Market Impact

• Old-School Stock Picker Weitz Struggles With Index Craze stks.co/gYnx Weitz has a really good long term track record, good guy $$
• High-Yield Companies Cash In on Dividend Deals stks.co/cXCJ W/the rise in interest rates, junk corporations move 2 refinance $$
• IRS Reconsiders What Qualifies for REIT Status stks.co/jYiU There should b1 tax law for all things like corporations in the US $$
• New Revenue Recognition Rules Arriving Soon stks.co/rFvA I’m afraid the new rules will b less clear than current GAAP rules $$
• How the Robots Lost: High-Frequency Trading’s Rise & Fall stks.co/gYk9 Every investment strategy has a capacity limit, even HFT $$
• Sam Zell says sell stks.co/rFr3 1 month old; he also thinks that efforts by corporations 2 manage single family homes will fail $$
• Banks will take hit on mortgage refi buststks.co/pFwq This may true 4 whole industry, but some banks will profit via MSRs, ALM $$
• FASB’s Seidman: Americans Prefer Rules to Principles stks.co/pFpb We should stick w/GAAP & ditch IFRS convergence. We know GAAP $$
• IFRS Makes Progress Around the Worldstks.co/tFir Incomparable Financial Reporting Standards r less converged than many realize $$
• 401(k)s Are Doing Great Except For A Few stks.co/eX9U Fine,except 401(k) users don’t put enough away 2 care 4 their retirements $$
• Why Low Volatility Is Losing Its Alphastks.co/cX0J Any strategy can be overfished. Monoculture rarely leads to good results $$
• “Any strategy can be overfished. Monoculture is a recipe for disaster. How many analogies do I…” — David_Merkeldisq.us/8dev71 $$
• Money-market fix is a flawed compromise stks.co/dWtx My proposal was cleaner and far better: stks.co/dWty$$
• Bet on CDOs Returns to Wall Streetstks.co/bWy4 Synthetic CDOs take the field again, just in time to fleece anxious yield hogs $$
• Bruce Berkowitz Places Bet on Fannie, Freddie stks.co/jYCL A lot of this rides on political future of F&F, w/Berkowitz unsure $$
• Don’t Sell Your Soul for Yield, Pimco’s Simon Says stks.co/qFRi He retires @ 52 2pursue philanthrophy & fun; bond risks high $$
• Rise in US Bond Yields Jolts High-Dividend Stocks stks.co/qFIa If they r used as bond substitutes, will trade more like bonds $$
• Brokerage firms debate value of Certified Financial Planner title stks.co/dWU1Interesting 2c firms asking CFPs to decertify $$
• The 100% Stock Solution stks.co/sEyrOnly the stoutest souls should try this; best time to start is after a meltdown, if u can $$
• The Intelligent Investor: How Funky Is Your 401(k)? by @jasonzweigwsjstks.co/dWKf Unusual bond funds not recommended 4 novices $$
• Why Hedge Funds Aren’t Worth the Money stks.co/iXxM Double-alpha & leverage r great in theory; in practice they don’t work well $$
• ‘ @Matthew_C_Klein @felixsalmon But I disagree: blogs.reuters.com/felix-salmon/2… Cov-lite loans r a sign of general credit degradation $$
• Interesting argument by @felixsalmonthat cov-lite bonds are good because they give borrowers greater flexibility:blogs.reuters.com/felix-salmon/2…

US Politics

• The NSA Doppelganger stks.co/jYiY Govt has been collecting records on every phone call made in the US ever since Patriot Act $$
• Will New Health Insurance Be Too Expensive 4 America’s Lowest-Paid?stks.co/rFvF Law of unintended consequences teaches $$ lessons
• Trading Dollar Bill for Coin Big Savings, No Small Change stks.co/iYrY This could makes sense if we eliminate the penny as well $$
• Fed Hurdle of 4 Straight 200,000 Payrolls Sets Bernanke View stks.co/iYrW I don’t think the Fed has a coherent policy response $$
• An Insider’s Guide to Obama’s Summit With China’s Xi stks.co/sFp7 Makes me think that nothing much will come out of this summit $$
• Start Your Engines: NatGas Revs for Transportation stks.co/hYwm This is more complex than it looks b/c liquification low temps $$
• Obama’s Civil-Liberties Record Questioned stks.co/qFu9 Obama is not a change agent; he is merely Bush-plus & we r the losers $$
• US declassifies phone program details after uproar stks.co/hYwd Terrorism is an unlikely threat – doesn’t justify the snooping $$
• Alan Greenspan’s Epic Incompetence: Another Shoe Drops stks.co/jYXF This piece provided the link 4 the last tweet $$#greenspan
• How Elite Economic Hucksters Drive America’s Biggest Fraud Epidemicsstks.co/eXA3 Of course fraud should b a crime, it’s theft $$
• NSA seizes phone records of Verizon customers stks.co/jYXC Shouldn’t a warrant b required 4 such indiscriminate investigation? $$
• Jefferson County, AL, Reaches Bankruptcy Deal stks.co/gYbR $JPMloses most, then taxpayers. “gross incompetence, waste, graft” $$
• Debt Deal in Alabama Will Cost JPMorgan stks.co/aX7U Sewer rates rise. Everyone loses except the speculators who bot debt cheap $$
• Warplanes to Tankers Delayed by Contested US Contracts stks.co/gYUYLosers contesting contracts is now normal & slows things $$
• FHA Losses Could Hit $115 Billion in Extreme Scenario stks.co/gYLJ 4 political reasons, FHA guaranteed lousy loans, losses come $$
• Jefferson County Paves Way for Bankruptcy Exit stks.co/cWky The biggest losers r taxpayers, but then they elected the schmoes $$
• Mistake: $AIG, $PRU, $GE Named Systemically Important by Panelstks.co/jYCN Focus should b: financing long assets w/short loans $$
• The Real Scandal at the IRS stks.co/sFMf“…larger threat of abusive behavior by a fearsomely powerful government agency.” $$
• ObamaCare Bait and Switchstks.co/jYCG Obamacare was never meant 2 make healthcare affordable 2all, only 2 those w/o insurance $$
• It really annoys me, because the key of financial safety is asset/liability mgmt & all of new regulations do not tighten this up $$
• Risk that the Feds should care about is the toxic mix of illiquid assets funded by liquid liabilities; long liability structures r safe $$
• Feds close to picking ‘risky’ non-banksstks.co/iY88 Really looks like the Feds r going2goof again & call non-risky firms risky $$
• Overstated: Risk-Averse Culture Infects US Workers, Entrepreneursstks.co/eWev Generally moderate risk-taking leads2best result $$
• Little Cause for Inflation Worriesstks.co/jXms Far better 2 use median or trimmed mean CPI, than the more doctored core PCE $$

Europe

• France demands emergency EU summit over China’s wine tax threat stks.co/dX8ATrade wars have 2 start somewhere, however small $$
• Moody’s Casts Doubt Over Nordic Havens Amid Housing Risksstks.co/bXCh Rest of world adopts bad monetary policy of US, EZ&Japan $$
• Central Banks Put More Scandinavian Currencies in Reserve stks.co/jY4tEnables the Nordic countries to import asset inflation $$
• Swiss Seen Passing US Bank-Tax Law to Avoid Worse Fate stks.co/qFJY Most compromises r better than seeing many banks die $$

Companies & Industries

• Tyson CEO Says Smithfield Deal Could Aid Pork Exports stks.co/iYnc Many Chinese might like 2 buy high quality American food $$
• $COST CEO Craig Jelinek Leads the Cheapest, Happiest Company in the World stks.co/gYk1 Investing in workers vs cheap workers $$
• Wells Fargo Will Benefit From Interest-Rate Increase, Sloan Says stks.co/eX42Could just b brave words, few give up income $$
• Fannie Shares Seen as Worthless Surging in Disconnect stks.co/dWtw The politics of the situation r in flux; no margin of safety $$
• Goldman Wants You to Forget About Too Big to Fail stks.co/gYUx There is a subsidy to the big banks, not as large as some think $$
• Like Berkshire, Markel thrives on buy&hold stks.co/rFbN Thomas Gayner, like Buffett is a compounder w/underwriting float $$ $MKL
• Alcoa Junk Downgrade Is Rare Trauma for Dow Stocks stks.co/iYYW Time2 modernize & create News Corp Indexstks.co/gYUZ $$
• Whale of a Trade Revealed at Biggest US Bank With Best Control stks.co/iYYVLong but definitive article on $JPM credit trade $$
• Scor to Buy Generali Reinsurance Unit for $750 Million stks.co/tFMQ How do u say “Scottish Re” in French? “Scor” $RGA$$ #spitspit
• Apple Saves $724 Million With Well-Timed Sale stks.co/qFCo 20-20 hindsight, but $AAPL timed their debt sale well $$
• Kinder Morgan Cancels $2 Billion Pipeline Plan stks.co/iY7O Sending crude via rail costs same & does not require LT contract $$

Asia

• Hedge Funds in Japan Ride Small-Cap Rally on Abenomics Boost stks.co/eX41Be wary here, because there is no clear macro path $$
• The Wonk With the Ear of Chinese President Xi Jinping stks.co/qFfh A modernizer who wants the Communist Party 2 keep control $$
• Topix Profits Percentage Increase Tripling World Even in $400 Billion Wipeout stks.co/qFUz Wait. Weak yen also has bad effects $$
• Poultry-Plant Fire in China Kills Dozensstks.co/jXzF Sad, but it is common 4 firms that hire low wage workers 2 cut corners $$
• Muddy Waters to Jupiter Seek Profit as Risk Rises stks.co/eWeV Convoluted financial systems can’t handle as much debt b4 crisis $$
• Heard on the Street: Let Me Not See Old Age in China stks.co/qFCr Elderly poor who live away from the coasts suffer in China $$

Other

• Co-hosts of radio show ‘The Pursuit of Happiness’ commit suicide togetherstks.co/sFhK Happiness pursued as its own end fails $$
• Harvard Humanities Fall From Favor Among College Students stks.co/rFgfThere is no one more unrealistic than a humanities prof $$
• To Catch a Thief: Banks Try Using Big Data stks.co/jYPf The banks try 2 detect correlated behavior among fraudsters & succeed $$
• How Retirees Pay Zero Taxesstks.co/eX3v If you r older & have little wage income there r often ways 2 reduce your taxes $$
• Bermuda With Ireland Targets of Tax Vigilantes, Minister Says stks.co/hYTPThey were really surprised when NATO blockaded them $$
• Marriage Advice: Sharing a Hobby Is Good for Your Relationship stks.co/tFMwOur hobby is raising kids, will have2find a new one $$
• Meredith Whitney’s “Great Migration”stks.co/fYHh Disliked by genuine muni experts @catelong &Joe Mysakstks.co/gYGr $$
• Government 2 Hold Back Growth for Years stks.co/qFJ0 Balancing the budget may have far less drag than most suppose, lowers risk $$
• Vatican says Pope Francis got it wrong, atheists do go to hell stks.co/iY8I Adults @ Vatican correct Pope’s wishful thinking $$
• Wrong: Smartest Decision Ever Made by Bill Gates, Warren Buffett stks.co/rFAj If u raise your children right, they can handle $$
• Behind the ‘Internet of Things’ Is Android—and It’s Everywhere stks.co/tF9hAmazing how 1can change the world on lo profit mgns $$

Finance

• Has BIS Found the Solution to Too Big to Fail? stks.co/fYcY Has issues, but much better than what was done in 2008. Worth a try $$
• The rise of the real collateral ‘mining’ business stks.co/bX4T Overproduction of commodities feeds the shadow banking system $$
• What is the opposite of helicopter money? stks.co/eX43 Negative interest rates suck liquidity, as people seek stores of value $$
• World Chasing U.S. Yield With 25% Deal Jump: Real Estate stks.co/hYUF Enough inventory 2 pick from & seems 2b recovering $$
• A World Awash in Credit with Much Work to Do stks.co/gYHW Increasingly hard to find safe yield; EM still seems promising,but… $$
• i’d like to see: zip code level correlation between house price growth from 2011 to 2013 against absentee purchase share during same period.
• Hedge Funds Boost Gold Bull Bets Most in Two Months stks.co/jY4r Makes me a little edgy for gold prices $$
• Mortgage Investors Get Blindsidedstks.co/pFMV Bonds Backed by Subprime Loans Had $1B Previously Undisclosed Losses $$ #surprise
• Emerging-Market FX Gets Ugly. Very Ugly. stks.co/qF1e Yeah, I feel it, just look at the chart in $EDD of which I am long $$

FWIW

• My week on twitter: 51 retweets received, 58 new followers, 34 mentions. Via:20ft.net/p

Let me admit my bias at the start.  Physics is the wrong model for financial markets and economics.  The better models are ecological or biological, because people adapt to conditions that change.  Perhaps we are predictable on average, but there is a wide variation in specific behaviors.

Economics and ecology deal with scarcity and plenty.  Physics does not.  Physics is exact, aside from the quantum and universal scales.  Economics and ecology are never exact, and prediction is fraught with error.

But what of financial instruments where the math of physics might have application?  Perhaps physics has some application there?

Okay, sort of.  Even something as pervasive as option modeling does not truly have a simple model, but implied volatility has to be re-estimated regularly for the Black-Scholes Model.  A true model does not require re-estimation of a parameter, particularly when it varies by time and strike price.

What I liked  about the book

I liked reading about the mathematicians who applied analogies from physics to economics. Even though the models had their flaws, they improved the explanatory power.

I also appreciated how the author kept explanations simple.  He could have gone into a lot more detail, and a lot more math, and he would have lost most of his audience.

He also explained the life circumstances of the men he wrote about.  That adds depth, because science does not occur in a vacuum.  It is a social activity.   Few men think purely abstractly, and those that do ride the edge of genius/insanity.

There are two motives for understanding  how men approach markets — to explain, and to make money.  The book has both sorts, and it is a strength to see one validate another.

Quibbles

Already given

Who would benefit from this book: If you want to learn about men who shaped the market by their knowledge of math, you will like this book.  If you want a book that explains the markets, this is not it.  If you want to, you can buy it here: The Physics of Wall Street: A Brief History of Predicting the Unpredictable.

Full disclosure: I received a free copy from the publisher.

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.

Note to readers: I plan on doing a series of book reviews over the next few weeks.  I may do more than a dozen.  I hope you enjoy them.

I am a value investor.  That’s what I do for a living, and I do it well.  One month ago. I wrote a piece called “Value Investing Flavors.”  In it, I took a broad view of value investing, because there are many common principles to value investing employed by all, but many variations on implementation. [Note to those reading at Amazon; they don’t me post links, but if you Google “Aleph Art of Value Investing” you will find it.

The Art of Value Investing takes a similarly broad view, quoting well over 100 value investors (I lost count) on topics where professional value investors agree & disagree.  The authors have interviewed the grand majority of those cited, and have useful historical quotes from well-known figures familiar with the subject.  Better known and more accomplished value investors tend to get more play in the book — I think the authors chose well.

The book is organized by topic.  It covers these questions:

• The importance of a margin of safety
• Buy high margin quality businesses, or cheap low margin businesses?
• What attention should be paid to growth opportunities? (Controversial)
• What is your circle of competence? (I.e. what opportunities do you rule out because you don’t get how to value them?)
• How small of a company would you consider buying?
• How much do you incorporate top-down macroeconomic considerations?
• What countries would you not consider buying a company within?
• The advantage of being able to buy and hold for years.
• How careful research often conquers uncertainty.
• Do you buy turnarounds or not? (Controversial)
• How do you generate good buy ideas?
• How do you create a firm that ignores the conventional perspective, and generates correct ideas that few know?
• How do you analyze what could go wrong with a company?
• Do you look for catalysts to unlock value or not? (Controversial)
• Do you analyze value through one framework or many?  Cheap going concern or transformation of underused assets? Both?
• Do you manage for absolute value or relative value?  I.e., what is the value of safe assets, or even gold?
• When do you establish an position?  How do you size it?
• How diversified do you want to be?  How do you weight positions?
• How much do you care about stocks being correlated within the portfolio?
• How long are you willing to wait to see if an idea works?  When do you admit that you are wrong?
• Are you willing to advise management?  Are you willing to fight management?  When does it make sense?
• Do you short bad stocks or not?
• When do you sell?  Do you do it never, gradually or rapidly?
• How do you maintain a sound mind and humility amid all of the clamor of the markets?
• How do you admit mistakes, so as to avoid them in the future, and show humility to your clients?

If you want to understand the nuances of how a firm doing value investing works, I can’t think of a better book, because this book implicitly goes over all of the choices that a value investor has to make.  What factors will I focus on, and what will I ignore?  How detailed will my analysis be?  How much will I diversify?  How will I make choices among so many stocks vying for my attention amid all of the news noise?

I have strong views on value investing myself, but I questioned my own ideas as I read the replies of those more successful than me.

Quibbles

Initially, as I read the book, I wondered if a better book could be made by organizing by each firm, rather than topic.  By the end of the book, I realized I was wrong.  Not all firms have opinions on many questions, and doing the book by topic highlights the variation in opinions across a wide spectrum of organizations.

Who would benefit from this book: Amateur and professional value investors will benefit from this book; if the reader does not want to put the effort into learning value investing, this book will be of no use to him.  If you want to, you can buy it here: The Art of Value Investing: How the World’s Best Investors Beat the Market.

Full disclosure: I received a free copy from the publisher.  I personally know a few of the value investors cited.  I would like to meet more of them.

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.

What does it take to create a global or national financial crisis?  Not just a few defaults here and there, but a real crisis, where you wonder whether the system is going to hold together or not.

I will tell you what it takes.  It takes a significant minority of financial players that have financed long-dated risky assets (which are typically illiquid), with short-dated financing.

The short-dated financing needs to be rolled over frequently, and during a time of financial stress, that financing disappears, particularly when creditors distrust the value of the assets.  It typically happens to all of the firms with weak liability structures at the same time.

During good times financing short is cheap.  Locking in long funding is costly, but safe.  That is why many financial firms accept the asset-liability mismatch — they want to make more money in the short-run in the bull phase of the market.  But when many parties have financed long risky assets with loans that need to be renewed in the short-term, the effect on the markets is multiplied.  The value of the risky assets falls more because many of the holders have a weak ability to hold the assets.  Where will the new buyers with sound finances come from?

Areas of Short-dated Financing

Short-dated financing is epitomized by bank deposits prior  to the Great Depression.  If doubt grew about the ability of a bank to pay off its depositors, depositors would run to get their cash out of the bank.  Deposits are supposed to be available with little delay.  After creation of the FDIC, deposits under the insurance limit are sticky, because people believe the government stands behind them.

But there are other areas where short-dated financing plays a significant role:

• Margin accounts, whether for derivatives, securities, securities lending, etc.  If a financial company is required to put up more capital during a time of financial stress, they may find that they can’t do it, and declare bankruptcy.  This can also apply to some securities lending agreements if unusual collateral is used, as happened to AIG’s domestic life subsidiaries.
• Putable financing, particularly that which is putable on credit downgrade.  This has happened in the last 25 years with life insurers [GICs used for money market funds], P&C reinsurers, and utilities.  Now this is similar to margin agreements on credit downgrades because more capital must be posted.  Anytime a credit rating affects cash flows, it is a dangerous thing.  The downgrade exacerbates the credit stress.  Then again, why were you dancing near the cliff that you created?
• Repo financing was a large part of the crisis.  The weakest large investment banks relied on short-term finance for their assets in inventory.  So did many mortgage REITs.  As repo haircuts rose, undercapitalized players had to sell, lowering asset prices, leading to a new round of selling, and higher repo haircuts.  It was the equivalent of a bank run and only the strongest survived.
• Auction-rate preferreds — a stable business for so long, but when creditworthiness became a question, the whole thing fell apart.
• Finance companies — GE Finance and other finance companies rely on a certain amount of short-term finance via commercial paper.  It is difficult to be significantly profitable without that.
• All other short-term interbank lending.

Crises happen when there is a call for cash, and it cannot be paid because there are not enough liquid assets to make payment, and illiquid assets are under stress, such that one would not want to sell them.  This has to happen to a lot of companies at the same time, such that the creditworthiness of some moderately-well capitalized institutions, that were thought to have adequate liquidity are called into question.

The Value of a Long Liability Structure

Let me give a counterexample to show what would be a hard sort of company to kill.  In the mid-1980s, a number of long-tailed P&C reinsurers found their claims experience in a number of their lines to be ticking up dramatically.  But the claims take a long time to settle, so there was no immediate call for cash.  Later analysis showed that for many of the companies, if the full value of the claims that eventually developed were charged in the year the business was written, many of them would have had negative net worth.  As it was, most of them suffered sub-par profitability, losing money on the insurance, and making a little more than that on their investments.

But they survived.  Other insurers cut some corners in the ’90s & ’00s and wrote policies that were putable if their credit was downgraded.  This would supposedly give more protection to those buying insurance or GICs [Guaranteed Investment Contracts] from them.  Instead, the reverse would happen when the downgrade came — there would be an immediate call on cash that could not be met, and the company would be insolvent.  Even if the majority of the liability structure is long, if a significant part of it was short, or could move from long to short, that’s enough to set the company up for a liquidity crisis of its own design.

Credit cycles come and go.  The financial companies in the greatest danger are the ones that have to renew a significant amount of their financing during a crisis.  It’s not as if firms with long liabilities don’t face credit risk; they face credit risk, and sometimes they go insolvent.  But they have the virtue of time, which can heal many wounds, even financial wounds.  If they die, it will be long and drawn out, and they will hold options to influence the reorganization of the firm.  Creditors may be willing to cut a deal if it would accelerate the workout, or, they might be willing to extend the liability further, in exchange for another concession.

In any case, not having to refinance in a crisis makes a financial company immune from the crisis, leaving aside the regulators who may decide the regulated subsidiaries are insolvent.  But, the regulators may decide they have more pressing issues in a crisis from firms that can’t pay all their bills now.

AIG, Prudential & GE Capital

So the Financial Stability Oversight Council [FSOC] has designated AIG, Prudential & GE Capital as systemically important.  They are certainly big companies in their industries, but are they 1) likely to be insolvent during a credit crisis, and 2) does the failure of any one of them affect the solvency of other financial firms?

That might be true for GE Capital.  They certainly still borrow enough enough in the commercial paper market, though not as much as they used to.  If GE Capital failed, a lot of money market funds would break the buck.

AIG?  The current CEO says he doesn’t mind being being systemically important.  Still, Financial Products is considerably smaller than it was before the crisis, they aren’t doing the same foolish things in securities lending that they were prior to the crisis, and they don’t have much short-term debt at all.  The liabilities of AIG as a whole are relatively long.  And even if AIG were to go down, we shouldn’t care that much, because the regulated subsidiaries would still be solvent.  Financial holding companies are by their nature risky, and regulators should not care if they go bust.

But Prudential?  There’s little short term debt, and future maturities are piddling on long term debt.  If the holding company failed, I can’t imagine that the creditors would lose much on the $27B of debt, nor would it cause a chain reaction among other financial companies.

I feel the same way about Metlife; both companies have long liabilities, and would have little difficulty with financing their way through a crisis.  Just slow down business, and free cash appears in the subsidiaries.

I can make a case that of these four, only GE Capital poses any systemic risk, though I would have to do more work on AIG Financial Products to be sure.  But what the selection of companies says to me was it was mostly a function of size, and maybe complexity.  Crises occur because a large number of financial companies finance long-dated assets with short-dated borrowings.  I think the FSOC would have done better to look at all of the ways short-term finance makes its way into financial companies, and then stress test the ability to withstand a liquidity shock.

My belief is that if you did that, almost no insurers would be on such a list; the levels of stress testing already required by the states exceed what FSOC is doing.

Time for the promoted penny stock scoreboard:

Tonight’s loser-in-waiting is Dephasium Corp [DPHS], which surged to a high of 59 cents today, probably off of the promotion of the stock, and the completion of an acquisition.  Here are my bullet points on why this company will fail:

• No earnings
• No revenues
• Negative tangible book value
• Acquires an asset of dubious value.
• Formerly known as Expertelligence, Inc, Pay Mobile, Inc, & Allied Ventures Holding Corp.  What do you want to be when you grow up?  Sorry, *if* you grow up.
• Auditor doubts the the company will continue its existence.
• Company has consistently lost money through all of its existence.  Has survived through continual dilution of its stock.
• To do the acquisition, they sold stock at six cents a share.  They bought back stock at three cents per share.  Now it trades at nearly 60 cents per share.  That makes no sense at all.

As for the acquisition, let me quote from the article linked above:

Since 2006, Dephasium Ltd. has launched a program of research and development to become the leader in the field of people protection against electromagnetic waves emitted by mobile phones. Dephasium Ltd. has succeeded in developing an Ancilia product that it believes protects up to 98% of electromagnetic waves issued by cell phones. This conclusion is based upon the results of technology tests administered by Cetecom ICT Services and included in its written report dated August 10, 2009.

Let me get this straight: you have a product that can reduce electromagnetic waves from cell phones, and you are willing to sell it for a piddling 70M shares of this crud company?  Why didn’t you do deals with Samsung, Apple, LG?  If the test is four years old, why don’t you have a big business by now?

The promoter paid $2.7M to advertise Dephasium.  When I googled the promoter and the one paying, I came up with nothing.  The amount paid is more than the value of the company acquired.  The whole thing stinks.

So avoid promoted stocks.  Don’t buy what someone is trying to sell you; buy what you have researched and discovered on your own.

From an email from a reader:

Dear David

My name is YYY, an I am from Ecuador. I am the owner of ZZZ. ZZZ is a business that is focus on wholesaling construction machinery to the whole country. Before my business, I study and graduated from University of St. Thomas in Houston with  a BA in Business administration and Finance. After graduating, I became a an admirer of value investing.

While doing some research of the the book “The Aggressive Contratian Investor” I run into your blog. Currently, I want to invest while I ran my business. I have read The Intelligent Investor, The snowball, The Essays of Warren Buffet, Financial Statement Analysis by Ben Graham and by Warren Buffet, Phil Fisher, Poor Chalie’s Almanack, etc. I just started reading Security Analysis 6th edition. However, with all this knowledge, I still feel that I dont know

“How to valuate a company”

I dont know if I should take MFA course in Austin University, or read a book, what to do whatsoever. Do you have any advice? What do I need to learn or research to be able to valuate business/analyze a security?

Sincerely,

YYY

Dear friend, I have several answers for you.

1) You can learn how to value companies the way I did: start as an amateur, and compare and contrast companies.  Build up knowledge over time.  Pick an industry and get the data from a lot of companies.  I remember when I did Trucking in 1994.  That was fun for my kids to see all the trucks in the annual reports.  I eventually bought one firm, MTL, and it doubled in a year, and got taken private.  What was interesting was that company had a reputation for safety, quality, and doing things right.

2) You can read books by Aswath Damodaran.  His books are overkill, in my opinion, but he gives the right theory, just with too many bells and whistles.  Most good valuation work is simple.  Focus on the big issues.

3) Rather than estimate the value of a company, look at the earnings yield of the company versus alternatives.  Buy companies that offer good returns off of current market prices.

4) Compare the company and it peers on current valuations and past valuations versus earnings, EBITDA, free cash flow, etc.

5) Look at a history of prior M&A activity for public and private companies within that industry.

There are many ways to learn how to value companies, but I would encourage you to learn by doing.  Have at it, and prosper.

The usually good Felix Salmon wrote a piece that I disagreed with called: Don’t worry about cov-lite loans.  This is what I wrote as a response:

Ask a loanholder, “All other things equal, would you rather have a cov-lite loan or a normal one?” The answer will always be “Normal, of course. Why are you asking such a dumb question?”

Loanholders would prefer more defaults with lesser severity than fewer with higher severity. What is flexibility to the borrower is a higher degree of expected credit costs to the lenders.

To make this general, I have to explain to you the four phases of competition in uncertain outcomes. I know I’ve written about this before, but I can’t remember where. It applies to a wide number of phenomena, including insurance underwriting and fixed income investing.

Phase 1: the market is offering a bargain in yields relative to normal default costs, and terms & conditions are firm. More competition causes prices to rise & yields to fall.

Phase 2: the market is fully priced in yields relative to normal default costs, and terms & conditions [covenants] are firm. More competition causes terms & conditions to erode. Conservative firms end new purchases. Assets with good terms get premium pricing.

Phase 3: the market is fully priced in yields relative to normal default costs, and terms & conditions [covenants] are soggy. More competition causes some to speculate that “maybe things won’t be so bad, besides, we have money to put to work.” Conservative firms sell existing positions.

Phase 4: Market crashes, defaults are realized. Lower quality assets lose more money. Conservative firms buy assets at a discount from posers who thought they knew what they were doing, some of which are now broke.

So, no Felix, the presence of cov-lite loans indicates that we are in phase 2 at minimum. I think we are in phase 3. I have sold my loan funds for clients last year — we are on borrowed time now.

The same sort of thing happens with insurance underwriting, and I even think bull markets in stocks.  After a disaster, insurance surplus levels are low, and pricing is generous, with terms & conditions tight.  Additional competition lowers profitability to levels that justify the cost of capital employed.  After that, pricing stays at that level, and terms and conditions deteriorate, until they can decline no more. After that, pricing deteriorates further until the next disaster uncovers their folly.  Conservative insurers drop out before the disaster, and return capital to shareholders rather than writing bad business.

With bull markets in stocks the first phase is disbelief, the next phase is belief.  During that phase, parties lessen risk controls and buy what is hot.  In the last phase, valuation plays little role for the marginal decision-makers, until the bull market peaks.

Maybe I am overgeneralizing here, but to me there seems to be an inflection point in bull markets where in order for equity managers to compete, they toss away risk discipline.  After that, managers stretch their willingness on valuations.

In closing, two articles that relate to this:

• The Price and Risk of Playing Defense Are Up
• Rising Stock Prices Flash a Warning…Selloff Ahead?

Both of these articles make me think we are in the last phase of a bull market.  Valuation is getting ignored.  Be wary, and play some defense, but avoid the idea that traditional defensive stock types will be defensive, particularly with low volatility and dividend paying stocks.

Europe

• Risk of Bank Failures Rising in Europe, E.C.B. Warns stks.co/iXnFdgzCpNK1ctKk7ijN/w&pagewanted=all&pagewanted=print Bad scene $$
• New BoE chief Carney will devalue sterling, Pimco warns stks.co/sEin It’s useless but everyone has 2try2 “beggar thy neighbor” $$
• The French Economic Maginot Line: A Very Weak Strongpoint stks.co/cVlX French economy weakening; 2 big 4 Germany 2 rescue $$
• Greek Economy Optimism Seen in Yield-Curve Switch stks.co/aVsv Perhaps they r doing better, but what of France & Germany? $$
• Hungary Cuts Policy Rate to Record Lowstks.co/sENf Another nation sucked into the march to global ZIRP; what will break first? $$

Asia

• Asia’s Huge Debt Growth Problem: Remember 1997? stks.co/sEsy Graph on this page is worth a look; could b another Asia crisis $$
• Aging Chinese Face a Bleak Picturestks.co/cWG6 This should b no surprise; it is the logical outcome of the 1 child policy $$
• China Failure to Grow With $1T Is Warning to Li: Economy stks.co/jXddNegative Marginal productivity of capital in China $$ #FTL
• China’s Xi Comes Calling on Americasstks.co/rEua Interesting to see the Chinese need 4 products in the Western Hemisphere $$
• China Failure to Grow With $1T Is Warning 2 Li: Economy stks.co/dVzl 10 years from now, they’ll wonder y we worried about China $$
• China-Based Cyber Attacks Rise at Meteoric Pace stks.co/sEco This is not news. Practice safe computing, & you will be safe. $$
• Japanese Housewives Cooling on Aussie Uridashi stks.co/sEcn The strong yen is gone,& small investors realize there is no gain $$
• Tokyo Shares Down Sharplystks.co/bW4G Japanese stocks get hit, why should anyone be surprised? BOJ engaged in voodoo economics $$
• Japan’s Bond Market Wants BOJ to Purchase More Short-Term stks.co/gXRpTraders off-balance as BOJ stops giving them easy profit $$
• China’s Shuanghui to Buy Smithfield Foods stks.co/pEdZ A wise addition to the strategic pork reserve; let the pigs flow west! $$
• Japan plays down concerns bond price spike could hurt recovery stks.co/fXGZKuroda thinks 3% higher interest rates won’t hurt?! $$
• Fears over US stimulus highlight Japan’s fragility stks.co/aVlz Japan is reaching the limits of what monetary policy can do $$

Rest of the World

• Sudan Threatens to Close Pipelinestks.co/cVvE Two corrupt regimes arguing over oil – a lose/lose situation $$
• Bank of Israel Lowers Rate Again After Surprise Mid-May Cut stks.co/eVoS Many fringe economies import low rates 2 aid exporters $$
• Despite Detractors, Don’t Buy Talk of Dollar’s Demise stks.co/cVeU The US is in good shape compared to Japan, Eurozone & China $$
• Fringe economies are forced to absorb loose monetary policy, or let exports suffer while hot money tries to get yield in their countries $$

Central Banking

• Simon Johnson: Choosing the Next Head of the Federal Reservestks.co/bWEQ No doubt that Dick Fisher would b a lot better $$
• Is the Fed Right to Calibrate Asset Purchases to Economic Data?stks.co/fXYR Coarse data doesn’t allow 4 fine policy precision $$
• US Banks Looking Solid As Bernanke Keeps The Juice Flowing, But Perils Of Financial Crisis Loom stks.co/pEdg Low rates will end $$
• Fed’s 100-Year Roots Grew From Virginia Congressman stks.co/sEWJ Puff piece of secular hagiography fawning over Carter Glass $$
• Kuroda Struggles W/Communication as Japan Rates Rise stks.co/eVkQ Most central bankers don’t know forces w/which they r toying $$
• Also, strong communication skills at central banks r a weakness, not a strength; better 2 move back to the pre-87 era, operate in shadows $$
• The more communication a central bank puts out, the more markets become “tightly coupled” w/the CB, thus limiting the effects of policy $$
• Stephen Poloz: Top 10 headaches BoC chief faces right off the bat stks.co/qEKO2 much debt amid a mortgage bubble germinates $$

Market Impact

• NYC Pension Chief Seeks $500,000 Managers to Cut Out Wall Street stks.co/eWPZ Insourcing looks easy; u need bright mgmt 2do it $$
• Contrarian Investing in Quality Franchises stks.co/dWEz It is not enough 2b contrarian, u have 2b right $$ $STUDY
• James DeMasi on Overcoming Adversity to Start and Grow a Value Investment Management Firm stks.co/eWPVIntelligent stuff $$ $STUDY
• Pension-Fund Swings Make Case for Cutting Risk stks.co/tEuZ Much as I like ALM, probably the wrong time 2 trade stocks 4 bonds $$
• Junk Bonds Having A Bad Week (Down 0.96%) Amid Broader Pullbackstks.co/bWEV Yet this is small & we need it 2 persist 4 weeks $$
• Evaluating 3 Bullish Argumentsstks.co/dW9s PR better than logic, but he is right that the market is overvalued $$
• Sallie Krawcheck: Big Banks Still Don’t Have Enough Capital stks.co/rEou No 1 knows how large the ultimate catastrophe could b $$
• Morgan Stanley to Downsize Fixed Income stks.co/dVzj I think this is a mistake. Wall Street exists 2 sell debt$MS $$
• Record Cash Sent to Balanced Fundsstks.co/eVv4 Hail the humble balanced fund, which has the virtue of keeping panic away 4most $$
• SEC Refocuses on Accounting Fraud stks.co/gXI1 With Crisis-Related Enforcement Ebbing, SEC Is Turning Back to Main Street $$
• A hedge fund for u & me? Best move is 2 pass stks.co/eVoW Sage advice from @ritholtz | survivor & reporting bias & fees 2 high $$
• Goldman Sachs Buyback Orders Reach Highest Level of Year stks.co/bVkE Are buybacks part of the voting or weighing machine *now* $$
• Margin Debt Hits a Record, Showing Confidence stks.co/fX96 Confidence or froth, amid a market influenced by aggressive $$ policy?
• Beware of ‘Bargain’ Stocks stks.co/hXKKI disagree for now; look4 strong companies in industries under stress that will survive $$
• Defaulted Manhattan Complex Rewards Patient $$ stks.co/iXCC Sadly, equity & mezzanine were wiped out, patience pays only4 snr debt

Insurance

• MetLife cuts 2,500 advisers seen lacking chance of success stks.co/dWF0 Retail chief says productivity ‘way up;’ costs way down $$
• Regarding the prior tweet, I have wondered 4 ~25 years when something like that would happen; has long been needed @ most life insurers $$
• $PRU Takes On $AFL in Benefits After Health Law stks.co/fXpO Much easier2 “enter” a market than create a sales force $$ FD: + $AFL
• $ENH CEO steps down, replacement named stks.co/iXML Sudden. Former CEO of $AXS picked, owns ~1.5%, will own ~4% as comp; FD: +$ENH
• The former CEO of $AXS was pushed out by his board; he built Axis, but was a bit of a prima donna. What will he do to $ENH ? | FD: + $ENH $$
• One more note: the competent former CFO of $PRE is now CEO of $AXS , having been passed over for the CEO job @ $PRE $$ #musicalchairs

US Politics

• Pelosi: “We have to pass the bill so you can find out what is in it.” The more we find out, the less sense it makes.stks.co/pF0S
• GOP senators want IG probe of Sebelius’ ‘Obamacare’ fundraising stks.co/dWA5Obama administration is more corrupt than Nixon $$
• Bible Class in Texas Schools Faulted as Unconstitutional stks.co/iXnP Look in the comments 4 bigoted ideas that aren’t American $$
• Obamacare Competition Has Roots in Economist’s Passion stks.co/dW9n If you believe in neoclassical economics u r deluded $$ #loser
• Regulators Want Better Financial Datastks.co/gXjV Well, duh, but there are costs involved & the government does not bear those $$
• When Chinese Walls Come Crumbling Down stks.co/rEot There r still conflicts of interest on Wall Street. Be aware & defensive $$
• Deposits Guaranteed Up to $250,000—Maybe stks.co/pEdo Congress transfers insured deposit risks to the taxpayers & depositors $$
• Liberty Reserve Joe Bogus Account Said to Reflect Evasion stks.co/jXKv Money laundering goes high-tech; Feds take action $$
• Obama Accepting Sequestration as Deficit Shrinks stks.co/gXIj Whaddaya know? A policy no one liked actually isn’t that bad $$
• Health Law Critics Seek to Gut It by Attacking Exchanges stks.co/rEO6 Exchanges will only attract sick, will b high costs4all $$
• The US Federal Government Spending: a Huge Fiscal Drag http;//stks.co/iXMS Cutting less useful spending it may help, not harm $$
• Hollywood Loses Blockbusters as ‘Iron Man’ Finds Subsidy stks.co/gXIX Like building stadiums, except u have to keep doing it $$
• Obama Nominates 2 Senate Aides for S.E.C. Posts stks.co/fX8w A team 2 assure continued incompetence & weak enforcement $$
• Banks’ Lobbyists Help in Drafting Financial Bills stks.co/pEJH Basic goals: min capital reqs, max flexibility, weaken regs $$

Other

• Cord Cutters Lop Off Internet Service More Than TV stks.co/hXwv You can cut your costs, but what does that do to your life? $$
• Online Course Providers Reach Out2 Wary Professors stks.co/jXde Better to ask the question, “Where is new revenue coming from?” $$
• Victor Davis Hanson: Why Some Wars Are So Savage stks.co/bW4K Evenly matched wars that take a long time lead to barbarism $$
• Mary Meeker is Back With Her 2013 Internet Trends Report Slidesstks.co/pEfP A lot of interesting information $$ Things change
• European Sunscreen Roadblock on U.S. Beaches stks.co/tENx If you sunburn like me, maybe European sunscreens will help u $$
• Dear Grads, Don’t ‘Do What You Love’ stks.co/hXVe The solution is 2love what u do; working 4 $$ helps other priorities in life
• Death Jolts Texas Investorsstks.co/aVsN Since his body was found 2 weeks ago, investors say they lent him millions of $$ #badodor
• Common Core Education Is Uncommonly Inadequate stks.co/sENHNational curriculum standards tend 2b dumbed-down; local better $$
• Science Can’t Pin Powerful Tornadoes on Global Climate Change stks.co/eVoUA rare fair article on climate @ Bloomberg. Who knew $$
• Noahpinion: Bets do not (necessarily) reveal beliefs stks.co/dVdu In which Noah Smith arbs Brad Delong & Patrick Chovanec $$ #FTW
• Immunology Gets Turned On Its Headstks.co/jX4P Discovery may aid vaccine design&begins2explain y gene therapy runs in2 trouble $$
• Is This Google X’s Plan to Wire the World? stks.co/hXKJ Solar powered balloons dot the skies, could last 5 years & upgrade $$

Companies

• Buffett’s Safe Bet on Vegas stks.co/gXjUThe Maestro does it again, takes a marginally profitable company, & refinances it $$
• Goldman Upgrades Defense Contractors stks.co/gXjT My but how contrarian; won’t there b less cash flowing to defense companies? $$
• Berkshire Hathaway Unit to Buy NV Energy for $5.6B stks.co/dVzk Another wise move by Buffett; utility earnings make $$ vs funding
• Alcoa Cut to Junk by Moody’s as Aluminum Price Declines stks.co/pEkEAnother sign of economic weakness, but Alcoa will survive $$
• Payday Lenders Evading Rules Pivot to Installment Loans stks.co/eW4q I like people to have choice, but not 1 that leads2a trap $$
• Empire State Building IPO Plan Is Approved stks.co/fXUM ”The second-largest IPO for a U.S. real-estate investment trust” ever $$
• BHP Halts Coal Expansion stks.co/dVthDownturn in the global economy & thus steel makes demand fall for metallurgical coal $$ $BHP
• Newsweek for Sale: IAC Seeks Buyersstks.co/jXKo The internet changes everything; say goodbye to a dinosaur $$
• Utilities Weigh Entering Rooftop-Solar Business stks.co/sEWA Sounds dumb; it’s a very different biz in almost every way $$ #FTL
• Samsung, Sony Court Indians as Subsidies Fund Factories stks.co/gXIgIndia gives 25% subsidy4capital costs2setup tech plants. $$

Energy

• As US Oil Booms, an Unlikely Word Rises: Depletion stks.co/dVl5 Wells created by fracking have shorter production profiles $$
• U.S. Oil Boom Divides OPECstks.co/pEUQ Those most dependent on oil revenues want others in OPEC 2 cut, so that they can cheat $$

Replies, Retweets & Comments

• I just left a comment in “Energy stocks down, look to end week higher – Energy Stocks – MarketWatch”on.mktw.net/18DiBrm
• “I have read both. Buffett made mistakes that cost him, but never such that he could not bounce back…” — D_Merkeldisq.us/8da393 $$
• Commented on StockTwits: Old tweet deleted, new tweet out stks.co/iXMe
• “Don’t forget his purchase of 83% of CVR Energy. Equally good. FD: +$CVI ” — David_Merkel disq.us/8d9jmi cc:@refomedbroker $$
• @AlephBlog Growth and the Market. Useful piece to help people make sense of seemingly over-valued equity market:wp.me/p3nd6r-4s
• Sets up future losses $$ RT@tomkeene: ‘Cov-lite’ loans soar in dash for yield - FT.com on.ft.com/12daxfK
• @kurtgodeldabomb I like your name. Yes, that’s y I said it; I think its the voting machine 4 most companies, & weighing machine 4 a few
• “Until the strategy fails, and he asks you to leave.” — David_Merkeldisq.us/8d97f5 $$
• @pope_stephen Sadly, monetary policy was much better run under Volcker & Martin, & they were not going out of their way 2 explain the Fed $$

FWIW

• My week on twitter: 42 retweets received, 2 new listings, 60 new followers, 37 mentions. Via: 20ft.net/p

Maybe I should call this article “the product that saw the light of day, after a long sleep.”  Barron’s had an article last week, “Top 50 Annuities.”  Guess what? Almost all of the annuities they featured were stripped down and low cost.  That’s the way things should be.  If you have time and interest, read the article; it’s a good thing.  Also note at the end the skepticism of investment managers, particularly hedge funds running insurers.  The skepticism is deserved.

That’s all.  A rare short piece.

You might recall my letter to Warren Buffett, and his response to me.  A number of my readers made some very nice offers to help me on this project.  Many thanks to you all, but I found a way to shrink the size of the project.  Look at this table:

This table lists all of Berkshire Hathaway’s domestically domiciled insurance subsidiaries, all 55-56 of them, maybe minus a few intermediate holding companies that are just shells.  The NAIC # uniquely identifies each company for the National Association of Insurance Commissioners.  Then comes the assets, liabilities, and surplus for regulatory purposes.  Then there are the groups that each subsidiary belongs to, and what percentage  of the total statutory surplus each one represents.

The table is sorted by the major subsidiary groups, and then in declining order of surplus.   Here is the key to the groups:

1. AU = Applied Underwriters
2. BHH = Berkshire Hathaway Homestate
3. CSI = Central States Indemnity
4. GEICO (what else?)
5. GenRe = General Reinsurance
6. Guard = AmGuard
7. MedPro = Medical Protective
8. NI = National Indemnity
9. USLI = United States Liability Insurance
10. Wesco = Wesco Financial

A number of the companies are not writing new business; they are in what is called “runoff.”  Two companies may have the same name “APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.” but are domiciled in different states.

So, back to my challenge to understand the structure of Berkshire Hathaway.  The above table makes my life easy.  Really, I only need to get the reports of the following companies:

• Berkshire Hathaway Homestate
• General Reinsurance
• GEICO
• National Indemnity (really, the one most needed)
• Medical Protective

Those five companies cover ~94% of the statutory surplus of  all of Berkshire’s insurance companies.  I can afford to get that data.  But how should I do it?

1. I can buy it though the NAIC
2. I could write Warren another letter asking for his approval to ask each company for their statutory statements.
3. I could ask each subsidiary for their statements, and see how they react.
4. I could troll the web, and see if they aren’t hiding out there.  One reader suggested that the Statements are out there on some state insurance department websites, but that would surprise me. That hasn’t been true in the past.

I am thinking of doing #2, but am open to advice.

As an aside, note that the sum of $128 billion of statutory surplus is far more than the $106 billion listed in the latest 10-K.  That is because of capital stacking, which is a form of double counting.  Lower lever subsidiaries surplus gets counted in their intermediate parent companies.  But if I eliminate all of the lower level companies, I only end up with $100 billion.

This is a different approach to Berkshire Hathaway, approaching it as a group of  insurance companies that owns businesses.  It is very different, yet successful.  When I get the data, I hope we all learn a lot.