2008 – Page 26 – The Aleph Blog

Book Review: When Genius Failed

Posted on 4 June 200822 June 2017 by David Merkel

One review of a good Roger Lowenstein book deserves another? Perhaps good things come in pairs. 😉

I decided to review “When Genius Failed,” because reading “While America Aged” reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.

I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)

When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.

The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.

Um, oh yeah, book review.? LTCM suffered from a number of troubles:

They were systemically short liquidity.
They did not consider the effect of others mimicking their trades.
They were internally disorganized; leadership was weak.
They intensified their leverage at the wrong time.

The liquidity aspect is significant.? Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also.? LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities.? This set the stage for the run-on-the-fund.? Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.

In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.

The lack of discipline inside LTCM, was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book.? Financial businesses that last require tight controls on risk taking.

Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends.? They levered up at the wrong time.? The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.

Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed.? It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking.? The assets are illiquid, the liabilities are more liquid.? Their balance sheets are opaque.? Many of them are in the same risk posture.? Many of them are more leveraged than they would like to be.? Bear has already fallen, will Lehman fall next?

Just because investors are smart does not mean that they are infallible.? Any investor playing at a high enough level of leverage can be ruined.? This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors.? Not losing money is a big help in making money, and skepticism in investing is usually a plus.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission, and your costs don’t increase. This is my version of the ?tip jar.? Thanks to all who support me.

Abandon the Playbook; Adopt the Global Playbook; Adjust the Playbooks for Valuations

Posted on 3 June 200822 June 2017 by David Merkel

It was 7 3/4 years ago that I modified my value investing method to incorporate industry rotation.? That was probably the most significant change to my methods that I made in the last 16 years.? I did it reluctantly, after an analysis of where I had done best over the prior eight years.? I had many significant wins when I had gotten the industry cycle correct.

I commented recently on industry selection.? I want to make two additional points on that here.

1)? Analyze where an industry gets its demand.? Is it domestic or foreign?? If foreign, then use the global playbook.? Instead of looking at GDP growth, look at the growth from foreign demand.? Decouple your reasoning from the traditional view, because in a global economy, things get messy.

2) Even if an industry is driven primarily by domestic demand, often portfolio managers using the playbook may trash the valuation to levels that should be below trough valuations.? These are long-term opportunities, and should be bought.? VIce-versa for companies that have favorable future growth prospects, but the valuation discounts those prospects, and then some.? Those should be sold, even if they are in industries with good prospects.

That’s all for the evening.? I wrote this piece because active managers haven’t been doing well lately.? Uh, in order to do well, one must be willing to brave the possibility of failing (you can’t hug the benchmark), by taking opportunities that others find distasteful.? I benefit because I don’t care about tracking error; I just buy cheap stocks, in industries where the long run value is not appreciated by most investors.

A Comment on SFAS 159

Posted on 3 June 2008 by David Merkel

I am ambivalent about fair value accounting standards because they ruin comparability of financial statements across companies.? Recently, SFAS 159 has come into the news because some securities firms used it to book gains because the market value of debt that they issued had fallen.? Four notes:

1) They had no choice, they had to do it.? Their debt has liquid markets — those are level 1 and at worst level 2? liabilities.

2) Many of the assets that they carry have credit risk also.? The pressures that are leading the prices of their debt to fall, are also causing the carrying value of some of their assets to fall as well.

3) If credit markets for their debt improve, they will have to write those liabilities up to higher values.? Even if creditworthiness stays the same, the passage of time will make the liabilities rises in value as they get closer to the ultimate payoff.

4) In bankruptcy, their obligation to pay par does not change.? It is not as if they can pay the reduced market? value to pay off their debt, except through a deal agreed to by the court and plaintiffs.

Look, I don’t like the confusion SFAS 159 creates at this point any more than the next guy, but the gains here will likely reverse over time, absent bankruptcy.? As an analyst, I strip those gains out of income, and I should strip out losses on the asset side that I think will reverse as well.

We can change the way that gains and losses are reported — book, market, model, hybrid… but we can’t change the ultimate cash flows from the business, which is what will ultimately drive the value of the firm.? Be careful and conservative here, as accrual entries get more subjective, they become less trustworthy, and managements on average release more into income from accrual entries than they ought to.

Again, Not Worried About Reinsurance Group of America

Posted on 3 June 20083 June 2008 by David Merkel

From the 6/2 RealMoney Columnist Conversation:

		David Merkel
		Rebalancing Sales, and a Buy
		6/2/2008 4:08 PM EDT

Late last week, I had two rebalancing sells, Charlotte Russe and Smithfield. Today, two more, Honda Motor and Nam Tai Electronics. As the market has risen (or, some of my stocks at least), cash has been building up, and I have added some of my own free cash to the Broad Market portfolio. I’m at about 14% cash.

So, it’s time to buy something, though I am waiting on the market to show a little more weakness before I act. But, though dinner may wait, perhaps an appetizer is in order: today I added to my position in Reinsurance Group of America. MetLife finally decides to shed this noncore asset in a tax-free stock swap, allowing current MetLife shareholders to swap their MetLife shares for shares in RGA.

RGA should get a higher multiple as a “pure play” life reinsurer; that will come later. Today was the selling pressure in advance of the new supply. I like the management team at RGA, and think this will allow them the freedom to add value on their own. One other odd kicker… it might allow them to do more reinsurance business with MetLife, because they will be independent and thus truly be a third party.

Position: long CHIC SFD HMC NTE RGA

A few additional notes, for me long only means running with 0-20% cash. I don’t go above 20%; I don’t borrow. Under normal conditions, I like running around 5-7% cash. If the NAHC stake is counted in, (arbitrage gets a pseudo-cash return) then we are at that 20% upper limit.

That leads me to take a few actions — I have bumped up my central band for my holdings by 16%. Translated, the points at which I do buy and sell rebalancing trades has risen 16%, as has my normal position size. Looking back through the years, back to 1992 when I started value investing, my position sizes were 5% of what they are today, and back then I had 10 positions, not 35. There’s been growth. 🙂

My second action was a temporary purchase of some RGA. I doubled my position temporarily, because I think most analysts will smile on the deal, and RGA has always been a good buy at book value.

No telling whether buying at 1.0x book will continue to be a good idea in the future. RGA is a well-run company in an oligopolistic industry. The management is smart and conservative. They have international growth opportunities, and now, possible new business from MetLIfe. The moat is wide here. You can’t reverse engineer the #2 life reinsurer in the US and the World.

So, I’m happy with my position here. That said, I may trade away the speculative part of my holdings in the short run, and I may buy some MetLife as well. MetLife is cheap, though not as cheap as RGA, but I suspect when MetLife offers RGA shares in exchange for MetLife shares, they will have to make the tradeoff sweet in order to get some flexible institutional investors to do the swap. Why? MetLife is a large cap stock that is very diversified. RGA is a midcap that is not as diversified. MetLife is a well-respected brand name. RGA? Who?

Insurance is opaque; reinsurance is doubly so. There are no comparables for RGA. MetLife has Pru, Principal, Lincoln National, and a few more. So, I may speculate on MetLife in order to get some cheap RGA. Most likely, I’ll need to see the terms, but if RGA is up a lot tomorrow, and MetLife is not, I may just do the swap.

Note to my readers: one odd thing about my blog is that I write about a wide number of issues. I know I have been doing more on my stock investing lately, but that is partially due to the lack of news on the macro front. That’s the nature of what I do. I am an investor that pays attention to the global economy. I’m trying to make money off my insights, and not merely report on what is happening. I hope some of it rubs off on my readers also, and that you personally benefit from it. For those who find my blog to be a confusing melange — well, that’s who I am, a generalist whose interests are broad.

But, if you like the individual stock coverage, let me know. If you hate it, let me know also.

Full disclosure: long CHIC SFD HMC NTE RGA NAHC LNC

Book Review: While America Aged

Posted on 31 May 20081 June 2008 by David Merkel

Where were you while America aged? 😉 I’ve been following the issues in this book written by Roger Lowenstein for over 20 years. As an actuary (but not a pension actuary) and a financial analyst, I have written about the issues involved since 1992.

Roger Lowenstein motivates the issues surrounding pensions by telling three stories, those of General Motors, the New York City Subway, and the City of San Diego. He captures the essence of why we have pension problems in a way that anyone can appreciate. I sum it up this way: promises today, payments far in the future. Get through the present difficulty, at the price of mortgaging the future.

If you repeat that recipe often enough, you get into a tough spot, as GM is in today. Give GM credit though, a lesser firm would have declared bankruptcy long before now, and shed its pension liabilities to the Pension Benefit Guaranty Corporation [PBGC].

Given the softness of funding requirements for pension liabilities, the easy road for corporations and municipalities has been to skimp on funding pensions, leaving a bigger problem for others to solve 10+ years later. As for municipalities, review my recent post here.

Now, why didn’t the US Government insist on stricter funding standards for pension plans? Because of pushback from corporations and municipalities. The US Government hoped that their funding methods for corporations would encourage the creation of pension plans, and that corporations would be good corporate citizens, and not play it to the edge.

As for municipalities, which are not subject to ERISA, as corporations are, the government assumed that they would act in their best long-term interests. Alas, but governments are run by men, not angels.

I found each of the three stories in the book to be interesting and instructive. They are tales of people aiming at short-term results, while letting the future suffer. In the case of the NYC Subways, the plan sponsors finally fought back. With GM, they accomodated until they were nearly dead. With San Diego, they compromised until it cost them their bond rating, and many people involved got sent to jail.

As any good author would, the book offers a few solutions at the end, but it recognizes as I do, that we are pretty late in this game — there are no “good” solutions. There are solutions that may aid future generations. An example is making municipalities subject to the funding requirements of ERISA. I agree, and add that we should apply that to Federal DB [defined benefit] plans, and Social Security too. This could be our own Sovereign wealth fund, investing overseas for the good of US retirees. (What, there is no money available to do that? What a shock.)

I would also add that the funding requirements specified in ERISA are weak. The standards for life insurance reserving are stronger. The weak standards were there to encourage the creation of DB plans. Well, you can encourage creation, but maintenance is another thing.

A certain level of overfunding is need in good times, hopefully, with discipline not to increase benefits. That overfunding is hard to achieve, because the IRS discouraged overfunding above a certain level, because it did not want companies to shelter income from taxation by contributing to the DB pension plans.

Now, I have also reviewed the book Pension Dumping. Which one is better? For the average reader, While America Aged motivates the topic better, but if you want to dig into some of the deeper issues, Pension Dumping does more.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission. This is my version of the “tip jar.” Thanks to all who support me.

PS — In some ways, the actuarial profession comes out with a black eye in books like this, and I would say that it is deserved. I don’t believe in professions, per se. Self-regulating guilds/industries are a fool’s bargain. There are no guilds/industries where if you can’t explain it to a bunch of average folks, there should be no cause for discipline from society at large. What stinks to me, is that there is no hint of discipline to any of the actuaries, and other third party consultants from the actions that they took to support the actions of politicians and corporations where they bent and broke pension funding rules. The ABCD? What a joke.

A Good Month — A Good Year, so far

Posted on 31 May 2008 by David Merkel

Of the 35 stocks in my portfolio, only 4 lost money for me in May: Magna International, Group 1 Automotive, Reinsurance Group of America, and Hartford Insurance.? My largest gainer, OfficeMax, paid for all of the losses and then some.

I am only market-weight in energy, so that was not what drove my month.? Almost everything worked in May: company selection, industry selection, etc.? My other big gainers were: Charlotte Russe, Helmerich & Payne, Japan Smaller Capitalization Fund, and Ensco International.? I have often said that I am a singles hitter in investing — this month is a perfect example of that.

Now, looking at the year to date, I am not in double digits yet, but I am getting close — I am only 3.6% below my peak unit value on 7/19/07.? My win/loss ratio is messier: 15 losses against 32 wins.? It takes the top 5 wins to wipe out all of the losses.? The top 5: National Atlantic, Cimarex, Helmerich & Payne, Arkansas Best, and Ensco International.? Energy, Trucking, and a lousy insurance company that undershot late in 2007.

The main losers: Deerfield Triarc (ouch), Valero, Royal Bank of Scotland, Avnet, and Deutsche Bank.

I much prefer talking about my portfolio than individual stock ideas, because I think people are easily misled if you offer a lot of single stock ideas.? I have usually refused to do that here; I am not in the business of touting stocks.? I do like my management methods, though, and I like writing about those ideas.? If I can make my readers to be erudite thinkers about investing; I have done my job.

So, with that, onto the rest of 2007.? I don’t believe in sitting on a lead — I am always trying to do better, so let’s see how I fail or succeed at that in the remainder of 2007.

PS — When I have audited figures, I will be more precise.? You can see my portfolio, for now, at Stockpickr.com.

Full disclosure: long VLO AVT NAHC XEC HP ESV MGA GPI RGA HIG OMX CHIC JOF

Industry Ranks

Posted on 31 May 2008 by David Merkel

Time for another dose of my industry ranks.? Here’s the list, complete with the ideas that are most attractive for me to investigate:

Remember, this uses the Value Line Industries, and it can be used in Value mode (green industries), or Momo mode (Red industries)? I look to buy from the green list, but I have a tendency to let companies that I own that are on the red list hang around.? Momentum tends to persist in the short run, and I have usually trimmed exposure due to my rebalancing discipline.

My next reshaping is not until early July, but I expect that it will be a doozy, because I will redeploy proceeds from National Atlantic, as well as a new slug of cash that I have received.? I’m running at 12% cash now, but if you count in National Atlantic, it is more like 18%.? That has to come down, so in a month or so, I will have to deploy cash.? I’m looking for a downdraft to do it in, but those don’t always come on schedule.

Full disclosure: long NAHC

Accepting Defeat

Posted on 31 May 200831 May 2008 by David Merkel

Part of being a good investor is recognizing when you have lost, so that you can cut your losses, or focus on what can win in the future. Today, I recognize my loss on National Atlantic. Why today? After talking with a friend who knows more than me about appraisal rights in this situation, in New Jersey, in cash deals there are no appraisal rights allowed, unless specifically granted in the corporate charter. Here is an example from a NJ bank deal.

Ugh. It shouldn’t be this way, but it is. Maybe someone with deep pockets could sue NAHC and its board and management, jointly and severally for fraud, but those pockets aren’t mine. So, I look forward to the merger vote. I will vote my 0.15% of the shares “against,” but I realize the NAHC management plus the arbs hold enough shares to win. Personally, I really dislike the disinformation that they have written in their definitive proxy regarding runoff; they paint a scenario that does not ring true with my knowledge of the insurance business.

$6.25/share — It could be worse, right? No, probably not. 🙁

Full disclosure: long NAHC

A Quick Run Through a few of my Indicators

Posted on 30 May 200822 June 2017 by David Merkel

After this article, I plan on doing a run through some longer-dated thoughts of mine — I figure when things are relatively quiet, it is time to start thinking about the bigger picture.

Quiet? Are things quiet now? Well, sorta… we still have problems:

We still have an oversupply of houses.
Investment banks are still overlevered in their swap books.
Commercial property prices are beginning to fall, and that will have negative effects on the equityholders, and those who finance them.
Though there is no logical replacement for the US Dollar as the global reserve currency, the US is gaming the system, passing inflation through to the rest of the world. Maybe the world doesn’t need a reserve currency. In any case, there are a lot of annoyed central bankers looking to drop their peg to the US dollar at a convenient time that doesn’t hurt their home economies badly.
We are still waiting for the junk issuance from 2004-2006 to start defaulting in size.
Our retiree healthcare cost crisis is coming in five years, and will last for two decades.
The pension crisis comes in the next 5-10 years, and will last for two decades.
Most of the demographic crises will cover the developed world.

But as for now, the news flow is light, and nothing is presently cratering. Consider the short-term lending markets:

This graph shows the difference between yields on A2/P2 commercial paper and the 2-year Treasury. What this says is that a BBB company can borrow unsecured for a month at 2.7%. Not bad. Now look at the Treasury-Eurodollar [TED] spread:

Things have improved. The TED spread is down to 0.78%. To me, normal is 60 bp or lower. The question still remains as to what happens when the Fed begins withdrawing its new lending facilities.? As it stands now, they seem to be increasing them further.? (I don’t get it.)

In the midst of this, the Fed has not increased the monetary base in a loosening cycle. The last permanent injection of funds was 5/3/07, long before they started to cut rates. What growth in credit has come from a loosening of the leverage policy toward the banks.

As you can see, we have hit levels of total liabilities of the banking system versus the monetary base of the Federal reserve that we haven’t seen since the early 80s. (I need to multiply that graph by 1000 to show that the multiple is 11x. Oops.)

But, my proxy for bank profitability on new money shows that if you can borrow at 12 month US LIBOR, and lend to fund Fannie Mae 30-year mortgage passthroughs, you can make good money now.

What of Fed funds policy? The market is expecting a 25bp hike in December. I think they are dreaming, but if you are going to bet, you have to know the line.

What of inflation expectations? Above is my 5-years forward 5-year inflation graph. The expectations of inflation are low, at least as far as institutional investors are concerned, even as the measure of inflation underlying TIPS rolls ahead at 4% or so.

At least the yield curve has resumed a normal shape, as noted before, that will be good for the banks in the long run.

Now, since mid-March, global long rates have bottomed.? I use 10-year swap rates here because they are more comparable than government bond rates.? From my viewpoint, this is due to an increase in expected nominal growth for the Gross World Product.? I can’t tell whether that is coming through inflation or real growth, but I am guessing at mainly inflation.

So, after all of this, where do I stand?

We still have problems to work through. (See top list above.)
The short term lending markets have largely normalized.? So has the yield curve.
The economy may not be in recession.? Then again, it is probably close to the line.
Long-term implied inflation measures are quiet amid a jump in global inflation measures.
Global long rates are rising.
If the banks can lend, they can make decent money on new loans.
The Fed is still trying to be “too cute,” solving problems through unorthodox means.? Hey, for now it is good, but who can tell what the long term effects will be.? I am still a skeptic here.? Until they unwind the new lending schemes, and return to a clean balance sheet, the game is not over.

One Way to do a Good Survey

Posted on 29 May 200822 June 2017 by David Merkel

I get asked to participate in surveys, and frequently, I look at the surveys and think, “You’re wasting everyone’s time here. Some people grade everything harshly, some people grade everything easily. Many people keep their responses within a restricted band, other go for the poles.? Besides, you’re asking too many questions.? Few people have that many strong opinions.”

What I am going to suggest here applies to questions like, “How can we improve our marketing, service, or operations?” I used this technique several times to improve the marketing at an insurance company that I worked for. Here is the core of the idea: if you want to elicit accurate opinions on surveys — use a constraint.

When I survey people, I do a one question initial survey to ask what the issues are that they care about. It is just a brainstorm to identify issues. Then I follow with a one-question survey that lists all of the issues, and then I say: “Pretend you are the marketing director, and that you have a budget of $100,000. How would you divide up the budget?”

Placing a budget constraint on their answers forces respondents to optimize. It also standardizes, so you don’t have to adjust for optimists and pessimists. It’s a very simple question, so answers are sharp. And, if someone feels very strongly about just one item, they can express that. Plus, it values the time of those you are surveying, so they are more willing to answer; you get almost 100% completion.

Anyway, this method has worked well for me. If you try it, and it works well for you, or doesn’t, let me know.