International Diversification

Posted on 23 April 200720 June 2017 by David Merkel

The Wall Street Journal had two bits on international diversification: a poll, and an article. Both were good as far as they went, but the past outperformance of international over domestic stocks doesn’t help us analyze which will be better in the future. That macro question is hard, particularly because once a streak gets long, it gets more touchy to be long. But let’s look at a “micro” angle on foreign investing.

One of the reasons to invest abroad is to diversify currency risk. Let’s pretend for a moment that we know the dollar is going down over the next few years. What stocks would I buy? I would buy foreign companies that import US goods (costs are getting cheaper), foreign companies that are purely local (earnings stream rising in dollar terms), and US companies that export (sales should rise as the dollar falls).

Now let’s pretend for a moment that we know the dollar is going up over the next few years. What stocks would I buy? I would buy foreign companies that export goods to the US (sales should rise as the dollar rises), US companies that are purely local (earnings stream rising in foreign currency terms), and US companies that import (costs are getting cheaper).

All that said, foreign investing is more complex because of:

Expropriation risk
Different accounting standards
Often less disclosure
Poor corporate governance (US investors don’t know how good they have it, or on the negative side, SOX chases foreign firms away from US listings.)
Inability to get fair redress in the courts
Language issues
Foreign trading costs if not listed in the US.
War
Exchange controls

As for me, I am mainly country-indifferent in investing. I agree with John Templeton, who said something to the effect of: “Buy the cheapest companies in a given industry.” I do look for the “rule of law,” though. Just as when we buy shares in a company, we check to see how they treat outside passive minority shareholders, with foreign firms, we have to go a step further, and ask how the country treats foreign outside passive minority shareholders.

With bonds the issue is simpler, because it boils down to yield, currency and repayment issues. The challenge there is to understand what will drive the relative forward interest rate policy between countries. In the intermediate term, it is better to invest in currencies where the central bank is tightening, particularly if there are any “surprise” tightenings.

I believe in international diversification; in general it is a good thing. But it should not be done blindly; investors should consider the factors that I have mentioned above, if not more factors.

Another Boon from RealMoney.com

Posted on 12 April 200720 June 2017 by David Merkel

Well, my RealMoney column from April 9th got republished on the free site, and got syndicated out to Yahoo! as well. When I write a piece where I mention a company, like Assurant, it’s fun to see the piece appear on the Yahoo! news. But when I don’t mention a ticker, I know that if they put it on the free site, I know they also syndicate it out to Yahoo!, and a number of other places as well. I get amazed at times where my stuff ends up. Well, I hope it makes money for them, and most of all, I hope it benefits those who read it.

That’s particularly true for this piece, because it focuses on risk control in a very direct way. Too many market players don’t realize that risk control is a way to make more money on average over the long term. How does that work?

It keeps you in the game. Absent war on your home soil and aggressive socialism, being an owner in society is a winning strategy over the long haul.
Rebalancing allows you to pick up an incremental 2-3% annually on average. It forces you to buy low and sell high.
There will be drawdowns. You will get drawn down less, and if you stay with strong companies in industries that have previously underperformed, when the bottom arrives, you will outperform the market.

I view risk differently than most market players, and than almost all academics. Risk means trying to avoid loss on every name in my portfolio, not avoiding loss on the portfolio as a whole, and certainly not standard deviation of returns, or even worse, beta.

“Don’t keep all your eggs in one basket.” True enough. “Keep all your eggs in one basket, and watch that basket carefully.” Also true. “Watch every egg.” That’s what I try to do. I’m a singles hitter, not a home-run hitter with attendant strikeouts. I try to make money on every company, by following my eight rules. That doesn’t guarantee success, but my losers over the last 6.5 years have been less than 10% of the names that I invested in. And, in each case where I lost, the error of judgment came from neglecting one of the eight rules.

All that said, I encourage you to focus on risk control. It’s a lot easier to make money if you don’t lose it.

Full disclosure: long AIZ

Cemex Cements The Deal

Posted on 11 April 200712 April 2007 by David Merkel

Cemex finally achieves it great ambition of becoming the world’s largest cement company by market capitalization with its acquisition of Rinker. Holcim and Lafarge slip behind Cemex.

Cemex is still cheap in my opinion, and will wrench cost savings out of Rinker. The US authorities have already passed on the deal, telling Cemex what they must divest. The market rendered its own verdict, sending both Rinker and Cemex up in price. That’s a good sign for the future.

Today was another good day for me, with Cemex leading the pace, followed by Bronco Driling and Anadarko. Trailing the pack were Dow Chemical, Tsakos Energy Navigation, and Komag.

Full disclosure: CX LR BRNC APC DOW TNP KOMG

Dow is Up; the Dow is Flat

Posted on 9 April 200722 June 2017 by David Merkel

The broad market portfolio did well yesterday. A leading reason for that was the rumors regarding Dow Chemical being acquired by private equity. I don’t care about private equity, Dow Chemical is cheap; I’ll own it anyway. Also adding to the party was YRC Worldwide. In an economy as strong as this one, trucking should be strong.

Away from that, for those with subscriptions to RealMoney.com, I had an article published there that explained how to size portfolio positions. This article was inspired by Rob Pollock, the CEO of Assurant, who encouraged me to read “Fortune’s Formula,” which is a popularization of the Kelly Criterion.

Full Disclosure: long DOW YRCW AIZ

What I Have Been Doing Lately

Posted on 4 April 20074 April 2007 by David Merkel

Recently I have had rebalancing trades, selling a little Dorel Indsutries and Sappi. Also, I swapped Sonic Automotive for Group 1 Automotive early on Tuesday. I was able to enjoy two unexpected sell-side upgrades. It’s not supposed to work this well, but it is nice when it does.

On another note, from a piece by Lloyd Byrne of Morgan Stanley, in 2006 only 73% of oil production was replaced by new reserves for companies that they follow. This is just another reason why I am overweight energy. The replacement ratio has fallen for the last four years.

Finally, if you subscribe to RealMoney, be sure to read Jim Griffin’s post, Fed-Watchers Have Blinders On. I have been contending that the housing lending crisis is serious but will not derail the economy on is own. With the decline in the dollar, it is no surprise that our exporters are seeing some growth. Funny that few notice that. I guess we are used to being importers only….

Full disclosure: long GPI DIIB SPP

Your Money or Your Job! (Or Both!)

Posted on 4 April 20074 April 2007 by David Merkel

I must admit to being unimpressed with Sam Zell’s bid for Tribune. I can’t remember the last time someone put up so little money for so great an asset, aside for when I was the juniormost member of the AIG team considering whether to take over The Equitable. (AXA walked away with it, and the untold story is how AIG botched the whole thing.)

The skinny is this: Tribune the company borrows money, and gives it to the ESOP [employee stock ownership plan] to buy up the shares of Tribune. Sam Zell provides a small amount of subordinated financing ($325 million) to Tribune to help make this happen, and receives a warrant to purchase 40% of the company for $500 million. If the true value of the company is $8 billion, this is one sweet deal for Zell. Imagine getting interests in a company worth $3.2 billion, and only having to put up $825 million for that right.

Now, Tribune in its soon to be levered state might not be worth that much, to Zell, or to the employees. This deal presumes a lot in terms of the future profitability of Tribune. Will they be able to carry the debt load?Those that have read me for a while (at RealMoney) know that I am a bear on the newspapers, and most non-internet media businesses. The internet is destroying the margins that support newspapers in three ways:

Classified ads are more effective over the web
Advertising on the web is more targeted
Why subscribe to a paper, when the data is freely available online?

Now in each area a newspaper is still useful, but enough erosion occurs to ruin the economics. I doubt you can turn around a newspaper; perhaps you can create ancillary businesses off of proprietary content, but try to get people to pay for it, or stream a ton of traffic to get ad revenue.

As for the use of the ESOP to finance the takeover, it puts a gun to the heads of employees, who can only vaguely affect firm performance. Any value that they had built up in the ESOP is now at greater risk. If they succeed, they could make quite a bit (while Sam Zell makes proportionately more. If Tribune fails, the ESOP will be worthless, for any who were relying on it. (I realize some older workers can diversify some, but that’s not enough.) Sam Zell would lose his investment, but he can afford that easily. The proportionate impact to workers whose largest asset might be the ESOP would be much worse.

If I were a Tribune worker, I would urge the ESOP to vote down the deal. The downside is more significant than the upside.

Update on Indicators

Posted on 31 March 20072 April 2007 by David Merkel

Usually I look at my indicators at the beginning of a month. If I look at them more frequently, the changes are too small, and I don’t get the signal. In no particular order, here are my thoughts, both Bullish and Bearish:

Bullish

Contrary to what the bear in Barron’s said this weekend, the chart for the Merger Fund is bullish. They paid a dividend at year end, and the current chart shows that arbs are making money, which is bullish.
ECRI’s indicators are forecasting growth up, and inflation down.
Both emerging market stocks an bonds have bounced back well.
Earnings yields are still high relative to Treasuries, though if profit margins mean-revert, this argument is hooey.
ISI Group’s broadline retailer’s survey is showing some life.
Securitization of subprime loans, and CDOs containing tranches of subprime deals rated less than AA, are not getting done. These assets are getting sold to financial intermediaries that have adequate balance sheets to fund them.

Bearish

From Alan Abelson’s column in Barron’s this weekend, Henry Kauffman uses a concept akin to my “bicycle stability versus table stability” to discuss liquidity. The former is access to credit, while the latter is excess high quality assets that are readily salable.
Imposing tariffs on China is a real dumbkopf move. Eventually that will bite into the capital flow that keeps our interest rates so low, in addition to decreasing the benefits from the global division of labor.
M3 is falling, and significantly. The banks are pulling back from landing, and credit availability is shrinking. My M3 proxy is the total liabilities of the banking system. Works very well.
Fed funds continues to miss on the high side, since the FOMC meeting. The monetary base has gone flat, and there has been only one permanent open market operation this year, on 2/26.
Financial stocks are lagging the market.
The yield curve is still flat.
Equity REITs don’t yield enough relative to Treasuries.
Housing prices are falling nationwide.
Asset price changes are increasingly in two camps: safe and risky. Correlations within the two camps are high and positive. Correlations of the two camps are very negative.
Inflation remains high over the Fed’s comfort zone.

Neutral, or You Call It

Implied volatilities have bounced up, but are still low.
Corporate bond spreads have bounced up, but are still low.
Implied 5 year inflation, five years forward, has been in a channel between 2.2% and 2.8% for the last four years.
TED spreads are higher, but still low.
The swap curve gained slope after the recent mini-crisis.
The FOMC tightened less this time relative to prior times, if the measure is inflation versus the Fed funds rate.

That’s all for now. The two biggest bits of news are the tariffs on Chinese goods, and the decline in my M3 proxy. Bearish items both.

A Good Quarter

Posted on 31 March 200731 March 2007 by David Merkel

I’m still looking for a way to document my performance to readers, but let me simply say that the broad market portfolio beat the S&P by a few percent. What worked?

Fresh Del Monte
Grupo Casa Saba
Valero Energy
Helmerich & Payne
ABN Amro (sold too soon) 😉
Dorel Industries (wish they hadn’t delisted)
Lyondell Chemicals
Dow Chemicals, and
SPX Corp

You see any commonalities there? Energy, especially refining. Chemicals. Aside from that, I don’t see anything really correlated.

What didn’t work?

St. Joe
Barclays plc
Japan Smaller Capitalization Fund
Nam Tai Electronics
Cemex
Lithia Motors
Conoco Phillips
Magna International
Jones Apparel
Deerfield Triarc, and
Allstate (ouch)

Commonalities? Autos, maybe? Away from that, it seems eclectic to me.

In my balanced mandates, my foreign bonds and floating rate securities worked. High quality paid off as volatility rose. Really didn’t have any problems with my bonds.

Now I just have to do as well next quarter. 🙂

Full disclosure: long? FDP SAB VLO HP ABN DIIB LYO DOW SPW JOE BCS NTE CX LAD COP MGA JNY DFR ALL

Getting Your Portfolio in Better Shape

Posted on 29 March 200730 March 2007 by David Merkel

I had a two-part series that was published at RealMoney, and at the free site, TheStreet.com, that further explains a series of posts that I did here on my recent portfolio reshaping. Here are the links:

Getting Your Portfolio in Better Shape

Getting Your Portfolio in Better Shape, Part 2

It’s relatively unusual for my articles to be out on the free site, so enjoy the boon from The Street.com.

Around the Web, and then Some

Posted on 28 March 200731 March 2007 by David Merkel

There were two articles on reinsurers this morning suggesting that there should be a lot of consolidation via M&A. I’m not so sure. First, most players there want to acquire, not be acquired. Second, most of them don’t trust the underwriting and reserving of their competitors to the degree that they trust their own. To the extent that current players want to diversify, it is cheaper to do it organically than by acquisition. With the high degree of ease of entry into the market, the franchise value of a reinsurer is low. Now, maybe the property-centric reinsurers want to diversify (a smart idea, but they are stubborn), or the new reinsurers want to buy in a reverse merger one of the class of 2001 to eliminate the capital haircut from the ratings agencies (but they don’t have the cash for it). Those ideas make sense, but scale isn’t that much of a virtue here, and with P&C reinsurers the reserving is opaque as mud. I can see a deal or two getting done, but not a lot of them.
With all the hand-wringing in the Wall Street Journal this morning on free trade, just watch, we impose some series of tariffs or restrictions that reduce the current account deficit, only to see the capital account surplus shrink also, leading to higher interest rates and a lower dollar, breaking the current cycle giving the US cheap imported goods in exchange for dollar denominated bonds.
Throw a rock, hit a commentator who says that the Bank of China (or other major central bank with large dollar holdings) would never sell their positions because it would work against their interests, driving the value of the dollar down. That’s a half truth at best. Here’s why: the central bank will eventually focus on the future, realizing that sunk costs are sunk. Just because you have a big dollar position, does that mean you have to add to it to preserve its current value. Ignore the past, and let the dollar denominated securities mature. Use fresh cash and maturity proceeds to buy assets in the currencies that you like. It won’t cause a panic, but the dollar will still adjust down. Recognize from the start that the dollar assets are worth less than current exchange rates, and maximize value from there. (Large holders of any asset under pressure have to think this way to maximize value.)
Buyer Beware. Or maybe, it should be borrower beware. People are generally less competent at making rational choices when they are borrowing rather than paying cash. So it is no surprise that when Beazer finances homes that they sold, buyers might have gotten less than an optimal deal. This is true with many financial transactions. In general, the more moving parts in a transaction, the worse off the average person is in evaluating a deal. Better to line up your financing separate from the decision to purchase an asset, or you could end up up with a bop on your beezer, figuratively speaking.
So FASB might have a tighter leash on its neck from the SEC? Not sure whether that is good or bad. Neither organization gets high marks in my book. FASB desperately needs a more coherent overarching approach to accounting, rather than the piecemeal addjustments that they are doing. The SEC, if anything, is more beholden to political pressure, and the idiocy that that brings into accounting.
Then there’s Texas, basically invalidating the GASB on reporting the liability for long term government employee benefits. You might remember my piece at RealMoney, Pensions: Things Can Always Be Worse. Well, this is an example of that, and it is not limited to Texas. Though the Texas argument may have merits, governments all over the country are finding that they have to finally recognize the present value of the pension promises that they have made, and disclose it to the citizenry. It will be a mess, because a large amount of these promises are totally unfunded, much like Social Security, Medicare, and most other programs of our Federal Government.
It takes a week, but finally the market comes around to my view of the FOMC, though it takes Bernanke before Congress to correct the view of the markets. Inflation is not on hold, but the FOMC is, for now.