Category: Value Investing

Around the Web

Around the Web

  1. There was an article in Forbes interviewing Jeremy Grantham that made me think. He suggests that value investing might be heading for a period where it will underperform. I.e., value stocks are not as relatively undervalued as they normally are. If he is correct, what should I do? I could shut off the value discipline, and run my industry models in GARP [growth at a reasonable price] or even momentum mode. That cuts against my grain; perhaps what I would do is give a little more weight to the industry models as I make my selections. That would tilt me away from hard value measures. My methods are eclectic, so I have to adapt to what the market is likely to reward 2-4 years from now.
  2. “Minsky moment.” Ah, cute phrase. Well, I loved Edward Chancellor’s, “Devil Take the Hindmost,” and he has an interesting article at Institutional Investor. The themes he talks about are dear to me. My only quibble is that we aren’t yet there for a collapse. There is enough cash available to mop up problems at present. Whether that will continue to be true is another question.
  3. My biggest concern is the dollar, and the carry trade. If the dollar dips below 112 yen, I suspect that there will be a self-reinforcing panic as short yen positions get covered. The Economist had a piece on this recently that made a lot of sense. Eventually we will have an unwind here, but it will come with a lot of kicking and screaming in Asia.
  4. For wonks only, First American Corelogic posted a report called Mortgage Payment Reset 2007: The Issue and the Impact. Very informative on the effects of the loan reset features on hybrid loans, and what might happen to the real estate markets.
Beat, but not Beaten

Beat, but not Beaten

Ugh. What a day. It’s 1:30AM as I begin to write this, and I have been going since 4AM after traveling to Manhattan to DC and back, with the usual difficulties. The two highlights of my day were meeting with the best operational management team in insurance, Assurant, and meeting up with my work colleagues for dinner to celebrate new members coming onto staff. The lowlight was not getting any time with my family.

Now, one of the nice things about my portfolio management style is that I can ignore the markets for short amounts of time, and 99% of the time, it doesn’t matter. I do 95-99% of all my trades through portfolio rebalancings and portfolio reshapings. Like Buffett, who I admire (though I don’t always agree with), I wouldn’t mind if the market were closed more frequently. So today my broad market portfolio was up 50 basis points in my absence. I am now ahead of where i was at 2/26, before the shock.? Maybe I should be absent more often. 🙂

While traveling, I put the finishing touches on six (yes) articles that will be published on RealMoney over the next month. One should be next week, and is a compilation of what I have written here on my recent portfolio reshaping, with a few bits taken out and another page of explanatory data added for greater clarity. The other five articles are a series that I have worked on for a while which I have informally entitled “The Excellent Analyst” series. It goes through the framework of questions that I ask when I have a management team all to myself. I don’t go for material nonpublic information; I also don’t go for earnings trivia, rather, I try to see how the management team thinks as businessmen. Another place where I agree with Buffett, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”

With insurance, that comes natively to me, having done pricing, reserving, reinsurance, and corporate work as an actuary, having managed a small division of a company, with underwriting, marketing, and investment risk control. And my time managing insurance assets, mortgage bonds and then corporates, together with the derivatives. Having done all that, understanding insurance managements is second nature to me. I can sense a bad management team, and I delight in a great management team.

This brings me full circle to Assurant. Why are they the top operational insurance management team to me? This is a non-exhaustive list:

  1. Few other companies in insurance have seriously thought about sustainable competitive advantage. Assurant does it well, being #1 or #2 in almost all of the businesses in which they choose to compete.
  2. They invest in IT and customer relationships to create barriers to entry that are difficult to reverse engineer.
  3. Few insurance companies figure out their core competencies so closely, and then look for adjacent markets to apply them to.
  4. Few insurance companies look for “blue ocean” markets, where there is an unmet need and no competitors.
  5. Excellent capital allocators.
  6. Excellent at M&A, doing small infill acquisitions and growing them organically.
  7. Understands the concepts in market segmentation, and applies it to pricing, reserving, customer service and risk control.
  8. Executes almost flawlessly. What a great culture.

And if that’s not enough, they earn an ROE that is solidly in the top quartile for insurers, and I have no doubt that they will do the same next year. Progressive and AFLAC, move over. There is a new growth insurance name in town, and their valuation metrics are inexpensive, compared to what we are likely to get.

 

Full Disclosure: Long AIZ

Final Step and My Portfolio Decisions

Final Step and My Portfolio Decisions

Here?s the final list that I worked with in making my trades. Working up from the bottom of my list, I decide on what to sell. If I?m not selling something that rates low on my quantitative screen, I have to have an explanation as to why I am keeping it.

What I Am Not Selling

 

St. Joe ? This doesn?t score well. The idea here is the land is considerably more valuable than the share price would indicate.

SPX Corp, Sara Lee ? These are still in turnaround mode. Metrics don?t look good now, but should improve.

Sappi ? Value of underlying assets not reflected in the metrics. South Africa is also out of favor.

Dow Chemical ? it?s still cheap, and there are probably transactions that can unlock value.

DTE Energy ? My one US utility. Would benefit from a sell-off of their energy production arm. I might be close to selling, but am not there yet.

Premium Standard ? The merger with Smithfield will go through, and Smithfield will be able to take out costs. They might also gain a wee bit of pricing power. I think cost pressures have reached their maximum here, and profits will improve more than street estimates.

What I Am Selling

ABN AMRO ? Barclays may do the deal or not. ABN Amro is fully valued here, and then some.

Devon Energy and Apache ? I like them both, but their valuations have risen, and I have other places to deploy money.

What I am not Buying

After this, I look from the top down, and look for replacement candidates from the list. If I reject a highly rated name, I have to have a reason:

Group 1 Automotive ? I already have Lithia Motors and Sonic Automotive. It?s in less desirable areas of the country, so I will pass on it for now, but will revisit it at a later date.

Georgia Gulf ? It?s cheap, but I worry about the balance sheet, and I already own Dow and Lyondell.

Thornburg Mortgage ? Would give me conflicts of interest with my employer.

Optimal Group ? This is the most interesting of the ones that I did not buy. They have some interesting payments technologies, but the earnings estimate momentum was negative, and I could not really discern what competitive advantages they had.

Encore Wire ? A bit of a cult stock. I just don?t like the business that they are in.

Arkansas Best, P.A.M. Transportation ? I own YRC Worldwide, and these are not appreciably cheaper.

Foot Locker ? Too many earnings disappointments.

Spectrum Brands ? Lousy set of brands, and a poor earnings history.

Stolt Neilsen ? I own Tsakos, and I think it has better growth prospects.

National Coal ? Too small.

Home Solutions of America ? I don?t like their business, given my view of the housing market.

What I am Buying

Bronco Drilling ? Seems to be a cheap land driller, and replaces some of the exposure I lost selling Apache and Devon.

Komag, Nam Tai Electronics, Vishay Intertechnology ? Cheap technology stocks that are near the beginning of the technology food chain. The businesses are more stable than those who buy their products.

Full Disclosure: long VSH KOMG NTE BRNC BCS LAD SAH DOW LYO JOE SPP SPX SLE DTE PORK YRCW TNP

There Is Always Enough Time To Panic

There Is Always Enough Time To Panic

I always get a little amused when the permabears emerge from their dens and parade around for the media to observe.? I myself am often bearish, but I have an investment policy that keeps me from expressing too much confidence in it.? I have no doubt that the permabears will eventually be right on much of what they are claiming will happen? but permabears by their nature are too early, and miss more gains from the ?boom? than they typically make in the ?bust.?

In general, and over the long run, prudent risk taking is the best strategy.? The only exceptions are when there is war on your home soil, and aggressive socialism.? That said, in this post, I want to detail reasons to be concerned, and reasons to not be concerned.? Here we go:

Concerns

  1. Earnings growth is slowing year-over-year to about a 4% rate, and actually fell from the third to fourth quarters of 2006.
  2. Loan covenants for loans to private equity have almost disappeared.? Bullish in the very short run, but what are the banks thinking?!
  3. Anytime the bond market maxes out in a given sector, tht is usually a bad sign for that sector.? 42% or so of the whole Investment Grade corporate bond market is financials.? (Contrast that with its weight of 21% in the S&P 500.)? I would be very careful with financial companies as a result.? Were I running a corporate bond portfolio, I would deliberately tilt against financials, and give up income in the process.
  4. Have you noticed the small stocks have begun to underperform?? Not bullish.
  5. The balance sheets of US consumers are in poor shape.? The further down the income spectrum you go, the worse things are.
  6. Abandoned housing is becoming a problem in many parts of the urban US.? (Hey, I?m in the suburbs, and I have two abandoned homes on my block!)
  7. According to ISI Group, corporate capital expenditures exceeds free cash flow by $70 billion.? (That?s what?s driving corporate bonds!)
  8. In 1998, one of the causes of the volatility was a rise in the Japanese yen, which blew out the ?carry trade? at that time.? That may be happening now.
  9. Chinese and Indian inflation is accelerating.
  10. In general, central banks of the world are tightening monetary policy.? The US is an exception, which helps to explain the weak dollar.? Even China is tightening monetary policy.
  11. I don?t worry about the budget deficit; it is part of the overall current account deficit, which I do worry about ? particularly the fact that investment income we receive from abroad is exceeded by that which we pay out.? This shift occurred in 2006, and is unprecedented for at least 50 years.
  12. Inflation is above the FOMC?s comfort zone, even with the bad way that the government measures it.
  13. Private equity is overlevering otherwise stable assets.? That is bullish for the public markets in the short run, but unsustainable in the intermediate term.
  14. Merrill had to withdraw a CPDO in February; to me, this means that corporate default spreads had reached their absolute minimum.
  15. According to Bloomberg, Moody?s says that $82 billion in corporate bonds will mature between now and 2009, and 61% is rated B1 or less.
  16. Actual volatility of stock prices has risen relative to implied volatility.? Further the average holding period of stocks has declined markedly over the last four years, to around seven months, according to the WSJ citing Bernstein.
  17. Margin debt is at its highest level since the 1920s, though as a percentage of market capitalization, it is lower than it was in 2000.
  18. Troubles in subprime and Alt-A lending are leading to declines in US residential real estate prices.
  19. Mortgage equity withdrawal is declining significantly in 2007.? The higher quality the loan, the lower the equity extraction generally.? A reduction in subprime and Alt-A affects this considerably.

Not to Worry

  1. In general, stocks are better buys than bonds at present.? The earnings yield exceeds the 5-year Treasury yield by 120 basis points.? Note though, if profit margins mean-revert, bonds will be the better asset class.
  2. At present, there is no lack of financing for CDOs and private equity, and corporations are still buying stock back aggressively. ?Investment grade corporate bond issuance is robust, surpassing the amount issued in 2006 YTD. On the other hand, high yield has slowed down considerably.? (CDO mezzanine and subordinated debt spreads have widened though, particularly for asset-backed deals.? The arb spread has not been so wide in years.)
  3. Many new BBB bonds are coming with change in control covenants.
  4. The VIX hasn?t closed above 20 yet.
  5. Investment grade corporate balance sheets are in relatively good shape.
  6. The relationship of earnings yields to corporate bonds is a fuzzy one. From the seventies to the nineties, P/Es moved inversely to bond yields.? Not so, so far, this decade, or in the 1960s.? If bond yields rise due to growth expectations, P/Es may follow along.
  7. Money supply growth is robust in the US and globally.? In the short run it is difficult to have a bad market when money supply growth is strong, and measured inflation is low.
  8. There is a still a desire to purchase US assets on the part of foreigners; the recent fall in the dollar has not affected that.
  9. My view is that we won?t have a recession in 2007, and that we might have one in 2008.
  10. ECRI forecasts inflation falling in the US, together with decent growth in 2007.
  11. Proxies for systemic risk have been receding, though they are considerably higher than one month ago.
  12. Export sectors are finally showing some decent growth, partly due to the weak dollar.
  13. IPOs are outweighed by LBOs and buybacks.? With a few exceptions, IPO quality doesn?t seem too bad.
  14. Global demographics favor net saving because of the various baby booms after WWII.? Excess money growth is going into the asset markets for now.
  15. Most M&A deals are for cash, which is usually a bullish sign.? M&A waves typically crest with a bevy of stock deals.? Deal premiums are not out of hand at present.
  16. According to the ISI Group survey state tax receipts are quite robust, indicating a strong economy.
  17. Also according to ISI Group, China is now a net coal importer.
  18. Commodity indexes, scrap steel pricing, and Baltic freight rates are still robust.
  19. Foreigners are buying some of the excess US homes as second homes.? Having a residence in the US offers flexibility.

I did not aim for nineteen of each, I just went through my research pile, and summarized everything that was there.? To me, this is a fair rendering of the confusing situation that we are in today.

Second to Last Step

Second to Last Step

Here’s the file for my progress on the portfolio change so far. Because of the data license that I have from Bloomberg, no numeric data fields from Bloomberg are listed here; only fields that I have calculated.

The grand rank is a weighted average of the ranks of the other variables, where a low number indicates desirability. Rsi Px 52week rank is a measure of price level. 0 means a 52-week low, and 100 means a 52-week high. NOA is net operating accruals; 0 means a low level of accruals on the balance sheet. 100 means there are a lot of accruals on the balance sheet.

Rsi Px 52week rank, NOA, Price-to-Sales, and Price-to-Book get a double weight. Everything else gets a single weight. I vary the weights each period based on what concerns me. When I am more bearish, I overweight the things that I am overweighting now.

Tomorrow I should have my portfolio changes. I choose 2-4 companies in the top half of my portfolio to replace 2-4 companies in the bottom half. Why do I do it this way? It forces me to make trade-offs, tossing out appreciated positions, and adding in promising names.

A Good End to a Good Week

A Good End to a Good Week

The Broad Market portfolio was up a little more than 2% this week. The economic sensitivity of the portfolio helped, as did the Latin American names in the portfolio: SABESP, Cemex, Industrias Bachoco, and Grupo Casa Saba.

The week was characterized by a retreat from perceived systemic risk As the week went on risk went from general to localized. The true offenders in the subprime lending world were taken out and executed, and the rest of the market recovered.

I have been sounding bullish of late, but I want to caution you regarding the dangers of this present market. Though this panic did not spread to the market on the whole, it is possible that a future crisis might be more virulent. Remember, the current market prosperity relies on free trade in goods and services; any interruption of that could lead to a major decline. Bad FOMC policy is another risk here as well. Profit growth has slowed significantly as well. There are reasons to be concerned, but if you are concerned, tweak your portfolio toward less risk. Don’t leave the party entirely, but choose stocks with strong balance sheets and cheap valuations, and raise a little cash.

Full disclosure: SAB IBA CX SBS

My Main Industry Rotation Model

My Main Industry Rotation Model

I have several industry rotation models.? Some are short-term, others are longer term.? My main one is in the back of my head as I analyze where the pain is growing, and nearing maximum intensity.? (If anyone wants me to share shorter term models, I can do that.? I don’t use them much though.)

For me, the idea in industry rotation is to find stocks that fit one of two paradigms: 1) strong companies in troubled industries, and 2) well-run, cheap companies in industries where favorable trends are over-discounted.? My main model attempts to address the former.

My model has 6 1/2 years of Value Line industry rank data.? It asks the following questions:

  1. What is the industry’s current rank?
  2. Relative to your rank history, where is your current rank compared to the maximum and minimum ranks?
  3. How many standard deviations are you above or below your average rank? and
  4. Compared to past history, what percentile is your Value Line rank compared to prior dates in history.

The results from these questions are weighted and turned into a grand rank. From highest to lowest, the weights go 1, 4, 3, 2 for the questions listed above.? This spreadsheet lists the final results.?? Now the new ranks can be used in two ways, in value mode, or momentum mode.

Value Line ranks are a product of three factors: price momentum, earnings momentum, and analyst surprise.? They are momentum driven.? My model attempts to refine that, and give investors two ways to play the market.? If you like fast momentum-style trading, buy the companies in the red zone near the bottom of the list.? If you’re like me, buy the companies in dead industries in the green zone at the top of the list.

So what did I do here?? The list of industries entitled “dig through” I deemed interesting from the “green zone.”? I ran a screen on them to get a few more names for this current portfolio reshaping.? Here are the tickers:

HERO ADM SMG SE ABFS CMC CVX ESV GMRK GSF HES MRTN NAT NE NX OXY PDE PTSI RADN RDC SHOO TSO

Okay, so now I have two things ready to go: I have the full list of tickers that I will compare against my current portfolio.? I also have what my main industry rotation model recommends.? I call my methods “quantitative assisted,” because I use my intellect to overrule them when I think it is needed.?? The next step is lining up all of the candidates against my current portfolio to help decide who to add in , and who to kick out.? More on that on Monday.

Life in Warren’s World is Still Expensive

Life in Warren’s World is Still Expensive

Last year, I wrote and ill-timed piece at RealMoney entitled, ?Life in Warren’s World Is Expensive,” and a follow-up, ?Buffett the Businessman.” I claimed that Berkshire Hathaway was overvalued. It has since risen by 15-20%. I am eating my crow, and wish that I had more salt.

Trouble is, I think that my thesis is still correct. I view Berkshire Hathaway as an insurance company that uses its liability structure to fund its operating businesses. To me, the performance of the insurance enterprises is a critical aspect of whether Berkshire is a good or bad investment.

In 2006, Berky wrote some of the riskiest coverages that the rest of the insurance industry would not touch on the property side of the business. Then came a ?no catastrophe? year. Is it any surprise that the stock is higher? Give Buffett credit for the AAA balance sheet that allowed him to be the last man standing in writing risky property coverages. Even in this year?s letter, he says he is willing to lose $6 billion in a single event. Pricing is slipping, and I have no doubt the Berky won?t chase the pricing down below levels where they can?t make their profit on average. That may mean that Berky will have a lot of idle cash.

Warren has changed his tune regarding retrocessional coverages in the last few years. In the 2007 letter, he explains how it can be used to ameliorate the risks of other insurers. This is a good and proper use of retro. In years 2005 and prior, he would crow about his riskless deals, which no doubt passed accounting muster, even if they missed the spirit of the regulations.

Berky has $50-70 billion to put to work. I don?t see how they can do that easily. Berky?s acquisition pattern over the past few years is to scrape up a few distressed companies, and a few companies where the owner was willing to sacrifice on price to preserve the culture. Outside of bold moves like acquiring ConocoPhilips outright, I don?t see how they can deploy that much capital.

Give Buffett credit for staying in enough of his foreign currency trade to draw a profit from it. I agree with Buffett over the state of our national finances, and think the dollar is headed lower over the intermediate term. That said, I increased my size of the trade when he lightened up in 2006.

Finally, they are looking for a successor to Buffett. Whoever that man may be, he will have to reckon with a few realities. If the objective is to grow long term book value, what is he best way to do that? Hold onto cash and wait for a crisis? Buy reasonably priced operating businesses with a hope of growth? Wait for utilities to go on sale? Behave like Magellan, Contrafund, or any other large mutual fund? (Not Buffett?s way.)

In summary, I can?t see Berky doing that well over the next twelve months because of the weak pricing environment for insurance, and the difficulty the Buffett will have in deploying the free cash of Berky. It is a more competitive environment for investments, which means that Berky will not deploy much cash.

Full Disclosure: Long COP

Not That Amazing Of A Day

Not That Amazing Of A Day

Today the broad market fund was up about 75 basis points, which isn’t that amazing. Leading the parade were Cemex, Fresh Del Monte (that has been on a tear), SABESP, and Lyondell Chemical. Bringing up the rear were… wait, none of my stocks were down more than a percent yesterday. That’s a pretty broad based rally.

In general, the markets feel like the majority of players are concluding that they don’t have to worry about systemic risk for the nonce. Swap spreads, bond spreads, implied volatility, and other variables show a continued willingness to take risk. I wouldn’t want to say that I like being a short term bull; there are many worries in the present environment. But at present, the willingness to take risk and finance risk taking persists. That may change, but until then, the bull market continues. I will combat risk through my ordinary risk control mechanisms, as described in my eight rules.

I’m going to have to defer on my industry models for one more day because of time constraints.? Apologies.

Full disclosure: Long CX FDP SBS LYO

Up On A Down Day

Up On A Down Day

Up about 1/4% today, against a lousy market. Giving extra help today were Valero Energy (though I sold a little), Helmerich & Payne, and ConocoPhillips. Hurting the cause were Royal Bank of Scotland and Lithia Automotive.

Is the recent panic over? Yes and no. No, because you can never tell what additional macroeconomic problems will crop up. Yes because CDOs [Collateralized Debt Obligations] are still getting funded. I have a saying that bubbles only pop when cash flow is insufficient to finance them. Well, the riskiest part of the debt markets, CDO equity, still has willing participants. That indicates that it is not bubble-pop time yet, and that has positive implications for the junk debt and equity markets. Party on!

Industry models tomorrow.


Full Disclosure: Long HP VLO COP RBSPF LAD

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