This is a difficult book to review.  Let me tell you what it is not, and then let me tell you what it is more easily as a result.

1) The book does not give you detailed biographies of the people that it features.  Indeed, the writing on each person is less than the amount that Ken Fisher wrote in his book, 100 Minds That Made the Market.  If you are looking for detailed biographical sketches, you will be disappointed.

2) The book does not give detailed and comparable reviews of the portfolio performance of those that it features.  There’s no way from what is written to tell really how good many of the investors are.  I mean, I would want to see dollar-weighted rates of return, and perhaps, measures of dollar alpha.  The truly best managers have expansive strategies that can perform well managing a large amount of money.

3) The book admits that the managers selected may not be the greatest, but are some of the “greats.”  Okay, fair enough, but I would argue that a few of the managers don’t deserve to be featured even as that if you review their dollar-weighted performance.  A few of them showed that they did not pay adequate attention to margin of safety in the recent financial crisis, and lost a lot of money for people at the time that they should have been the most careful.

4) If you wanted to understand the strategies of the managers, this is not the book for you.  They are not described, except in the broadest terms.

5) There is no integration of any common themes of what makes an investment manager great.  You don’t get a necklace; you just get a jar of pretty, non-comparable beads that don’t have any holes in them.

What do you get in this book?  You get beautiful black and white photos of 33 managers, and vignettes of each of them written by six authors.  The author writes two-thirds of the vignettes.

Do I recommend this book?  Yes, if you understand what it is good for.  It is a well-done coffee table book on thick glossy paper, with truly beautiful photographs. It is well-suited for people waiting in a reception area, who want to read something light and short about several notable investment managers.

But if you are looking for anything involved in my five points above, you will not be satisfied by this book.

One final note on the side — I would have somehow reworked the layout of Bill Miller’s photograph.  Splitting his face down the middle of the gutter does not represent him to be the handsome guy that he is.

If you would like to buy it, you can buy it here: The Great Minds of Investing.

Full disclosure: I received a copy from the author.  He was most helpful.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Photo Credit: Jugbo

Photo Credit: Jugbo || A puzzle to solve…

From a friend of mine:

About a quarter of my assets are in my company stock. I have been counting this as a stock in my portfolio, but now I am wondering if that might be making my portfolio too conservative. The company is privately held, and they manage the “price”, so that it goes up consistently with the growth of the company. As long and the company does not go bust, this seem to be more stable than a stock fund.

What do you think?

I don’t think you are being too conservative.  Count it as stock.  Here’s why:

Don’t look at the price, on the first pass.  Consider the underlying stability of the company.  Here’s a way to think about it: if the company borrowed money over the intermediate-term from a bank, or floated a bond, what kind of rate would they pay?  Would they be considered investment grade, and pay a low interest rate, or would they be more like a high-yield bond, where both the covenants on the debt and the yield paid are significant.

If it would be an investment grade lending risk, you might be able to think about it as partially stock and partially a bond.  If not, then stock.  Regardless of how you think about it, you have to realize that you are running a concentrated risk here, and play everything else a little safer as a result.

Now, the stock price that they quote to you does have a meaning, which varies based on what your employment plans are with your firm.  If you are thinking of leaving, you would like a high price to get cashed out at, but if you are thinking of staying, you would probably like a lower price, as you may get more shares.

I don’t know everything here, so my advice is general.  It would change if you could buy or sell with discretion, but that is not likely.  If you have some idea of how upper management views the long-term prospects of the company, that could guide your reasoning.  As an analogy, consider the investment banks on Wall Street prior to their becoming publicly traded.  Management viewed their ownership in the bank as part of their pension, so they shot down ideas that were too risky.  They were happy to see the value of the firm grow at a reasonable rate with near-certainty, rather than a rapid rate with a moderate probability of failure.

So, think about your management team and what they do.  Make discreet inquiries to them if you think it is wise.  Be careful with the rest of your assets.  How careful depends on the soundness of the firm, your risk tolerance, and your time horizon for when you will need to convert the assets to another form for your own use.

There is no getting something for nothing.  There is always a cost involved, even if it is feeling vaguely obligated to listen to the person giving you a gift.  We are social creatures, and we want to favor people who are kind to us.

I get a lot a pitches in the mail because I profile well to wealth managers and those like them.  The age, assets, income add up to a likely client, except that I am in a related business, and am not interested in making my assets less flexible, at least right now.

My advice to you is that you do not respond to free gifts, whether it is good food, baubles, etc.  It’s not worth it, and if you have a need, it would be far better to draw up your own story, and send it to five wealth managers, putting them in competition with one another, so that you can compare and contrast what they do and charge.

Even in my own limited experience, going to free conferences I find that I am the product being sold, and for months thereafter I have to tell marketers that I am not interested — and to the pesky ones point out some flaw in what they do.

Your time is valuable.  So is your money.  Thus remember what I always say:

“Don’t buy what someone else wants to sell you.  Buy what you have researched that you want to buy.”

Thus, make them play your game.  Don’t play their game.  Send out your proposal for competitive bid, and choose the one that is best for you.

Today I saw an article about a high school investing contest, and like most contests of that type, it does not teach investing, but speculation.

I’ve wanted to try this for about ten years or so.  I’d like to try running a stock picking contest, but only if I can offer decent prizes, and get enough participants.  I’ve written about this before, these would be the rules:

  1. No leverage and no shorting
  2. No trading — buy & hold
  3. No Exchange Traded Products, and only common stocks
  4. Minimum market capitalization of $100 million
  5. Only stocks traded on US exchanges
  6. Forced diversification — a portfolio of ten stocks equally weighted
  7. One stock from each of ten volatility buckets, to reduce speculation
  8. Highest geometric mean return wins — this gives a bonus to consistency, which also reduces speculation.  (Alternative rule: the best return on the seventh best stock in each portfolio wins.)
  9. Six month time frame.
  10. One entry per person.

The most critical rules are seven and eight.  The idea is to get people to think like investors, not speculators.  By forcing investors to buy a broad range of companies from conservative to aggressive will force them to evaluate individual companies, with an eye to avoiding big losers.  Rule number one, as many say, is don’t lose money.  This would honor the idea of avoiding losses while trying to make gains.  It would be a lot like what intelligent investing in a portfolio of stocks is really like.

The idea is to promote stock-picking.  Now lest you think I have taken all of the speculation out of this, let me tell you what my rules don’t stop:

  • Factor tilts — you can assemble a portfolio with price momentum
  • Industry and sector tilts
  • Foreign tilts
  • Size tilts
  • Valuation tilts
  • Investing in special situations
  • Copying famous investors

Now, Who Would Be Sponsors?

I can’t fund this on my own.  Also, I don’t think registration fees could fund such a contest.  Parties that could benefit from the branding and free advertising would include financial information companies and brokerages — they are some of the logical beneficiaries of promoting stock-picking.  So, would the following consider sponsoring such a contest?

  • Wall Street Journal, Yahoo Finance, Bloomberg, Marketwatch, Reuters, Money, Value Line, theStreet.com, etc.
  • Nasdaq OMX, Intercontinental Exchange
  • Schwab, E-Trade, Scottrade, Interactive Brokers, Ameritrade, Fidelity, ETrade, etc.

I don’t know, but I would want to have at least 1,000 entrants and $50,000 in prize money if were going to run a contest like this.  I’m sure it would be a lot of fun, and would teach investors a lot about investing, as opposed to speculation.

Thoughts?  Send them to me.  (Especially if you are interested in sponsoring the event.)

I can’t help but think after the financial crisis that we have drawn some wrong conclusions about systemic risk. Systemic risk is when the financial system as a whole threatens to fail, such that short-term obligations can’t be paid out in full.  It is not a situation where only big entities fail — the critical factor is whether it creates a run on liquidity across the system as a whole.

Why does a bank fail?  It can’t pay in full when there was a demand for liquidity in the short run.  Typically, there is an asset-liability mismatch, with a lot of payments payable now, and assets that cannot be easily liquidated for what their stated value reported to the regulators.

Imagine the largest bank failing, and no one else.  Yes, it would be a mess for the FDIC to clean up, but it could be done.   Stockholders and preferred stockholders get wiped out. Bondholders, junior bondholders, and large depositors take a haircut.  Future deposit insurance premiums might have to rise, but there would be enough time to do that, with banks adjusting their prices so that they could afford it.

But banks don’t fail one at a time, except perhaps in good times with a really incompetently managed bank.  Why do some banks tend to fail at the same time?

  • They own many of the same debt securities, or same types of loans where the underlying asset values are falling.
  • They own securities of other banks, or other deposit-taking institutions.
  • Generalized panic.

What can stop a bank from failing?  Adequate short-term cash flow from assets.  Why don’t banks make sure that they always have more cash coming in than going out?  That would be a lower profitability way of running a bank.  It is almost always more profitable to borrow short and lend long, and make money on the natural term spread that exists — but that creates the very conditions that makes some banks run out of liquidity in a panic.

You will hear the banks say, “We are solvent, we just aren’t liquid.” That statement is always hogwash.  That means that the bank did not adequately plan to have enough liquidity under all circumstances.

Thus, planning to avoid systemic risk across an economy as a whole should focus on looking for the entities that make a lot of promises where payment can be demanded in the short run with no adjustments for market conditions versus assets available to make payments.  Typically, that means banks and things like banks that take deposits, including money market funds.  What does it not include?

  • Life insurers, unless they write a lot of unusual annuities that can get called for immediate payment, as happened to General American and ARM Financial in 1999.  The liability structure of life insurance companies is so long that there can never be a run on the bank.  That doesn’t mean they can’t go insolvent, but it does mean they won’t be part of a systemic panic.
  • Property & Casualty and Health insurers do not have liabilities that can run from them.  They can write bad business and lose money in the short-run, but that doesn’t lead to systemic panic.
  • Investment companies do not have liabilities that can run from them, aside from money-market funds.  Since the liabilities are denominated in the same terms as the assets managed, there can’t be a “run on the bank.”  Even if assets are illiquid, the rules for valuing illiquid assets for liquidation are flexible enough that an investment firm can lower the net asset value of the payouts, while liquidating other assets in the short run.
  • Even any large corporation that has financed itself with too much short-term debt is not a threat to systemic panic.  The failure would be unique when it could not roll over its debts.  Further, it would take some effort to actually do that, because the rating agencies and lenders would have to allow a non-financial firm to take obvious risks that non-financial firms don’t take.

What might it include?

  • Money market funds are different because of the potential to “break the buck.”
  • Any financial institution that relies on a repurchase [repo] market for financing is subject to systemic risk because of the borrow short to finance a long-dated asset mismatch inherent in the market.
  • Watch any entity that has to be able to post additional margin in order maintain leveraged asset finance.

How then to Avoid Systemic Risk?

  • Regulate banks, money market funds and other depositary financials tightly.
  • Don’t let them invest in one another.
  • Make sure that they have more than enough liquid assets to meet any conceivable liquidity withdrawal scenario.
  • Regulate repurchase markets tightly.
  • Raise the amount of money that has to be deposited for margin agreements, until those are no longer a threat.
  • Perhaps break up banks by ending interstate branching.  State regulation is good regulation.

But aside from that, there is nothing to do.  There are no systemic risks from investment companies or those that manage them, because there can’t be a self-reinforcing “run on the bank.”  Insurance companies are similar, and their solvency is regulated far better than any bank.

Thus, there shouldn’t be any lists of systematically important financial institutions that contain investment managers or insurance companies.  Bigness is not enough to create a systemic threat.  Even GE Capital could have failed, and it would not have had significant effects on the solvency of other financials.

I think it is incumbent on those that would call such enterprises systemically important to show one historical example of where such enterprises ever played a significant role in a financial crisis like the ones that happened in the 1870s, 1900s, 1930s, or 2000s.  They won’t be able to do it, and it should tell them that they are wasting effort, and should focus on the short-tailed liabilities of financial companies.

Tonight’s topic comes from a note sent to me by a friend. Here it is:

David, I have heard you say that you have entered into partnerships in the past.  What are your rules for partnerships, who will you enter with?  I have a neighbor who is interested in starting a business, the start up cash is small $5000.  I think there might be good opportunity, but I am concerned for good reason about my time availability, as well as Not being “unequally yoked”.  What business relations do Paul’s words govern.  do you have different rules for minority, majority, or controlling shares?

I appreciate your thoughts.

I have two “partnership” investments.  One is very successful and is an S Corporation.  The other is a limited partnership, and I wonder whether it will ever amount to anything.  Both were done with friends.

There are a few things that you have to think about with partnerships:

  1. Is your liability limited to the amount of money you invested, or could you be on the hook for more if there are losses/lawsuits?
  2. Are there likely to be future periods where capital might need to be raised?  Under what conditions will that be done?
  3. What non-capital obligations are you taking on as a result of this?  Labor, counsel, facilities, tools, etc?
  4. How will profits and losses be allocated?  Voting interests? How will it be managed? When will the partnership end?  How can terms be modified? How can partnership interests be transferred, if at all?  Etc.
  5. Do you like the people that you will be partners with?  You may be partners for a long time.
  6. Be ready for the additional tax complexity of filling out schedule C, or a K-1, or some other tax form.

Go into a partnership with your eyes wide open, and check everything.  If your partnership interests have limited liability, and the economics are structured similar to that of a corporation, then things are clearer, and you don’t have to worry as much.

Take note of any obligations that you might have that don’t fit into the “passive provider of limited capital with proportionate ownership” framework.  Those obligations are the ones that need greater scrutiny.  Include in that how those working on the partnership get compensated for their labor.  Parties to the partnership may have multiple roles, and there can be conflicts of interest — imagine a partnership where one partner works in the business and receives a large salary, thus depressing profits for the non-working partners.  How does that conflict of interest get settled?  (Note that the same problems that exist in being an outside, passive, minority public stock investor reappear here.)

Also be aware of how ownership interests can change, and whether you may be forced to add more capital to maintain your proportionate interest in the business.

Try to have a good sense of the skill of the partner or employee managing the business.  That makes all the difference in whether a business succeeds.

Most of what I say here assumes that you will not be a controlling majority partner, and that you will have limited influence over the business.  If you do have control, the problems of getting cheated by someone else go away, but get replaced with the problem of making sure the business is run adequately for the interests of all partners.  Your ethical obligations also expand.

You mention the “unequally yoked” passage from Second Corinthians 6, verses 14 and following.  In one sense, that doesn’t have much more application here than it does in all investing if one is a Christian.  Don’t involve yourself in businesses that of necessity involve you in things that you would not do yourself as a Christian.  Don’t invest in enterprises where it is obvious that management does not care about ethics — you can see it in their behavior.  This will be a little clearer and close to home in a partnership with a friend — you will know a lot more about what is going on.

With a non-limited partnership, there is an additional way the “unequally yoked” passage applies.  You expose your entire economic well-being to risk when you are a general partner.  It is like a marriage — it is very difficult to negotiate your way out of the unlimited guarantee that you make there.  It is like being a co-signer, which the Bible says to avoid.

Of itself, that doesn’t expose you to the unequal yoke, but when you are in an economic agreement that binding, if your partner takes the business in an ethical direction you find dubious, you will be in a weak position to do something about this.  There is where the unequal yoke appears amid unlimited liability.

That’s all for now.  There’s a lot more to consider here, but this is meant to be an introduction to the issues involved in partnerships.  Hope it works well for you.

I imagine the SEC (or the Fed, IRS, or the FSOC) saying: “If we only have enough data, we can answer the policy questions that we are interested in, create better policy, prosecute bad guys, and regulate markets well.”

If they deigned to listen to an obscure quantitative analyst like me, I would tell them that it is much harder than that.  Data is useless without context and interpretation.  First, you have to have the right models of behavior, and understand the linkages between disparate markets.  Neoclassical economics will not be helpful here, because we aren’t rational in the ways that the economists posit.

Second, in markets you often find that causation is a squirrelly concept, and difficult to prove statistically.  Third, the question of right and wrong is a genuinely difficult one — what is acceptable behavior in markets?  Do we run a market for “big boys” who understand that this is all “at your own risk,” or a market that protects the interests of smaller players at a cost to the larger players?  Do we run a market that encourages volume, speed and efficiency, or one that avoids large movements in prices?

This article is an attempt to comment on the Wall Street Journal article on the SEC’s effort to create the Consolidated Audit Trail [CAT], in an effort to prevent future “flash crashes,” like the one we had five years ago.  I don’t think the efforts of the SEC will work, and I don’t think the goal they are pursuing is a desirable one.

People take actions in the markets for a wide number of reasons.  Some are hedging; some are investing; others are speculating.  Some invest for long periods, and others for seconds, and every period in-between.  Some are intermediaries, while others are direct investors.  Some are in one market, while others are operating in many markets at once.  Some react rapidly, and others trade little, if at all.  Just seeing that one party bought or sold a given security tells you little about what is going on and why.

Following price momentum works as an investment strategy, until the volume of trading following momentum strategies gets too high.  Then things go nuts.  Actions that by themselves are innocent may add up to an event that is unexpected.  After all, that is what dynamic hedging led to in 1987.  There was no sinister cabal looking to drive the market down.  And, because the event did not reflect any fundamental change to where valuations should be, price came back over time.

My contention is even with the huge amount of data, there will still be alternative theories, information that might be material excluded, and fuzziness over whether a given investment action was wrong or not.

After that, we can ask whether the proposed actions of the government provide any significant value to the market.  Some are offended when markets move rapidly for seemingly no reason, because they lose money on orders placed in the market at that time.  There is a much simpler, money saving solution to that close to home for each investor: DON’T USE MARKET ORDERS!  Set the price levels for your orders carefully, knowing that you could get lifted/filled at the level.

This is basic stuff that many investors counsel regarding investing.  If you use a market order you could get a price very different than what you anticipate, as I accidentally experienced in this tale.  I could complain, but is the government supposed to protect us from our own neglect and stupidity?  If we wanted that, there is no guarantee that we would end up with a better system.  After all, when the government sets rules, it does not always do them intelligently.

One of the beauties of capitalism is that it enables intelligent responses as a society to gluts and shortages without having a lot of rules to insure that.  Volatility is not a problem in the long run for a capitalist society.

If you lose money in the short run due to market volatility, no one told you that you had to trade that day.  Illogical market behavior, as in 1987 or the “flash crash” could be waited out with few ill effects.  Most of the difficulties inherent in a flash crash could be solved by people taking a longer view of the markets, and thinking like businessmen.

“It’s Baseball, Mom.”

I often spend time watching two of my younger children play basketball, baseball and softball.  They are often in situations where they might get hurt.  In those situations, after an accident, my wife gets antsy, while I watch to see if a rare severe injury has happened.  My wife asked one of my sons, “Don’t you worry about getting hurt?”  His response was, “It’s Baseball, Mom.  If you don’t get hurt every now and then, you aren’t playing hard enough.”  That didn’t put her at ease, but she understood, and accepted it.

In that same sense, I can tell you now that regardless of what the SEC does, there will be accidents, market events, and violent movements.  There will be people that complain that they lost money due to unfair behavior.  This is all a part of the broader “game” of the markets, which no one is required to play.  You can take the markets on your own terms and trade rarely, and guess what — you will likely do better than most, and avoid short-term volatility.

The SEC can decide what it wants to do with its scarce resources.  Is this the best use for the good of small investors?  I can think of many other lower cost ways to improve things… even just hiring more attorneys to prosecute cases, because most of the true problems the SEC faces are not problems of knowledge, but problems of the will to act and bear the political fallout for doing so.  And that — is a different game of baseball.

This will be the last of my institutional error pieces. It is not that I have not made any other errors, but these were the big ones.

National Atlantic Holdings [NAHC]

I was wrong yesterday.  I actually do have a lot available that I have written on this failure, since I wrote about it here at Aleph Blog.  More than you can shake a stick at.

Let me start at the beginning.  NAHC was an insurer with a niche presence in New Jersey.  They competed only in personal lines, which usually is easy to analyze.  New Jersey was a tough but not impossible state to operate in, and NAHC was a medium-sized fish for the size of the pond that they were in.

Chubb was not in NewJersey at that point in time, and so they wanted to insure autos, homes, and personal property, particularly that of wealthy people.

I thought it was an interesting company, trading slightly below tangible book, with a single-digit multiple on earnings, good protective boundaries, and a motivated management team.  The CEO owned over 10% of the firm, which seemed to be enough to motivate, but not enough to ignore shareholders.

In 2005, we bought a 5%+ stake in the company, which in 2006 became 10%+, and eventually topped out at 17%.  We might have bought more with the approval of the NewJersey Department of Insurance, which was easy at lower levels, and harder at higher levels, which was an interesting anti-takeover defense.

The company showed promise in many ways, but always seemed to have performance issues — little to medium surprises every few quarters.  The stock price didn’t do that much bad or good.  When I left Hovde at the end of July 2007, the position was at a modest gain.  Hovde had a hard time finding long names in that era, so the performance up to that point wasn’t that bad.

If you want to see my original logic for buying the stock after I left Hovde, you can read it here.

Here was the stock price graph from May 2007 to May 2008:

NAHC_current_loss

My old employer Hovde owned 17%.  I eventually owned 0.15%, at the prices you see there, at an average cost of $6.67 for me.  I eventually sold out at an average price of around $6.10.  (In the above graph, “Exit” was not a sale, but where I cut off the calculation.)  This wasn’t my worst loss by any means, but it cost my former employer badly, and it was my fault, not theirs.

What Went Wrong?

  • Their competitive position deteriorated as companies that previously avoided New Jersey entered the state.
  • They announced that they had reserving errors, and reported moderate losses as a result.
  • They announced a sale to Palisades Insurance, a private New Jersey insurer for $6.25/sh, valuing the company at less than 60% of tangible book value.  The fairness opinion was a bad joke.  The company would have been worth more in run-off.
  • Really, the management team was weak.

The first problem would be a tough one to solve.  On the second problem, I never got a good answer to how the loss reserves got so cockeyed, and somehow no one was to blame for it.  This is personal lines insurance — the reserves validate themselves every year.

But the third problem made me think the management was somewhat dishonest.  A larger company could have paid a higher price for NAHC, but that probably would have meant that management would lose their jobs.  They gave shareholders the short end of the stick for the good of management, and perhaps employees.

My biggest error was giving too much credit, and too much patience to the management team.  I met far better management teams in my time as a buy-side analyst, and they were on the low end of the competence scale.  I let cheapness and a strong balance sheet blind me to the eroding competitiveness, and weak ability to deal with the problem.

Ultimately, Hovde found itself in a weak position because it could not file for appraisal rights, a fraud case would have been weak, and the NJ Department of Insurance would not let them acquire enough to block the deal.  Besides, once arbs got a hold of over 40% of the shares, the deal was almost impossible to block.

As I often say, risk control is best done on the front end.  On the back end, solutions are expensive, if they are available at all.

The front end for you can be learning from my errors.  Wise men learn from the mistakes of others.  Average men learn from their own mistakes.  Dumb men never learn.

In closing, be conservative in investing, and be wise.  I thought I was being both, so seek the counsel of others to check your logic.

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

This is one of the many times that I wish RealMoney.com had not changed its file structure, losing virtually all content prior to 2008.  (It is also a reason that I am glad I started blogging.  It’s more difficult to lose this content.)  When I was a stock analyst at Hovde Capital Advisors, I made 2 humongous blunders.  I wrote about them fairly extensively at RealMoney as the situation unfolded, so if I had those posts, it would make the following article better.  As it is, I am going to have to go from memory, because both companies are no longer in business.  Here we go:

Scottish Re

Sustainable competitive advantage is difficult to find in insurance.  Proprietary methods are as good as the employees creating and using them, and they can leave when they would like to.  This applies to underwriting, investing, and expense management.  What else is there in an insurance company?  There are back end processes of valuation and cash flow management, but those financial reporting processes serve to inform the front end of how an insurer operates.

One area that had and continues to have sustainable competitive advantage is life reinsurance.  An global oligopoly of companies grew organically and through acquisitions to become dominant in life reinsurance.  Their knowledge and mortality databases make them far more knowledgeable the life insurers that seek to pass some of the risk of the death of their policyholders to them.  They can be very profitable and stable.  I already owned shares of RGA for Hovde, and in 2005 wanted to expand the position by buying some of the cheaper and more junior company Scottish Re.

Scottish Re had only been in business since 1998, versus RGA since 1973.  These were the only pure play life reinsurers in the world.  Scottish Re had grown organically and through acquisition to become the #5 member of the oligopoly.  The top 5 life reinsurers controlled 80% of the global market.  I made the case to the team at Hovde, and we took a medium-sized position.

The first thing I should have noticed was the high level of complexity of the holding company structure.  Unlike RGA, they operated to a high degree in a wide number of offshore tax and insurance haven domiciles — notably Bermuda, Ireland, Cayman Islands, and others.  Second, their ownership diagrams rivaled AIG for complexity, and their market capitalization was less than 2% of AIG’s at the time.  [Note: balance sheet complexity did not bode well for AIG either — down 98% since then, but it beats Scottish Re going out at zero.]

The second thing I should have noticed was the high degree of underwriting leverage.  Relative to RGA, it reinsured much more life risk relative to the size of its balance sheet.

The third thing I should have noticed was the cleverness of some of the financing methods of Scottish Re — securitization was uncommon in life reinsurance, and they were doing it successfully.

The final thing that I should have noticed was that earnings quality was poor.  They usually made their earnings, but often because their tax rate was so low… and the deferred tax assets were a large part of book value.  (Note: deferred tax assets only have value if you are going to have pretax income in the future.  That was soon not to be.)

In 2005, Scottish Re won the auction for buying up another member of the oligopoly, ING Life Re.  I asked the CFO of RGA why they didn’t buy it, and his comment was that he didn’t think anyone would pay more than they bid.  That should have led me to sell, but I didn’t.  The price of Scottish Re drifted down, until August 3, 2006, when they announced second quarter earnings, reporting a huge loss, writing off a large portion of their deferred tax assets, and the stock price dropped 75% in one day.  I eventually wrote about that at RealMoney, noting it was the single worst day in the hedge funds history, and it was due to my errors.  You can also read my questions/comments from the conference call here (pages 50-53).

If you look at the RealMoney article, you might note that we tripled our position at around $6.90 after the disaster.  That took a lot of guts, and we didn’t know it then, but it was the wrong thing to do.  The stock rallied all the way up to $10 or so.  If it hit $11, we were going to sell out.   That was not to be.

I spent hours and hours going through obscure insurance filings.  I analyzed every document that I could get my hands on including the rating agency analyses, because they had access to inside data in aggregate that no one else had outside of the company.  The one consistent thing that I learned was that insolvency was unlikely — which would later prove wrong.

The stock price fell and fell all the way down to $3, with rumors of insolvency swirling, when Mass Mutual and Cerberus rode to the rescue on November 27, 2006, buying 69% of the company for a paltry $600 million in convertible preferred stock.  At that point, I finally got it right.  All of my prior research had some value, because when I read through the documents that day and saw the liquidity raised relative to the amount of ownership handed over.  Given the data that they now handed out, I concluded that Scottish Re was worth $1/share, and possibly zero.

But there was a relief rally that day, and we sold into it.  We ended up selling about 4% of the total market cap of Scottish Re that day at a price of $6.25.

The bright side of the whole matter was that we could have lost a lot more.  Scottish Re was eventually worth zero, and Mass Mutual and Cerberus took significant losses, as did the remaining shareholders.

As it was, the fault was all mine — my colleagues at Hovde deserved none of the blame.

The Lesson Learned

One year later, I wrote a note to the late Greg Newton who wrote the notable blog, Naked Shorts, when he was critical of Cerberus (they had a lot of failures in that era).  This was the summary that I gave him on Scottish Re:

Cerberus got into SCT @ $3; it’s now around $2.  For me, on the bright side, when their deal with SCT was announced, I quickly went through the data, and recommended selling.  We got out @ $6.25.  That limited our losses, but it was still my biggest failure when I was at Hovde.  The mixture of leverage, alien domiciled subsidiaries, reinsurance underwriting leverage, plus complex and novel securitization structures was pure poison.  I was mesmerized by the seemingly cheap valuation and actuarial studies that indicated that mortality experience was a little better than expected.  I violated my leverage and simplicity rules on that one.

He gave me a very kind response, better than I deserved.  As it was Scottish Re went dark, delisting in May 2008, and trading for about a nickel per share at the last 10K in July of 2008.  It eventually went to zero.

The biggest lesson is to do the research better on illiquid and opaque financial companies, or, avoid them entirely.  Complexity and leverage there are typically not rewarded.  I’d like to say that I fully learned my lesson there, but I got whacked again by the same lesson on a personal investment later in 2008.  That’s a subject for a later article.

I have one more bad equity investment from my hedge fund days, and I will write about that sometime soon, to end this part of the series.

Full disclosure: still long RGA for my clients and me

This will be the post where I cover the biggest mistakes that I made as an institutional bond and stock investor. In general, in my career, my results were very good for those who employed me as a manager or analyst of investments, but I had three significant blunders over a fifteen-year period that cost my employers and their clients a lot of money.  Put on your peril-sensitive sunglasses, and let’s take a learning expedition through my failures.

Manufactured Housing Asset Back Securities — Mezzanine and Subordinated Certificates

In 2001, I lost my boss.  In the midst of a merger, he figured his opportunities in the merged firm were poor, and so he jumped to another firm.  In the process, I temporarily became the Chief Investment Officer, and felt that we could take some chances that the boss would not take that in my opinion were safe propositions.  All of them worked out well, except for one: The — Mezzanine and Subordinated Certificates of Manufactured Housing Asset Back Securities [MHABS].  What were those beasts?

Many people in the lower middle class live in prefabricated housing in predominantly in trailer parks around the US.  You get a type of inexpensive independent living that is lower density than an apartment building, and the rent you have to pay is lower than renting an apartment.  What costs some money is paying for the loan to buy the prefabricated housing.

Those loans would get gathered into bunches, put into a securitization trust, and certificates would get sold allocating cash flows with different probabilities of default.  Essentially there were four levels (in order of increasing riskiness) — Senior, Mezzanine, Subordinated, and Residual.  I focused on the middle two classes because they seemed to offer a very favorable risk/reward trade-off if you selected carefully.

In 2001, it was obvious that there was too much competition for lending to borrowers in Manufactured Housing [MH] — too many manufacturers were trying to sell their product to a saturated market, and underwriting suffered.  But, if you looked at older deals, lending standards were a lot higher, but the yields on those bonds were similar to those on the badly underwritten newer deals.  That was the key insight.

One day, I was able to confirm that insight by talking with my rep at Lehman Brothers.  I talked to him about the idea, and he said, “Did you know we have a database on the loss stats of all of the Green Tree (the earliest lender on MH) deals since inception?”  After the conversation was over, I had that database, and after one day of analysis — the analysis was clear: underwriting standards had slipped dramatically in 1998, and much further in 1999 and following.

That said, the losses by deal and duration since issuance followed a very predictable pattern: a slow ramp-up of losses over 30 months, and then losses tailing off gradually after about 60 months.  The loss statistics of all other MH lenders aside from Vanderbilt (now owned by Berkshire Hathaway) was worse than Green Tree losses.  The investment idea was as follows:

Buy AA-rated mezzanine and BBB-rated subordinated MHABS originated by Green Tree in 1997 and before that.  The yield spreads over Treasuries are compelling for the rating, and the loss rates would have to jump and stick by a factor of three to impair the subordinated bonds, and by a factor of six to impair the mezzanine bonds.  These bonds have at least four years of seasoning, so the loss rates are very predictable, and are very unlikely to spike by that much.

That was the thesis, and I began quietly acquiring $200 million of these bonds in the last half of 2001.  I did it for several reasons:

  • The yields were compelling.
  • The company that I was investing for was growing way too rapidly, and we needed places to put money.
  • The cash flow profile of these securities matched very well the annuities that the company was selling.
  • The amount of capital needed to carry the position was small.

By the end of 2001, two things happened.  The opportunity dried up, because I had acquired enough of the bonds on the secondary market to make a difference, and prices rose.  Second, I was made the corporate bond manager, and another member of our team took over the trade.  He didn’t much like the trade, and I told my boss that it was his portfolio now, he can do what he wanted.

He kept the positions on, but did not add to them.  I was told he looked at the bonds, noticed that they were all trading at gains, and stuck with the positions.

Can You Make It Through the Valley of the Shadow of Death?

I left the firm about 14 months later, and around that time, the prices for MHABS fell apart.  Increasing defaults on MH loans, and failures of companies that made MH, made many people exceptionally bearish and led rating agencies to downgrade almost all MHABS bonds.

The effects of the losses were similar to that of the Housing Bubble in 2007-9.  As people defaulted, the value of existing prefabricated houses fell, because of the glut of unsold houses, both new and used.  This had an effect, even on older deals, and temporarily, loss rates spiked above the levels that would impair the bonds that I bought if the levels stayed that high.

With the ratings lowered, more capital had to be put up against the positions, which the insurance company did not want to do, because they always levered themselves up more highly than most companies — they never had capital to spare, so any loss on bonds was a disaster to them.

They feared the worst, and sold the bonds at a considerable loss, and blamed me.

[sigh]

Easy to demonize the one that is gone, and forget the good that he did, and that others had charge of it during the critical period.  So what happened to the MHABS bonds that I bought?

Every single one of those bonds paid off in full.  Held to maturity, not one of them lost a dime.

What was my error?

Part of being a good investor is knowing your client.  In my case, the client was an impossible one, demanding high yields, low capital employed, and no losses.  I should have realized that at some later date, under a horrific scenario, that the client would not be capable of holding onto the securities.  For that reason, I should have never bought them in the first place.  Then again, I should have never bought anything with any risk for them under those conditions, because in a large enough portfolio, you will have some areas where the risk will surprise you.  This was less than 2% of the consolidated assets of the firm, and they can’t hold onto securities that would likely be money good amid a panic?!

Sadly, no.  As their corporate bond manager, before I left, I sold down positions like that that my replacement might not understand, but I did not control the MHABS portfolio then, and so I could not do that.

Maybe $50 million went down the drain here.  On the bright side, it helped teach me what would happen in the housing bubble, and my next employer benefited from those insights.

Thus the lesson is: only choose investments that your client will be capable of holding even during horrible times, because the worst losses come from panic selling.

Next time, my two worst stock losses from my hedge fund days.