by ·Comments Off on The Kelly Criterion

In an upcoming article at RealMoney, I will be writing an article on optimal position sizing. To do that, I use the Kelly Criterion, which says that a position size should be equal to (edge/odds). There is added complexity in applying this to stocks, because in gambling, each game is uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another, particularly for me, because I concentrate sectors.

The Kelly criterion applied to stock investing would recommend a fixed weight portfolio. Optimally, you would rebalance daily to those fixed weights, but there are two factors that interfere: first, there are costs to trading, and second, momentum tends to persist in the short-run. To me that implies that one has fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, like maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. How much are each of the rules worth? Well, that I will describe in the article at RealMoney, and that hopefully will explain why holding 35 or so positions is proper for me in running my strategy.

One more thing, I appreciate the work done at the CASTrader Blog on the Kelly criterion. We manage money very differently, but we both appreciate the value of the Kelly Criterion.

PS — As an aside, I get ribbed by some at RealMoney, whether contributors or readers about holding 35 positions as hyperdiversified. In general I agree with portfolio concentration, but given that I concentrate sectors and industies, that makes 35 a lot more like 20 in terms of total volatility. On the other hand, compared to most mutual fund managers, 35 names would be a tighter ship than 95% of them run.

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I’m not an accountant.  I have never taken an accounting course in my life.  Yet as an actuary and a financial analyst, I have had to use accounting rules to understand financial statements, both in the production of them, and the interpretation of them.  (I even remember writing a paper explaining the effect of the then-current FAS 52 on foreign exchange when I was a grad student.)

 

There are a number of Statements of Financial Accounting Standards that I think have been mistakes.  We are between paradigms.  The central question is this: how often do we want to re-estimate the value of balance sheet items, and if they change, how should they be reflected in the income statement?

 

There are two consistent ways to do this.  Other methods are a kludge in my opinion.  Method one is amortized cost on both sides of the balance sheet.  Method two is the estimation of fair market value on both sides of the balance sheet.

 

But SFAS 159 allows companies to elect which assets and liabilities (with some restrictions, and subject to SFAS 115) they can value at amortized cost or at fair market value, together with disclosure on how the assets/liabilities are valued.

 

Now, I know that the FASB is trying to create standards that will be more consistent with international accounting standards, but what they are doing here will make accounting less comparable across US companies, particularly given that adherence to SFAS 159 is optional.

 

For companies with no long term agreements, SFAS 159 will not have any major impacts, but as for me, given that I follow the insurance industry, this will make my life more complex, without any equivalent increase in understanding.

 

As I said once to a panel of the IASB and FASB, create two consistent financial statements, one amortized cost, and one fair market value.  This would mean two income  statements and two balance sheets, and one cash flow statement.  They though that was too much work, but I disagree; companies are doing that work now, but they are not reporting it.  Better they should disclose what they know.

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When Wall Street comes up with a good idea, they overdo it until the system chokes on the product they created. After the market failure, the system becomes more sophisticated and risks are priced better.

The ABX.HE indexes were created to have a uniform way of trading tranched subprime mortgage credit on a consistent basis. This would allow parties to go long or short, and in greater volume than the underlying cash market would support. They started with the 06-1 deal, which reflected subprime mortgage deals from 20 different originators from the second half of 2005.  They have gotten as far as the 07-1 deal,which reflected subprime mortgage deals from the same 20 originators from the second half of 2006.

 

Well, now what?  Many of those originators are gone, and most of the rest have scaled back massively. Will there be an 07-2 deal?  In some ways, I wonder if the existence of the ABX.HE deals didn’t help to create part of the problem, in that the 20 originators had to come out with at least one deal of a certain size every six months.  Being in the index would mean cheaper funding, so an originator would want to do that if possible.

 

I don’t see how the ABX.HE 07-2 gets done, and honestly, the system might be better off if it doesn’t get done.  The existence of subprime mortgages encourages some people to take on onerous debt that they would be better off not incurring.  Anything that encourages more subprime lending (and other high interest forms of debt) is in my opinion, a bad thing.  Let people learn to defer their gratification, put more money down, and on the whole, they and the whole nation will be better off.

by ·Comments Off on Bond Market Notes

What a week. The yield curve disinverted with ten-year Treasury yields moving above two year yields. 30-year bonds traded off 11 basis points, 10-years 7 bp, 5 years 5 bp. The short end of the curve was largely unchanged.

But now look at Treasury Inflation Protected Securities. TIPS 10 years and longer fell a mere 3 bp. TIPS 5 years and shorter were flat. Now, I have a large allocation of my balanced mandates in TIPS and short-term debt, so my downside was protected this week.

So why did the bond market move that way? The FOMC shifted its monetary policy language this week in a way that said that they no longer have a bias to tighten policy, but they do have have a bias to worry about inflation. The Fed’s announcement this week says that they are willing to tolerate a little more inflation. The bond market reacted accordingly, and required more yield on bonds with no inflation protection.

What else happened? The equity markets rallied, both before and after the FOMC announcement. Credit spreads largely tightened, and the dollar fell on the FOMC announcement, before rallying back to flat the rest of the week. In general, the carry trade currencies, the yen and the swiss franc, underperformed, and higher yielding currencies did better.

What can I say, then? The willingness to take risk is alive and well, and the carry trade is re-emerging. M&A isn’t suffering; note the possible deals on Tribune, ABN AMRO, Chrysler and Volkswagen. And, at least according to Bloomberg, there are a scad of CDO deals in the pipeline waiting to be done. So, let the party continue; let others ignore the rising inflation (at your peril), and enjoy the punch that the Fed is serving. As for me, I’ll just enjoy my mug of tea, slowly reduce risk, and watch the spectacle.

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

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

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

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

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

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

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

 

Full Disclosure: Long AIZ

by ·Comments Off on Seventeen Days Later

We’ve had seventeen market sessions since the blowup in Shanghai and we are closing in on the level prior to the blowup. My broad market portfolio is down 40 basis points, versus the S&P being down 90 basis points.

This doesn’t mean that everything is back to normal. There are still significant imbalances in the financial system. The carry trade, CDOs, and private equity will yet have their comeuppance. The only question is when it will happen.

by ·Comments Off on He Who Pays The Piper Calls The Tune

There’s an article in the Wall Street Journal today entitled, “Credit-Ratings Firms Get Caught Up In Subprime Meltdown.” In some ways I anticipated this in my article at RealMoney, “Snarls in Insurance Investigation, Part 2.”

I experienced the difficulties that the ratings agencies had in 2001-2002 as a corporate bond manager. They are paid by the issuers, and have a conflict of interest. They can argue that they are zealous to protect their reputations, but in the short run, they get paid by issuers to rate deals. Only in times of crisis do they adjust their standards to meet the needs of the bond buyers.


In short, the problems with the ratings agencies are the same as the problems with auditors. He who pays the piper calls the tune. Except in crises, the ratings agencies are more beholden to the issuers than their subscribers. All the more reason to allow alternative ratings agencies into existence, to challenge their oligopoly.

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A reader posed this question to me a little less than a month ago:

With the financial markets providing such opportunities to transfer risk such as re-insurance and cat bonds how legitimate is it for the insurance companies to say that they must pull out of MS and LA? How much of that risk is transferred to other entities? Is it because the hedge funds and re-insurers refuse to play ball in MS and LA so the insurers are stuck? What other risk transfer mechanisms are available the insurers to spread risk to others?
 
Can you please do a piece on your blog that addresses how the cat risk is spread and how much remains on the insurers books? Thanks and yes I live in the Great State of Louisiana.

I didn’t write about this sooner because I was just getting started blogging, and had other goals. That said, he has a valid question. Property insurance, by its nature tends to be a high severity business. If there are enough uncorrelated property exposures, an insurer or reinsurer can write business, knowing that there might be bad years, but that nothing will kill them.

Unfortunately, the southeast coast of the US is a large part of the global property insurance market and not very diversifiable, because it would be a large percentage of the total premium for property coverages globally. Recently, the odds of disaster have been estimated higher by catastrophe modelers, and then by reinsurers and insurers. That has led insurers and reinsurers to ask for higher premiums or tighter terms. To the extent that state insurance departments will not allow for this, shortages occur.

I don’t derive any direct income from the P&C insurance industry. In general, I feel that allowing market forces to work yields the best overall result; it may take as many as three years for competition to do its work.

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

What I Am Not Selling

 

St. Joe – This doesn’t score well. The idea here is the land is considerably more valuable than the share price would indicate.

SPX Corp, Sara Lee – These are still in turnaround mode. Metrics don’t look good now, but should improve.

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

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

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

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

What I Am Selling

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

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

What I am not Buying

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

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

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

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

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

Encore Wire – A bit of a cult stock. I just don’t like the business that they are in.

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

Foot Locker – Too many earnings disappointments.

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

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

National Coal – Too small.

Home Solutions of America – I don’t like their business, given my view of the housing market.

What I am Buying

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

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

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

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

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

Concerns

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

Not to Worry

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

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