Category: Value Investing

Twenty-Five Ways to Reduce Investment Risk

Twenty-Five Ways to Reduce Investment Risk

Posted on by David Merkel

With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.

  1. Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
  2. Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
  3. Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
  4. Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
  5. Avoid explicit leverage; don’t use margin.
  6. Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
  7. Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
  8. Avoid balance sheet complexity; it can be a cover for accounting chicanery.
  9. Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
  10. Avoid owning popular companies; they tend to underperform.
  11. Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
  12. Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
  13. Focus on industries that are out of favor, and look for strong players that can withstand market stress.
  14. Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
  15. Take something off the table when the markets run, and edge back in when they fall.
  16. Analyze how any new investment affects your total portfolio.
  17. Don’t use any investment strategy that you don’t fully understand.
  18. Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
  19. Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
  20. Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
  21. Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
  22. When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
  23. Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
  24. Size positions inversely to risk levels.
  25. Finally, think about risk before you need to; make it a positive component of your strategies.

Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.

If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.

Portfolio Notes — July 2007

Portfolio Notes — July 2007

Posted on by David Merkel

I have three portfolios that I help manage. They are listed over at Stockpickr.com. The big one is insurance stocks, where I serve as the analyst, and have a lot of influence over what is selected, but don’t make the buy and sell decisions. The second is my broad market fund, over which I have full discretion. The last is my bond fund, which doesn’t have an independent existence, but fills the fixed income role for the two balanced mandates that I run, in which the broad market fund serves as the equity component. I’m going to run through each portfolio, and hit the high points of what I think about my holdings. Here we go:
Bond PortfolioI sold our last corporate loan fund in early June. We made a lot of money off these over the past two years as LIBOR rose, and the discounts to NAV turned into premiums. New issuance of corporate loans has been more poorly underwritten. I’m not coming back to the corporate loan funds until I see high single digit discounts to NAV, and signs that credit quality is flattening from its recent decline.

The portfolio is clearly geared toward preservation of purchasing power. We have TIPS and funds that invest in inflation-sensitive bonds [TIP, IMF]. We have foreign bonds [FXC, FXF, FXY, FAX, FCO]. The Yen and Swiss Franc investments are there as systemic risk hedges. The Canadian bonds and the two Aberdeen funds are there for income generation. If energy stays up, Canada might never need to borrow in the future. I also have a short-term bond fund [GFY] trading at a hefty discount, and cash. Finally, I have a speculative deflation in long Treasuries. [TLT]

This is a very eclectic portfolio that has done very well over the last 24 months. This portfolio will underperform if any of the following happen:

  • Inflation falls
  • The dollar strengthens
  • The yield curve steepens amid the Fed loosening
  • Credit spreads tighten

The Broad Market Portfolio

There are four things that give me pause about RealMoney. First, there is a real bias toward sexy stocks, and commonly known stocks. That bias isn’t unusual; it plagues all amateur investors. Two, few players talk about bonds, and how to make money from them, as well as reducing risk. Three, almost everyone trades more than me. Finally, there is a “home turf” bias, where everyone sticks to their niche, whether it is in favor or not.

I try to be adaptive in my methods through careful attention to valuation and industry rotation. Underlying all of it, though, is a focus on cheap valuations. There are seven summary categories here at present, and then everything else. Here are the categories:

  1. Energy — Integrated, Refining, E&P, Services, Synfuels. I am still a bull here.
  2. Light Cyclicals — Cement, Trucking, Chemicals, Shipping, Auto Parts
  3. Odd financials — European banks, an odd mortgage REIT [DFR], and Allstate [ALL].
  4. Latin America — SBS, IBA, GMK. All are plays on the growing buying power in Latin America.
  5. Turnarounds — SPW, SLE, JNY. Give them time; Rome wasn’t burnt in a day.
  6. Technology — NTE, VSH. Stuff that is not easily obsoleted.
  7. Auto Retail — LAD, GPI.

So far this overall strategy has been a winner for the past seven years. No guarantees on the future, though. In the near term, rebalancing trades could include purchases of JNY and sales of DIIB and SPW. Beyond that, I am waiting for a week or so to sell my Lyondell. It is possible that another bid might materialize. Allstate is also on the sell block, though, I might just trim a little. What makesme more willing to sell the whole position is the disclosure of an above average position in subprime loans.

Insurance

There is one easy play going into earnings season, and one moderate play. Beyond that, there is dabbling in the misunderstood.

Easy: buy asset sensitive life insurers, ones with large variable annuity, life and pension businesses. Who? LNC, NFS, SLF, MFC, PNX, PRU, MET, HIG, and PFG. Why? Average fees from domestic equities are up 5% over the first quarter, and the third quarter looks even better for now. Guidance could be raised. Away from that, the dollar fell by 2% on average over the quarter, so those with foreign operations (excluding Japan) should do well also, all other relevant things equal.
Moderate: no significant hurricanes so far. Given that there is some positive correlation between June-July, and the rest of the season, are you willing to hazard some money on a calm storm season? With global warming DESTROYING OUR PLANET!!!! (not, this is cyclical, not secular.) If you are willing to speculate, might I recommend FSL? They manage their business well, though they are new.

Beyond that, I would commend to you both Assurant (a truly great company that will survive the SEC), and Safety Insurance (investors don’t get the risks here, they are small, and management is smart).

Summary

Managing portfolios has its challenges. One has to balance risk and reward on varying investments. Sometimes the market goes against you, and you question your intelligence. But good fundamental managers persevere over time, and produce good returns for their investors. That’s what I aim to do.

Full Disclosure: all of my portfolios are listed here.

Late editorial note: where I wrote FSL above, I meant FSR.? Thanks to Albert for pointing the error out.

Joys and Difficulties of the Day

Joys and Difficulties of the Day

Posted on by David Merkel

Not such a great day for me. Yes, Lyondell got bought out. Nice. But in my insurance portfolio, Aspen gets tarnished by IPCR’s earnings warning regarding floods in North England and in New South Wales, Australia. Aspen has exposure to the UK, but not necessarily Australia. I find it unlikely that it should have driven down the price 4% though.On another front after falling 8% over two weeks, Safety Insurance fell another 1.3% today over fears that liberalizing Massachusetts auto insurance markets will lead to decreased profitability in the future. A few notes: 1) the proposed liberalizations will not likely make it through the legislature. 2) the liberalizations are not thorough enough to attract meaningful competition to Massachusetts. 3) Safety management is ready for the liberalizations if they should happen. They have proven themselves to be worthy competitors over the years.

Were I able to buy Safety for myself (I can’t because of restrictions), I would do so here. Have a good night.

full disclosure: long LYO SAFT AHL

All’s Wells at Assurant

All’s Wells at Assurant

Posted on by David Merkel

Assurant, which is still my favorite insurance company and stock, is down 10% as I write. The CEO, CFO, and EVP, Chief Actuary, and VP-Risk Management for Solutions/Specialty Property, have all received Wells notices, and are now on administrative leave.So what are the issues? Prior to its IPO, when it was a part of Fortis, Assurant entered into a treaty that provided a limited amount of reinsurance to Assurant’s property lines. From the 8/16/2005 NT 10-Q:

As disclosed in the Risk Factors section of Assurant, Inc.’s (the “Company”) Annual Report on Form 10-K for the year ended December 31, 2004, one of the Company’s reinsurers thinks the Company should have been accounting for premiums ceded to them as a loan instead of as an expense. Based on the Company’s investigation to date into this matter, the Company has concluded that there was a verbal side agreement with respect to one of the Company’s reinsurers under its catastrophic reinsurance program, which has accounting implications that may impact previously reported financial statements. While management believes that the difference resulting from any alternative accounting treatment would be immaterial to the Company’s financial position or results of operations, regulators may reach a different conclusion. In 2004, 2003 and 2002, premiums ceded to this reinsurer were $2.6 million, $1.5 million and $0.5 million, respectively, and losses ceded were $10 million, $0, and $0, respectively. This contract expired in December of 2004 and was not renewed.

From my reading, when the original reinsurance deal was done, the current CEO was CFO, and the current CFO was head of Solutions. So, all five were involved with the unit in question, so the Wells notices to the CEO and CFO do not necessarily mean that Assurant as a whole is implicated, just the Solutions unit, and not the Solutions unit’s current operations either. If earnings have to be restated, the net result should be near zero, and it would be only for 2002-2004.

It is possible that the finite reinsurance treaty in question may have smoothed earnings during the IPO and the first year, but from my angle, it seems to be going the wrong way. That said, in 2005, the audit committee found the side letter, which is the incriminating bit of data, which turned a reinsurance treaty into an accounting ploy that should have been treated as a loan.

There are only two risks here. Assurant loses five great employees, who get replaced from their exceptionally deep bench. No other insurer in the industry invests as much in their people as Assurant does. They have the people to fill the shoes, if need be. The second possibility is some sort of legal settlement, and in this day and age, who can tell how large that will be? For Ren Re on a more serious lapse on finite Re, the size of the fine was $15 million.

So, I have been buying Assurant today. Hasn’t been this cheap on earnings since 2004. You get a top quartile ROE insurer at a below market multiple.

Full disclosure: long AIZ

Ten Important, but not Urgent Articles to Ponder

Ten Important, but not Urgent Articles to Ponder

Posted on by David Merkel

I am an investor who does not consider background academic and semi-academic research to be worthless, even though I am skeptical of much of quantitative finance. Here are a few articles to consider that I think have some importance.

  1. Implied volatility is up. Credit spreads are up, and the equity market has not corrected. Time to worry, right? Wrong. When implied volatilities (and credit spreads) are higher, fear is a bigger factor; valuations have already been suppressed. Markets that rally against rising implied volatility typically have further rises in store.
  2. Many thanks to those that liked my piece on the adaptive markets hypothesis. Here is a piece about Andrew Lo, one of the biggest proponents of the AMH, which fleshes out the AMH more fully. I would only note that the concept of evolution is not necessary to the AMH, only the concepts inherent in ecological studies. Also, all of the fuss over neuropsychology is cute, but not necessary to the AMH. It is all a question of search costs versus rewards.
  3. John Henry alert! Will human equity analysts be replaced by quantitative models? Does their work have no value? My answer to both of those questions is a qualified “no.” Good quant models will eat into the turf of qualitative analysts, and kick out some of the marginal analysts. As pointed out by the second article analysts would do well to avoid focusing on earnings estimates, and look at other information that would provide greater value to investors from the balance sheet and cash flow statement. (I am looking at Piotroski’s paper, and I think it is promising. He has made explicit many things that I do intuitively.
  4. I work for a hedge fund, but I am dubious of the concept of double alpha. It sounds nice in theory: make money off of your shorts and longs without taking overall market risk. As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade. Typically, hedge fund investors are only good at generating alpha on the long side. The short side, particularly with the crowding that is going on there is much tougher to make money at. If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare).
  5. Maybe this one should have run in my Saturday piece, but some suggest that we are running out of certain rare metals. I remember similar worries in the early 70s, and we found a lot more of those metals than we thought possible then. There is probably a Hubbert’s peak for metals as well, but conservation will increase the supply, and prices will rise, quenching demand.
  6. For those that remember my piece, “Kiss the Equity Premium Goodbye,” you will be heartened to know that my intellectual companion in this argument, Morningstar, has not given up. Retail investors buy and sell at the wrong times because of fear an greed, so total returns are generally higher than the realized returns that the investors recieve.
  7. When there are too many choices, investors tend to get it wrong. When there is too much information, investors tend to get it wrong. Let’s face it, we can make choices between two items pretty well, but with many items we are sunk; same for choosing between two interpretations of a situation versus many interpretations. My own investing methods force me to follow rules, which limits my discretion. It also forces me to narrow the field rapidly to a smaller number of choices, and make decisions from that smaller pool. When I make decisions for the hedge funds that I work for, I might take the dozen names that I am long or short, and compare each pair of names to decide which I like most and least. Once I have done that, numeric rankings are easy; but this can only work with small numbers, because the number of comparisons goes up with the square of the number of names.
  8. Jeff Miller aptly reminds us to focus on marginal effects. When news hits, the simple linear response is usually wrong because economic actors adapt to minimize the troubles from bad news, and maximize the benefits from good news. People don’t act as if they are locked in, but adjust to changing conditions in an effort to better their positions. The same is true in investing. Good news is rarely as good as it seems, and bad news rarely as bad.
  9. This article describes sector rotation in an idealized way versus the business cycle, and finds that one can make money using it. Cramer calls methods like this “The Playbook.” (Haven’t heard that in a while from Cramer. I wonder why? Maybe because the cycle has been extended.) I tend not to use analyses like this for two reasons. First, I think it pays more to look at what sectors are in or out of favor at a given moment, and ask why, because no two cycles are truly alike. They are commonalities, but it pays to ask why a given sector is out of line with history. Second, most of these analyses were generated at a time when the US domestic demand was the almost total driver of economic activity. We are now in a global economic demand context today, and those that ignore that fact are underperforming at present.
  10. Finally, it is rare when The Economist gets one wrong. But their recent blurb on bond indexing misses a key truth. So bigger issuers get a greater weight in bond indexes. Index weightings are still proportional to the range of choices that a bond manager faces. Care to underweight a big issuer because they have too much debt outstanding? Go ahead; there are times when that trade is a winner, and times when it is a loser. Care to buy securities away from the index? Go ahead, but that also can win or lose. If bond indexes fairly represent the average dollar in the market, they have done a good job as a benchmark; that doesn’t mean they are the wisest investment, but indexes by their very nature are never the wisest investment, except for the uninformed.

Well, that’s it for this evening. Let’s see how the market continues to move against the shorts; there are way too many shorts, and too many people wondering why the market is so high. Modifying the concept of the pain trade, maybe the confusion trade is an analogue, the market moves in a way that will confuse the most people.

At The Periphery of Investing

At The Periphery of Investing

Posted on by David Merkel

I have a friend who works for the Williams Inference Service.? Those who work for WIS spend their time looking for deep trends in our world that are underappreciated.? I dedicate a little of my time to that as well, and try to draw investable conclusions from odd bits of data that come across my radar.? But even without explicit conclusions, it richens my knowledge of our world, and perhaps with other data, will yield some return for me.? If nothing else, I love reading and writing, so join with me on this tour of articles around the web.

  1. I’m not sure if pollution problems in China are any worse than the problems faced by the US or the UK at similar points in their development.? That said, one major constraint on their ability to grow is pollution.? These articles from the Wall Street Journal are an excellent example of that: heavy metals in the food supply, and lead in jewelry that they sell domestically and export, with the lead coming from US scrap metal.? These practices may allow businesses to survive in the short run, but soon enough, jewelry will get tested in the US, and importers sued for liability.? In China, there will be increasing pressure for change, perhaps even violent change.? In Chinese history, there is a tendency for change not happen, or to happen rapidly when troubles for average people become too great.
  2. Demographics is a favorite topic of mine, particularly as the world slowly heads into a shrinking population.? For the most part, national economies don’t work so well when population levels shrink, which leads to pressure to import low skilled laborers from nations with surplus workers.? One nation that is at the front of the problem is Japan, where the population is shrinking pretty rapidly today.? Japan is now seeing that its pension system will be hard to sustain because of the lack of children being born.? Europe will face this problem as well.? The US less so, because of the higher birth and immigration rates; for us, the foreign debt will be our problem.
  3. Is war with Iran a done deal in a few years?? I hope not.? Given the mismanagement of the Iranian economy in the hands of the cronyist mullahs that run the joint, and the genuine difficulty of producing effective nuclear weapons without a strong academic/technical/manufacturing base, my guess is that there will be another revolution there before a significant bomb gets made.? (We’re still waiting on North Korea; what a joke.)? Economically, Iran is a basket case.? As I have mentioned before, they have mismanaged their oil resources.? What is less noticed is their coming demographic troubles.? Not all Muslims are fanatics, and many are having small families, which will generate it’s own old age crisis thirty years out.? That said, if Iran is provoked, it’s leaders will not give in; they iwill fight, as the second article i cited points out.? Better to quietly hem the current Iranian leadership in by supporting their enemies, than to risk another war that the US does not have the resources to fight.? Iran is weaker and more divided than it looks; its government will fall soon enough.
  4. Memo to all quantitative investors: are you ready for IFRS?? IFRS, the European accounting standard, particularly for financials will change enough things that older formulas of calculating value and safety may need to be severely modified.? The larger the importance of accrual items to an industry, the worse the adjustment will be.? All I say is, watch this.? If it changes, it will affect the way that we numerically analyze investments.? We are definitely losing foreign economies on our exchanges, mainly due to Sarbox, not accounting rules, but I think we are rushing through a compromise with IFRS to protect the interests of our exchanges, and I think that is a mistake.
  5. Then again, maybe we don’t need the Europeans to mess up our accounting rules; we can do just fine ourselves.? Our accounting standards are a hodgepodge between amortized cost and fair value standards… we keep moving more and more toward fair value, but will the auditors be able to keep up?? Auditing amortized cost is one thing; there are different skills required when fungible but not liquid assets can be written up on a balance sheet. (Think about real estate or mortgage derivatives.)? Accounting will become less reliable in my opinion.
  6. I wish we had a harder currency; why else do I buy foreign bonds?? Anyway, I appreciated this short partial monetary history of the US, from the Civil War onward, from Elaine Meinel Supkis.
  7. When you can’t deliver the underlying, typically futures markets don’t work well.? It is no surprise then that a derivatives market on economic indicators closed.? Futures markets exist to allow commercial interests to hedge.? Where there is nothing to hedge, it is akin to mere betting, and without the extra thrill of a sports contest, that rarely attracts enough interest to be economic.? That said, aren’t the VIX futures and options contracts catching on?
  8. Not sure what the second order effects will be here, but a rule is finally coming that will require the trade execution occur at the best price.? It will be extra work for the exchanges, but it will probably centralize exchanges in the intermediate term.? If you have to share data, why not merge?
  9. One reason that Buffett was/is that best was his ability to learn from mistakes.? He kept his mistakes small and eventually found ways out of many of them.? US Air?? Salomon Brothers?? He eventually gets cashed out.? General Re?? The earnings from investing float bails him out. The “Shoe Group” and World Book?? Small, and you can’t win them all.
  10. What do you do when the market has passed you by?? You got burned 2000-2002, and moved to a more conservative posture, only to find that the market ran like wild while you weren’t there.? What do you do now?? My advice: do half of what you would do if the market hadn’t run.? If you are at 20% equities, and you know that in normal times you should be at 60% equities, raise your investment level to 40% equities.? If the market rallies, you have more on, if it falls, you will have the chance to reinvest another 20% into equities at more attractive prices.
  11. I usually agree with Eddy Elfenbein; he’s very common sense.? But here I do not.? Get me right here, Eddy is correct in all that he says.? I frame the problem differently.? You have someone sitting on cash, and the market has appreciated to where valuations are high-ish.? You can? 1) invest it all now, 2) dollar cost average, or 3) do nothing.? Eddy doesn’t consider that many will choose 3.? On average, 1 beats 2 by a small margin, but 2 beats 3 by a wide margin.? Dollar cost averaging is a way to get psychologically unprepared people into the market who would never risk putting it all in at once.? We use DCA to get inexperienced investors from a bad place to a “pretty good” place, because the best place is unimaginable to them.
  12. Desalination is the wave of the future, even in the US.? Potable water is scarce globally (think of India and China), and the cost of potable water justifies the energy and other costs associated with desalination.? The article that I cited does not capture the environmental costs of desalination, in my opinion, but it gives a good taste of what the future will hold.

And, with that, that completes my tour of the periphery.? Next week, I hope to provide more color for you on our changing risk environment.

A Fundamental Approach to Technical Analysis

A Fundamental Approach to Technical Analysis

Posted on by David Merkel

This was an article that I submitted to RealMoney, but was rejected because it was not relevant enough to “retail investors.” I offer it to you for your consideration. It was the follow-up piece to this article: The Long and Short of Trend Investing.

Throw in the Short Run

But now let?s move to the technicals of the situation. Given that I am a longer-term investor, this doesn?t play as great a role for me as other investors at RealMoney, but I don?t ignore it entirely. I simply view technicals through a fundamental framework. I have described this in the following articles, which still have value today, in my opinion:

1. Managing Liability Affects Stocks, Pt. 1

2. Separating Weak Holders From the Strong

3. Get to Know the Holders’ Hands, Part 1

4. Get to Know the Holders’ Hands, Part 2

(As an aside, I would simply say that technical analysis, as construed by most technicians, does not work on average. Most technicians die the ?death of a thousand cuts,? as they take multiple small losses. Successful technicians have something fundamental going on, whether they realize it or not.)

Institutional investors run most of the money in the market. Most of them have been trained to think in valuation terms exclusively, and so they set buy and sell prices for their positions. This influences even small investors, because of the impact of sell-side research. Almost every buy or sell recommendation comes with a price target. The sell side analysts often issue new buy or sell when a price target they have been looking for occurs.

But not every fundamental investor agrees on what the proper prices are for buying and selling. As the old saying goes, ?It takes two to make a market.? Sometimes, I will make it into the office and my trader will tell me that someone is aggressively selling a company that we own. I might ask him if our brokers have any feel for the size of the seller, and how desperate he is. The answer is usually ?no,? but if we do get an answer, that can help dictate our trading strategy. We would want to buy more as the big seller is closer to being done. In fact, we want to buy his last block of shares from him, if possible. Sometimes that can be arranged by talking to our broker; other times not.

As another aside, this is simpler to do in the bond market than the stock market. The large brokers generally know who is doing what. Be nice to your sales coverages, and you?d be amazed what they will tell you?. Here?s a stylized example.

Broker: ?You sure you want to buy that Washington Mutual bond??

Me: ?Yes, why??

Broker: ?Uh, there?s someone with size selling the name.?

Me: ?How much size??

Broker: ?Best indications are eight times your order size.?

Me: ?I can?t take that much down. Keep me in mind, and when he gets down to about double the size of my order, call me, and I?ll take the tail [everything that?s left].?

Broker: ?You got it.?

But suppose we don?t have any idea what the intentions of the seller are. We would have to be more humble, and try to infer from the chart what his methods are. Does he put a ceiling over the stock price, and only sell when it gets to a certain level? Or is he a ?mad bomber? that keeps selling regardless of the price level? Looking down the holders list, can I figure out anyone who might be incented to sell so much, and so aggressively? Who is disappointed at present that has a trading style like the group that is selling the stock?

Does he sell in dribs and drabs, scaling over time? Does he do a series of block trades? Is he using some sort of quantitative selling strategy that incorporates both time and price? These are the questions that I try to answer as I strategize my trading. It doesn?t give me perfect information, but it aids me at the margins.

So, say after your analysis of the technicals, you think the stock will continue to go down for a while, or won?t rise because the seller is big, seemingly larger than you can take down. Still, you like the company at the present valuation levels. What do you do?

You could sit on your hands, and wait out the seller. But what if you?re wrong about the size of the seller? The stock could move higher before you get a position on if the seller is smaller than you anticipated. Remember, other traders are watching the big seller also, and they will be waiting for him to be done as well.

You also could buy your full position immediately. After all, you have firm convictions about the secular trends and the stock?s valuation. Timing is for losers, and we are fundamental investors. Well, okay, but what if you are wrong, and the seller is right? Or, what if you like the idea here for the long run, but you would buy even more at lower prices? As Bill Miller has put it, ?Lowest average cost wins.?

Again, we could put on half the position and wait for the seller to be done. I like that, but are there alternatives? We could estimate the size of the seller (imperfectly), try to figure out how long he will be around and do a time-based scale where we put on 80-90% of a full position over that estimated time period. We also could do a price-based scale, and try to estimate (even more imperfectly) how much the seller will drive down the price before he is done. Buy 25% of a full position now, and then scale the remainder of what would be 80-90% of a full position down at the price you the seller gets exhausted at.

These strategies are illustrative, and meant to show the range of ways that one can balance off fundamental conviction versus the technicals of the market. In general, price scales work better when you think the seller is valuation sensitive, or other buyers are showing up in size to gobble up the seller?s supply at a given level. In the absence of that, time-based scales are the proper strategy if you have some confidence in the timing of the seller. Failing all of that, my humble strategy is to buy half and wait. It will never be perfect, but if I am right on the fundamentals, the results will be good enough.

Seven Notes on Real Estate

Seven Notes on Real Estate

Posted on by David Merkel

All the furor over subprime. The furor is deserved, but is getting adequately covered elsewhere. The bigger stories are over residential real estate generally, and Alt-A lending, where the problems are as big, but not as well publicized.

I would write about subprime, but I feel that I would be adding to the din at this point. I’ll write about a few other real estate issues this evening.

  1. Last November on RealMoney, I wrote a timely piece that described securitization, and the subprime market, and the credit default swaps that traded around it. It was an ambitious piece, and my editor told me it must be good, because she was able to understand the complexity of the market after reading the piece. Well, a picture is worth a thousand words. The Wall Street Journal has done me one better by giving a visual description of securitization. Here it is.
  2. Housing prices are falling nationally. Barry Ritholtz has a good summary of it. I would only add that the situation is not getting better. We have had falling prices during a peak sales time, and…
  3. More homes being built even as vacancy rates increase. In the short run, it seems optimal to a homebuilder to finish the projects he has begun. Sunk costs are sunk, and he wants to maintain good relations with those whom he worked with during the good times, so many will still build if it covers their variable costs, even if they take a loss in the process. The alternative would be to sell the land at a discount, and destroy useful subcontracting relationships that will be useful once the market turns. The trouble is, if all builders act in a way that is short-term rational, it can worsen the situation in the intermediate term.
  4. Is it time to speculate on the Homebuilders yet? I don’t think so. At residential real estate market bottoms, homebuilders trade for 50-80% of their fully written down book value. There are more writedowns to come, and many still trade over 80% of book, so I don’t think we are done yet. People are still too willing to speculate here. Perhaps the time to move will be when the vacancy rate begins a decline from the record levels that it is at now.
  5. What are Alt-A loans? Loans where the borrower is alleged to be prime, but for one reason or another, declines to prove it as comprehensively as one receiving a prime loan would. Loans that are “alternative prime” should be doing okay, right?? Well, no.? The trouble with Alt-A, is that even though the credit score is higher, the level of information that the lender is getting is a lot lower.? Good lending has safeguards in place, rejecting unworthy borrowers, and then charges an adequate rate.? Yes, it’s a lot more sexy to charge a high rate to whomever walks in the door with a high FICO score, but risk control is a key to all of business and finance.? Those who neglect it are asking for trouble.? As it is now, we have rising Alt-A delinquencies, and rising losses on mortgage loans.? This trend should persist until homeowner vacancy rates begin to fall again, and prices stop falling.
  6. In commercial real estate, rents are still rising in the office space.? I’m a little skeptical about the staying power of that trend, because vacancy rates aren’t low, except in highly desirable areas like Midtown Manhattan.? Away from office, thoug,h prospects are not as good.
  7. Beyond that, the trouble with commercial real estate is that borrowing costs often exceed current yields.? The valuation levels embed a high level of growth in rent, which may or may not happen.?? Part of the valuation problem is private equity, which is willing to borrow a lot more than REITs would.? My guess is that equity REITs are a good place to avoid for now.? Gains should be limited, and they bear the risks of a slowdown in private equity, slowing/falling rents, or a rise in financing costs.

That’s all for now.? The media can howl about subprime, but it’s really just a sideshow in the total set of problems facing residential real estate.

Quantitative Analysis is not Trivial — The Case of PB-ROE

Quantitative Analysis is not Trivial — The Case of PB-ROE

Posted on by David Merkel

I debated on whether to post on this topic or not. I try to be a gentleman, so I don’t want to be too rough on those I criticize. Let me start out by saying that those I criticize have honorable intentions. They want to make investing simple for investors. Noble and laudable; the trouble comes when one over-simplifies, and errors get introduced as a result.

I am both a quantitative and a qualitative analyst, which makes me a little unusual. It also means that I am not as good as the best qualitative or quantitative analysts. To be the best, it takes dedication that would squeeze out spending too much time on the other skill. I have always tried to stay balanced, which helps me as a businessman, actuary and investor. Good problem solving requires looking at a problem from many angles, and then choosing the right analogy/tool to do the job.

One of my readers, Steve Milos, forwarded to me a piece from Merrill Lynch’s life insurance analyst suggesting that Price-to-Book — Return on Equity [PB-ROE] analyses were simply low P/E investing in disguise. I tossed back a comment “The Merrill analyst doesn’t understand what he is talking about. PB-ROE analyses are richer than low PE, though in a few environments, like the present, they are similar.”, prompting Steve to say, “LOL, I love that ? now tell me what you really think!”

I decided to let the matter drop until Zach Maxfield, one of the analysts from Bankstocks.com, posted a laudatory article on Ed Spehar’s piece. I didn’t learn what I am about to write in a day, so let me take you on a journey explaining how I came to learn that PB-ROE analyses are valuable.

Back in 1982, I was a graduate teaching assistant at UC-Davis. The professor that I worked for used regression analysis in financial analysis to try to separate out effects that might be more complex than current modeling would admit. I did not get a chance to use the idea though, until 1992, when I began value investing, after my Mom gave me a copy of Ben Graham’s “The Intelligent Investor.” As I began investing, I noted that some stocks seemed better valued using book, others by earnings, and some by other metrics. Initially I began doing rule-of-thumb tradeoffs like Price to (book plus 5 times earnings). Eventually I wondered whether I had the right tradeoff or not, and how I might work in other metrics like dividends, sales, cash from operations [CFO], and free cash flow [FCF].

I’m not sure when it hit me, but I decided to run a regression of price versus earnings, book, sales, FCF, and CFO. Reasoning that sectors have different economic models, I did separate runs by sector. Truly, I should have done it by industry, or subindustry, as I do it today, but my initial attempts still found promising inexpensive stocks.

It was not until 1998 that I ran into PB-ROE analysis for the first time. Morgan Stanley was marketing a derivative instrument that would reduce book, turn it into earnings, and reduce taxes at the same time. I became the external expert on that derivative instrument, while hating its sliminess. (The whole story is a hoot, but it would take too long, and isn’t relevant here. Suffice it to say that the EITF and the IRS killed it six months after the first transaction got done.)

For those who believed PB-ROE analysis, the derivative was a godsend — less book, more earnings. With my more general model, I said, “So what, give up book, get “earnings,” which come back to book value anyway. These are just accounting shenanigans.” I didn’t see the value of PB-ROE then.

By 2001, I was a corporate bond manager. The Society of Actuaries Investment Section recommended the book, “Investing by the Numbers” by Jarrod Wilcox. An excellent book, I learned a lot from it, and he explained the PB-ROE model to me for the first time. To the best of my knowledge, it is the only place where I have seen it explained.

Where does the PB-ROE model come from? It is a simplification of the dividend discount model. In 2004, I gave a talk to the Southeastern Actuaries Conference. The relevant pages are 5-11, where I go through an example of a PB-ROE analysis, and give the limitations of the analysis. There are several limitations, here they are:

 

  1. Encourages maximization of ROE in the short run, rather than the long run
  2. Revenue growth is often equated with earnings growth in practice
  3. ?Run rate earnings? is adjusted (operating) GAAP earnings, versus distributable earnings (free cash flow)
  4. Implicit assumption of constant earnings growth, required return, and dividend policy in the Price to Book versus ROE metric
  5. The model assumes that capital is the scarce resource needed to produce more earnings.
  6. ROA is more critical than ROE; it?s harder to achieve. In bull markets, anyone can add leverage.

 

Items 4 & 5 are the only problems intrinsic to the PB-ROE model; the rest are problems with how the model gets abused by practitioners. I don’t think that any industry fits those conditions perfectly, but I usually think that the are good enough for a first pass, and after that I make adjustments for different expected growth rates, excess capital, earnings quality and more.

 

PB-ROE is equivalent to low P/E investing when the regression line comes close to going through the origin (0,0). From my experience, that rarely happens. For my nine insurance subgroups (bigger than Mr. Spehar’s analysis — I cover them all), almost all of the intercept terms are different than zero with statistical significance. Or, as a colleague of mine said to me recently, “Thanks for teaching me how to do PB-ROE analysis,it really helped with my analyses on Japanese banks and US investment banks.”

 

Now, there is a seventh problem with PB-ROE, but it is more complex. So you run he regression and get the tradeoff of P/B versus ROE that the market is currently pricing. Is that the right tradeoff in the intermediate term, or are investors overvaluing or undervaluing ROE? Hard to tell, but when the regression line is flat or downward sloping (it happens every now and then), one has to question whether the market’s judgment is right or not.

 

In some environments, PB-ROE and low P/E investing will be similar, but that will not always be true. Do not accept a false simplification, even though it may be true at present. The PB-ROE model is richer, and works in more environments, after adjusting for the limitations listed above. PB-ROE is a very useful tool, and not “gobbledygook.”

Portfolio Reshaping Mid-Year 2007, Part 3

Portfolio Reshaping Mid-Year 2007, Part 3

Posted on by David Merkel

Time for my most recent portfolio changes. The reshaping is complete, here is the data file and here are the qualitative details:

 

Buys

 

  1. Arkansas Best [ABFS] — Inexpensive, and trucking is out of favor. Trucking should pick up with the economy in the second half of 2007, and as the dollar cheapens, trucking is needed to get the exports to the ports.
  2. Deutsche Bank [DB] — Cheap major European bank. I’m light on financials (though if I lost my restrictions you would see a lot of insurance in my portfolio). 9-10x earnings for the next two years seems too cheap for me. Can they have that much exposure to the same problems faced by Bear Stearns? Maybe, but the valuation compensates for that.
  3. Gruma SA [GMK] — Inexpensive, and a play on the growing middle class in Mexico. Also a play on the growing popularity of Mexican food in the world. I don’t have a lot in consumer staples, so this helps.
  4. Mylan Labs [MYL] — returning to a name I last owned in 1988. Inexpensive generic drugmaker. I have nothing in healthcare, so this diversifies me a little. Generics are unlikely to fare badly as the branded pharmaceuticals should the Democrats win in 2008.

 

Sales

 

  1. Sold Komag [KOMG] because of the merger, and the arb premium (amount of incremental gains from holding on until deal consummation) was less than what I could earn in cash.
  2. Sold St. Joe [JOE], and I wish I had sold when one of my colleagues explained their likely troubles to me one month ago. St. Joe is going to have it tough for a while because they don’t have a lot of ways to generate cash, without selling property, and the land market is not as good as it was two years ago.
  3. Sold Sappi [SPP]. The glossy paper market, like other fiber markets faces their share of challenges. Demand is sluggish, and likely to stay that way for a while.
  4. Sold a little of Lafarge [LR]. Still have a position there. It’s had a nice run, so I rebalanced down to my normal target weight.

 

With these moves, I am back to 35 positions, up from 34. I am running with 16% cash, which is high for me. At the beginning of the year, I reinvested and brought cash down to 5% of the portfolio, but good investment results, combined with rebalancing has brought the cash back, and then some. If the cash hits 20%, I will raise my normal portfolio position size, and move cash to 10% or so. Maybe we get a pullback?

 

What I did not sell

 

  1. SPX Corp — the turnaround continues. For now, honor the momentum.
  2. Noble Corp — Hey, I just bought this last during the reshaping; I am not kicking it out so soon, no matter how well it has done.
  3. Sara Lee — the turnaround continues. No momentum here; maybe management will succeed. A few of their ideas seem to be on target.

 

What I did not buy

 

Many more entries here. As I worked down my list, I kept saying, “Cheap for a reason… cheap for a reason…”

 

  1. Too small: Charles and Colvard, PAM Transportation
  2. Don’t care for the industry: Chipmos Technologies, Finish Line, Foot Locker, Encore Wire, First Consulting, Freightcar America, Korea Electric, and Metrogas
  3. Already own something that I like better in its industry, and don’t want to increase exposure: Crystal River and MVC Capital (both interesting, though I like Deerfield better)
  4. Irregular operating history: Optimal Group and Northgate Minerals
  5. Tyco International is not as cheap as the data would indicate because of the recent spinoffs.

 

After I finish this, I will adjust the portfolio over at Stockpickr.com.
Full Disclosure: Long SPW NE SLE LR GMK DB ABFS MYL

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