Day: November 1, 2008

Fifteen Notes on the Markets

Fifteen Notes on the Markets

1) Where are we?? Is the equity market cheap or dear?? Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.? When the financials are compromised, all bets are off.? Here are some article indicating that things are cheap:

And, not cheap, consider the arguments of this humble student of the markets.? He considers survivorship bias and war as factors that investors should consider.? I agree, and I would urge all to consider that wars often occur as a result of economic crises.

2) The trouble is, quantitative finance is tough.? We don’t have enough data.? Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.? My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.? Okay, we are there now.? Volatility is high, and so are credit spreads.? The brain-dead VAR models used by Wall Street have been falsified again.? Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

4) This is a global crisis.? Where is it appearing?

5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.? But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

Consider their new plans for a short term lending facility, and the exogenous shocks facility.? They will have a lot to fund in this environment.

6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?? Possible, though for every seller, there is a buyer.

7) How do we pay back what we borrow?? Who will borrow more from us?? Those are? the great unanswered questions as we attempt to bail out many troubled entities.? I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.? (Among the cognoscenti, only “Greenspan” will do as a proper insult.)? On the despondent side, will the US default in 2009?? Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.? I see default as more of a 2017-2020 issue.

8 ) Uh, let Lawrence Meyer pontificate.? There is nothing good about a zero Fed funds rate.? Let him wax grandiloquent about Japan over the past two decades.? Consider how low interest rates destroy money markets funds.? Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

9) In an environment like this, every M&A deal is open to question.? M&A is credit sensitive, and higher volatility impairs the flow of credit.

10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.? True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).? The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.? It doesn’t matter what the accounting rules are when a company is running out of cash.? Cash is impervious to accounting rules.

11) Want a closer view of the Fed and politics.? Read this piece at The Institutional Risk Analyst.? While at RealMoney I espoused a view that the Fed was more political than economic.? This article confirms it.

12) How do I view Greenspan’s apology?

13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.? Well, we are there now.? It is seemingly the last form of credit to default on.? In this environment, one can lose their home, but losing financial flexibility can be bigger.

14) The FDIC can modify many mortgages, at a cost to taxpayers.? It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

15) If John Henry were alive, he would be smiling.? Let humans make markets, and not machines.

The Trouble with Investment Management Consultants

The Trouble with Investment Management Consultants

I have been on both sides of the table in equity money management.? I have hired and fired managers.? Now I am looking to be hired as a manager, and I face something that distresses me — the consultants that advise potential clients.? Personally, I think the consultants could do a lot better if they abandoned their overly simplistic model that categorizes managers on capitalization, value/core/growth, and domestic/international.? It does not serve their clients well — I believe the most fundamental risk model in a globally connected world considers industry exposures, and ignores other variables.

Why?? Industries tend to occupy specific areas of the “style box.”? At one firm that I worked at, external consultants complained that our risk control procedures were nonstandard, because they were focused on industries and sub-industries.? I counter-argued that our methods were better, because with a given industry, there was little variation in market capitalization and value/growth, but industry performance varied considerably.? Though I am no longer with the firm, it continues to do well, while many that used the consultants’ model have died.

Look at it another way. Isn’t investng about finding attractive opportunities, regardless of how big they are, where they are located, or how quickly they grow?? I think so, as does Buffett, Munger, Muhlenkamp, Heebner, Hodges, Rodriguez, Lynch, and many other successful fundamental investors.

Sometimes largecap names are attractive, sometimes smallcap.? Sometimes deep value is attractive, sometimes growth at a reasonable price.? Good managers analyze where the best value is, regardless of non-economic factors.

But if you have to cram me into the style box, fine, I am a midcap value manager that buys a few foreign stocks.? But there is a huge loss in constraining intelligent investors through the style box.? The better a manager is, the more one should ignore non-economic distinctions, and let him perform.

Recent Portfolio Moves

Recent Portfolio Moves

Since I wrote my last portfolio update two months ago, it is time for a new report.

New Buys

  • PartnerRe
  • Allstate
  • Assurant
  • Nucor
  • Genuine Parts
  • Pepsico
  • CRH
  • Alliant Energy

New Sells

  • Avnet
  • Lincoln National
  • YRC Worldwide
  • CRH
  • Jones Apparel
  • Assurant
  • Group 1 Automotive
  • Smithfield Foods
  • MetLife
  • International Rectifier
  • Cemex
  • Officemax
  • Universal American

Rebalancing Buys

  • Shoe Carnival
  • Charlotte Russe
  • Devon Energy (2)
  • RGA
  • SABESP
  • Ensco International (2)
  • Industrias Bachoco
  • Magna International
  • Valero
  • Kapstone Paper
  • Hartford International (3)
  • Cimarex Energy
  • Lincoln National
  • Smithfield Foods
  • Allstate
  • ConocoPhillips (2)
  • Tsakos Energy Navigation

Rebalancing Sells

  • PartnerRe
  • Safety Insurance
  • Devon Energy
  • Ensco International
  • Hartford Financial (3)
  • Kapstone Paper
  • Cimarex Energy
  • Nam Tai Electronics (2)
  • Honda Motors (2)
  • Lincoln National (2)
  • ConocoPhillips
  • Charlotte Russe
  • Shoe Carnival

I’ve had a lot of trades over the past two months, which is normal for me when volatility rises.

I have been asked by a number of parties why I don’t write about the insurance industry in this environment, given my past experience.? My main reason is that I have left it behind.? When I became a buyside insurance analyst, I had strong opinions about what made a good or bad insurance company.? For the most part, those opinions were correct, but there is a fundamental opaqueness to insurance.? One truly can’t analyze it from outside.? No boss would hear that, even if true.

I benefitted from the cleaning up of insurance assets 2002-3, and thought that the cleanup had persisted.? Largely, it has, but many life companies rely too heavily on variable products for profitability, and as the market has fallen, profits from variable products have fallen harder.? Thus my mistakes with Hartford, MetLife and Lincoln National.

That brings up two other possibilities where things can continue to go wrong in life insurance.? If fees are permanently reduced the companies might have to write down the deferred acquisition costs [DAC] that they capitalized when originally writing the business, if the expected cumulative fees are less than the DAC.? The second issue is hedging the guaranteed living benefits.? I will never forget the look that the CEO of Principal Financial gave me when I asked him how well the futures/options hedges during a month where the S&P 500 is down 20-30%.? It was not a pleasant look.? Not that that scenario could ever happen. 😉

My picks in pure P&C insurance have fared better.? Safety Insurance is a solid company; so is PartnerRe.? Would that I had done more there, and less in life companies, especially the equity sensitive ones.

So what do I hold today among insurers?

  • Allstate
  • Assurant (bought after the marginally bad earnings announcement)
  • Hartford (yes 🙁 )
  • PartnerRe
  • Reinsurance Group of America
  • Safety Insurance

Yes, I am overweight insurance, and I have paid the price, particularly with Hartford.? There is an uncertainty connected with life insurance holding companies about the ability to upstream dividends to service debt.? That uncertainty only appears in bear markets, and all the hubbub over optimizing the capital structure is so much hooey.? Assurant is in better shape because it ceased buying back stock because of the (somewhat bogus) investigation of a few of their executives.

Two final notes to close.? I had a bad October, worse than the S&P 500 by a significant margin.? My exposures in life insurance and emerging markets drove that.? Second, I may have my first equity client, and so I may be curtailing some of my discussion of individual names in my portfolio, and deleting my portfolio at Stockpickr.com.? My clients come first.

Full disclosure: long ALL AIZ HIG PRE RGA SAFT SCVL CHIC COP HMC NTE XEC KPPC ESV DVN TNP VLO MGA SBS CRH LNT PEP GPC NUE (what have I left out?!)

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