t eat away as much alpha as the long strategy generates.? Few managers are good at both going long and short.? Few are good at going short, period.? One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
  30. Investors like yield.? This is true of institutional investors as well as retail investors.? Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.? This is one reason why I prefer high quality investments most of the time in fixed income investing.? I will happily make money by avoiding capital losses, while accepting less income in speculative environments.? Most investors aren?t this way, so they take undue risk in search of yield.? There is an actionable investment idea here!? Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.? Better, run an arb fund that attempts to extract the difference.
  31. Most of the time, I like corporate floating rate loan funds.? They provide a decent yield that floats of short rates, with low-ish credit risk.? But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.? From the article, the fund with the ticker JGT intrigues me.
  32. This article from Information Arbitrage is dead on.? No regulator is ever as decisive as a margin desk.? The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
  33. As I have said before, there are many vultures and little carrion.? I am waiting for the vultures to get glutted.? At that point I could then say that the liquidity effect is spent. Then I would really be worried.
  34. Retail money trails.? No surprise here.? People who don?t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
  35. One more for Information Arbitrage.? Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.? Where I differ with his opinion is how credit instruments should be priced.? Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.? Proper valuation considers both the likelihood of being a going concern, and being in liquidation.

That?s all in this series.? I?ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage? definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I?m not holding my breath.

Deerfield: A Difficult Rebalancing Trade

Deerfield: A Difficult Rebalancing Trade

The following things that I write are more risky than normal, and may be wrong.? If you decide to imitate what I have done, you are doing so at your own risk.? Please do your own due diligence.

I have bought more Deerfield Triarc [DFR] today @ $9.76.? A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more.?? Truth is, I had been working on the issue for two weeks.? Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review.? I don’t automatically do rebalancing buys when a company is under stress.

Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold.? Point one that gives me comfort is that the financing is likely secure.

Most of it is repo funding on prime mortgage collateral, most of which is floating rate.? Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill.? You could contrast Deerfield and Annaly.? The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).

The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable.? The risk there is that the equity and subordinate bonds that they hold could be worthless.? Unlikely, but a possible loss somewhere north of $50 million.? They also have warehouse lines, where assets are held prior to securitization.? I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines.? (Note: they couldn’t sell the BBB securities.)? The lines are capable of financing $375 million, and extend to April of 2008 at minimum.

Point two is that very little of the assets inside DFR’s CDOs are subprime.? The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million.? Not huge.

Point three is that they might not be able to consummate the merger with Deerfield? Capital Management [DCM], since DFR has to pony up $145 million.? I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6.? But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of? bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.

Point four is might the deal terms adjust?? Couldn’t DCM allege a material adverse change, and try to get the terms changed?? It’s a little late for that.? The DFR shareholders meeting is one week from today.? Besides, many of the same problems facing DFR are facing DCM.

Point five is that much of what DCM manages are ABS CDOs.? Much of the ABS collateral is subprime residential mortgages.? (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure.? There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often.? The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that? are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.

In summary, why did I buy more?

  • The losses look limited, if they occur at all
  • The financing seems secure
  • Exposure to subprime losses are small, and
  • I think the deal goes through.

Could I be wrong on some of these points and lose badly?? Yes.

Full disclosure: Long DFR

The Five Pillars of Liquidity

The Five Pillars of Liquidity

Liquidity, that ephemeral beast.? Much talked about, but little understood.? There are five pillars of liquidity in the present environment.? I used to talk about three of them, but I excluded two ordinary ones.? Here they are:

  1. The bid for debt from CDO equity.
  2. The Private Equity bid for cheap-ish assets with steady earnings streams.
  3. The recycling of the US current account deficit.
  4. The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
  5. The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.? With equities, higher returns; with bonds, more yield.? Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.

Numbers one and two are broken at present.? The only place in CDO-land that has some life is in investment grade assets.? We must lever up everything until it breaks.? But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.

With private equity, it may just? be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.? Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.

Number three is the heavy hitter.? The current account deficit has to balance.? We have to send more goods, assets, or promises to pay more later.? The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.? Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.

With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).

The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.? There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.? With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.? The Boomers need it to live off of.

So where does that leave us, in terms of the equity and debt markets?? Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.? Everything else is suspect.? As for equities, investment grade assets that are not likely acquirers look good.? The acquirers are less certain.? Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.? The rest of the equity markets… the less creditworthy their debt, the less well they should do.

Dissent on Dividends

Dissent on Dividends

Everything old is new again.? If we jumped into the “wayback machine” (?Where are we going Mr. Peabody??) and turned the dial to 1957 (?1957. We are going to meet Elvis, Sherman.?) we would find that the few equity investors that are there are highly concerned about yield, and that the yield on stocks was threatening to dip below the yield on bonds.

This was the twilight for yield-based investing.? Through the next fifty years, there would be among value investors a few absolute yield investors that prospered for a time, then died when interest rates rose, and a few relative yield investors who would die when credit spreads blew out. (Note: an absolute yield manager will only buy stocks with more than a given yield, like 4%; a relative yield manager will only buy stocks that yield more than a benchmark, like the yield on the S&P 500.)

As an example, when I was with Provident Mutual in the mid-1990s, I created a series of multiple manager funds.? One was a value fund that we were creating to replace an absolute yield manager who had done exceptionally well over the past 19 years, but cruddy over the last four.? Assets had really built up in that fund, and our clients were getting jumpy.

A large part of the problem was that interest rates had fallen from 1980 through 1993, but had risen since.? Buying steady cash generating low-growth companies while interest rates were falling was a thing of genius.? As interest rates fell, the dividend stream was worth more and more.? When interest rates rose, that pattern reversed, and 1994 was particularly ugly.? We sacked the absolute yield manager as a one trick pony.? A wise move in hindsight.

Now we have enhanced indexers basing whole strategies off of yield, because their backtests show that yield is an effective variable for allocating portfolio weights.? Given that the last 25 years or so have had falling interest rates, this should be no surprise.? Yield will always be an effective variable when rates fall; but what if rates rise?

Also, what happens when Congress does not renew the reduction of the tax on dividends?? Don?t get me wrong, I like dividends; my portfolios yield much more than the markets.? But I don?t go looking for dividends.? I look for companies that generate cash earnings.? What they do with the cash earnings is important; I don?t want management reinvesting the cash foolishly, but if they have good investment prospects, then please don?t send me dividends.

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.? That is true.? We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.? Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.? Approach yield the way a businessman would.? If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.? At the end, privately, many scoffed, but I thought he was on the right track.? I still like dividends, but I like businesses that grow in value yet more.? Aim for good returns in cash generating businesses, and the dividends will follow.? Stretching for dividends is as bad as stretching for yield on bonds.? That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

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