Year: 2008

An Anomalous View of Stock Investing

An Anomalous View of Stock Investing

Posted on by David Merkel

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening.? I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional.? I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG With Est Growth, PEG With Hist Growth, and two of O’Shaughnessy’s screens – Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street.?? That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment.? There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle.? I mentioned how much I like the CXO Advisory blog.?? One page to visit is the Big Ideas page, if you like academic finance papers.? I want to give you my short synopsis of what seems to work:

  • Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
  • Price momentum
  • Low accrual accounting entries as a fraction of earnings or assets
  • Piotroski’s accounting criteria
  • Low net stock issuance
  • Positive earnings surprises
  • Low historical return volatility
  • Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues.? Let me summarize them one more time:

  • Look for a cheap valuation.
  • Look for mean reversion, but don’t try to catch a falling knife.
  • Grab positive price momentum and earnings surprises.
  • Look for sound accounting, and management that is loath to dilute shareholders.
  • Avoid volatile stocks
  • Look for neglected stocks

That’s my my quick summary for what seems to work in stock selection.? I invite commentary on this.? I downloaded a lot of the papers cited, and will be reading them over the next few months.

Score One Success for the Federal Reserve

Score One Success for the Federal Reserve

Posted on by David Merkel

I’ll give the Federal Reserve this, their TAF program has succeeded in bringing down US Dollar LIBOR rates relative to Treasuries and Fed funds.? I did not doubt that they could succeed at doing this; my main concern is what happens when they stop doing this.? Flooding the short end of the yield curve with liquidity has overwhelmed those seeking permanent liquidity cheaply, by offering large amounts of temporary liquidity cheaply, and saying that the program could become a regular part of the Fed’s policy tools.

So, the most recent auction priced out at 3.95%, well below the Fed Funds target of 4.25%, and below where Fed Funds have averaged recently, which is around 4.15%.? Why borrow at Fed funds if the TAF is available?? The TAF can accept a wider array of credit instruments as well.? Why even give a second thought to the discount window at 4.75%, if the same collateral can be financed by the TAF?? Granted, the rate was above the expected fed funds rate for the next month, but using that as a guideline is tantamount to surrendering control of the money supply to the Fed Funds futures market.

Looks like a win for the Fed, at least in the short run.? The long run could be a different story.? The old rule of Walter Bagehot was for the central bank to unlimitedly lend against secure assets at a penalty rate in a crisis.? In this case, it is lending against less than top-quality assets at what is a bargain rate.? In the long run, that is a recipe for monetary and price inflation.? Though longer-dated TIPS don’t reflect that future consumer price inflation, I expect that they eventually will.

Relying on the Kindness of Strangers as an Investment Strategy

Relying on the Kindness of Strangers as an Investment Strategy

Posted on by David Merkel

In 2002, when many credits were troubled, I would look at some of troubled positions that we held and do a recovery analysis, to see what we might get if the company filed for insolvency. Often in that process, I would find that investors elsewhere in the capital structure had different motivations than we did. The bank might prefer to liquidate the stinker, while the bondholders, in a more junior position, would prefer it kept as a going concern. Or, the equity investors that have control of the company might pursue a unprofitable strategy that encumbers the assets of the firm, leaving the bondholders with a less valuable entity for their debt claims. Or, the company could issue secured debt, effectively subordinating bondholders, while providing cash that could be used to buy back stock. Another case is when you have a valuable company with a liquidity problem. The banks will be willing to lend against that trapped value so that the company can repay bondholders, right? Right?! (Sigh.) In most of these situations, a bond investor finds that he is implicitly relying on the kindness of strangers. That is rarely a good place to be. 🙁

Now, a few judicious debt covenants could partially level the playing field, but with investment grade bonds those are rare. (Covenants work a lot better than fraudulent conveyance lawsuits, etc….) My main point here is that it pays to analyze situations in advance to understand when your bargaining power is weak. Risk control is best done on the front end, not the back end. Equity/Management will always hold the “capital structure” option to some degree, and unsecured lenders will always have a weak hand there.

So when I read this article about ladies in Baltimore losing their homes because they didn’t do enough scrutiny of the mortgage documents, partly because they were deceived by people who were seemingly experts, who said that they would be able to refinance the rate when the reset date hit, I thought about relying on the kindness of strangers again. It would be one thing if guaranteed refinance terms were offered at the initial refinancing, but absent that, credit conditions are fickle, and it can be a short interval between loose credit and tight credit. Relying on the ability to refinance a debt is always risky.

Today, consumer credit terms are tight. A year ago, they were moderately loose. Two years ago, terms were stupid loose. Who knows, later this year, terms could become stupid tight, where even good quality borrowers with adequate security can’t get credit.

Again, in investing, and even in personal finance, strive to understand your bargaining position. Do you hold the options? If it’s not you or those with you in your position, then others hold the options to control the assets. Usually those are held by the equityholders (or management, who sometimes act in their own interest, not that of the shareholders), and senior or secured debtholders. Those with weak positions, like preferred stockholders, unsecured and junior debtholders must be compensated for the weak position with extra yield or covenant protections.

The same analysis applies to structured securities, whether the credit enhancement comes from a guarantor or a senior-subordinate structure. In the good times, the equity controls the deal. In the really bad times, control often slides to those who are most senior in the capital structure.

On a personal level, a house is controlled by the owner if he can stay current on the payments (if any). Absent that, the bank controls the situation, subject to the rights of other claimants (the taxman, home equity lenders, mortgage insurers, etc.)

If strangers are kind to you, that is a good thing. Be grateful for a society that encourages that kindness. But don’t rely on it in investing or personal finance.

PS — sometimes even a good analysis of your rights and options can go awry. The KMart bankruptcy was a good example of that, where KMart had assets worth more than their liabilities, and could have gotten financing to continue. But a bankruptcy judge allowed their petition, and they were able to give creditors and lessors the short end of the stick. Those that controlled KMart post-bankruptcy made out handsomely. It would be difficult to repeat that aspect of the success.

Thus, you might look at this good article on Sears Holdings (successor name for KMart) in a slightly different light. The financial engineering gains can’t be repeated. It now must make its money as a retailer. As the article gently points out, being a good investor and a good retailer don’t naturally go together.

Bringing this back to topic, does management of Sears act in the best interests of shareholders? Management has the incentives to do so, but sometimes the intellectual gratification of the CEO can get in the way of making good business decisions. Management has control, the outside passive minority investors do not. Their only options are to ride on the Sears bus, or get off. If an investor doesn’t think the management of Sears is doing it right, he would be foolish to trust them with his money.

How to Manage a Portfolio

How to Manage a Portfolio

Posted on by David Merkel

Given the title above, I feel embarrassed to write, because the topic is too basic. I write because too few managers think clearly on the topic. The following analysis applies to long only funds and hedge funds; it also applies to equity and bond funds. The impetus to write this note arrived because the Fidelity Magellan Fund is reopening because cash inflows will make the life of the portfolio manager easier… not that he will get many inflows for now.

My view is that it should not be hard to manage a shrinking portfolio. It is much harder to manage a rapidly growing portfolio. (I have experienced that, and that is a topic for another day.) Here is the key concept: the portfolio manager must rank his portfolio by expected returns, adjusted for risk. This applies to both the longs and shorts. If there are cash inflows to a portfolio, assets should be allocated to the highest returning assets. If cash outflows, assets should be liquidated from the situations with the lowest expected returns. It is that simple, and I did that when I was a corporate bond manager. It worked well.

The reason why it will not be implemented at many asset management shops is that it takes work to do it, and we all avoid work if we can. But maintaining lists of long and short ideas ranked by likely risk-adjusted returns will yield better decision making, if one will do it.

What of the January Effect?

What of the January Effect?

Posted on by David Merkel

I’m not feeling well this evening, so this will be a short post dealing with one simple issue.? (If I have strength, I may do one more.)

The January Effect is one of the best known calendar anomalies.? Stocks and high yield bonds tend to do well after the first day of the new year. This happens because these assets get oversold as some investors sell losing positions for tax reasons.? This tends to be more powerful for stocks that have done poorly over the past year, and for small companies, and value stocks.? This year it seemingly hasn’t happened.? Why?

First, all anomalies exist within a broader market environment.? When enough market players jump onto an anomaly, the anomaly outperforms in the short run, but peters out, because all interested parties have bought in.? If that were true of the January Effect, we would see the gains made in December, rather than January.? That’s not what happened this year.? (Anomalies tend to do best when they are ignored.)

Second, in a market where small value stocks may be overvalued, the January Effect could disappear for a year while small value stock valuations adjust back to normal, or below that.? That might be true this year.

We are in the winter season, not just for the calendar, but for small stocks and value investing. ? I feel the winter chill in all that I do at present, and no, I am not talking about the lack of insulation in my hovel.? I have the winter wind in my face now (much as I remember walking home from high school in Milwaukee), and yet I know that this is the time that my best purchases are likely to be made.? I have to focus on my core disciplines, and buy good long-term cash flow streams cheaply.

Before I close, I would say that a new favorite blog of mine is the CXO Advisory Group blog.? For quantitative investors, there is a wealth of knowledge there.

The Fed, Financial Guarantors, and Housing

The Fed, Financial Guarantors, and Housing

Posted on by David Merkel

This post will be a little more disjointed than others. One housekeeping note before I start: I’m behind on my e-mail. I will catch up on it next week, DV.

Fed and Federal Government Policy

I don’t know; it seems like there are rumblings that the Fed will imminently take action, and that does not resonate with me. You can also read the stuff from Doug Kass at RealMoney, or consider the rebirth of the Plunge Protection Team. We are not so far from the next Fed meeting that waiting would make that much of a difference, particularly since the Fed tipped its hand when Bernanke spoke recently. There is a decent-sized cut coming, and the Treasury yield curve reflects it.

Now, I have my doubts as to the long-term efficacy of unusual measures from the Fed or the Treasury. You can’t get something by government fiat. Even a Fed Governor thinks we expect too much from the Fed, a sentiment with which I heartily agree, even though the Fed is partially responsible for creating that illusion. If the Fed took more of a “we do our best, but our powers are not that large in the long run” approach, market players might not give them so much credence.

Now, I’m not going so far as Anna Schwartz, who thinks the current Fed isn’t up to the task. That may or may not be true; what is hard to dispute is that Alan Greenspan dealt the existing FOMC a bad hand from a prior monetary policy that too easily responded to minor crises, rather than letting the economy take some pain. Moderate recessions are good for the economy; save the heroics for depression-like conditions.

Financial Guarantors

I may fail at it, but I try to be honest and self-critical here at my blog. For example, I did not suggest that Warren Buffett would buy Ambac, but I was misinterpreted as saying so. Now that Ajit Jain says that Berky might buy into one of the financial guarantors, I am not going to say that I predicted that, because I didn’t. It would be amusing if Buffett announced his new entry into the financial guaranty space to drive their prices down so he could buy a stake cheaper, but that is not his style. He values his reputation. That said, the NY regulator may not have thought enough steps ahead in pushing for Berky to set up a new guarantor. Good for new issues; perhaps not as good for old ones at legacy carriers.

Now, I admire Marty Whitman and Aldo Zucaro, but so far, their forays into the mortgage guaranty space have not worked out. I’m not counting them out, but it still may be early for that trade. Maybe we should wait for one of the companies to fail. The remaining companies should do well, once capacity drops out.

As for MBIA, they cut their dividend, which to me indicates a lower future level of profitability. Then they raise $1 Billion through surplus notes at their operating subsidiary, and pay 14% to do that. That has to be a record spread for a new-issue nominally AA-rated bond. Personally, I think I would pass on the notes, except for a flip. I would rather hold the common. Scenarios that would kill the common would most likely also kill the surplus notes. The common has more upside potential.

Residential Real Estate

I am fascinated by the willingness of some of the courts to insist on strict standards before they allow lenders to foreclose. Examples:

In general, I think there are legitimate flaws in the documentation that got ignored before the number of attempted foreclosures became so large. This is pointing out some stresses in the system. When this is done, securitization will not vanish; it will just be better managed.

Now as a final note, it is somewhat shameful that banks can’t follow FAS 114. The calculations aren’t hard; they just don’t want to recognize losses that they should recognize. That’s the real issue, so FASB and Congress should not give in here.

Industry Ranks and Additional Stocks

Industry Ranks and Additional Stocks

Posted on by David Merkel

If I did not use a mechanical method for ranking replacement candidate stocks against my portfolio, I would not let so many stocks go onto my potential replacement list. Today I updated my industry model, and here it is:

Industry Groups January 2008

(If you have any difficulty downloading that, let me know. I’ve been having trouble with that.)

From that, I ran a bunch of screens, adding in some technology industries that have been hit of late. Here are the additional tickers that will be added to my candidates list: AMIE ASYT BBBY BC BELM BGFV BIG BNHN BRLC BWS CAB CBR CHRS CHUX CMRG CRH CTR CWTR DBRN DECK DFS DSPG DSW ESEA EXM EXP FHN FINL FRPT FSS GASS HGG HLYS HTCH HZO IDTI IKN IM IMOS JAS JNS KSWS KWD LF LIZ LNY LSI MIPS MRT NSIT NSTC NTY ODP OPMR OVTI OXM PERY PLAB POOL RCRC RENT ROCK RSC RT RUTH SAIA SHOO SIG SMRT SNA SNX SONC SSI TJX TOPS TUES VLTR VOXX ZQK

Now, the mechanical ranking system is supposed to be a simple way of prioritizing value stocks, and typically it does pretty well in directing my attention to the stocks that I should analyze, not necessarily the ones I should buy. That’s true of any screening method, no matter how simple or complex. You always find some companies that look really good initially, but got there because of data errors, accounting mis-characterizations, or a business situation that was vastly different when the accounting snapshot was taken.

Now, after all of this work, I’m only trading 3-4 stocks into and out of my portfolio of roughly 35 stocks. But the idea is to end up with a portfolio with better offensive and defensive characteristics, such that the relative performance will be good, and should the market turn, I will be in the industries and companies with a lot of potential to outperform.

Time for the Next Portfolio Reshaping

Time for the Next Portfolio Reshaping

Posted on by David Merkel

I will admit, I don’t feel much like doing my portfolio reshaping now, even though it is a part of my management discipline, because the portfolio has been kicked around.? Not much worse than the rest of the market, though, and there are some stocks that look interesting that could be worth considerably more three years out.? As you look through my tickers list for candidates for addition, you’ll see a few commonalities:

  • Energy (still)
  • Industrials (still)
  • Retail (now, that’s new)
  • Insurers (many still cheap, particularly some stronger operators, also title names)
  • Technology (different for me)
  • ?A few odd real estate names (not likely, but there are some places where values are protected)

So, the process begins.? Within a few days, I’ll run my industry model, and do a few screens off of it, adding a few more tickers.? Beyond that, I invite you to send me ideas as well.? Last time, ideas suggested by readers made up two of the four new names that I bought.? So, send them in, and thanks as always for reading me.

The replacement candidate tickers:?? AA ABK ACIW AEO AES AIG AIT ALL APA APL ARM ARO ARW ASGN ATU ATW AVCA AVZA AZ BAC BCS BER BGP BKE BKS BRO BRY CACC CAE CAKE CALL CAMD CBL CCRT CHS CNQ CNX COF COST CQP CRI CRK CRZO CSCO CSG CSGS CSL CTLM DDS DFG DITC DLB DNR DRI DTLK DVN EAT EEP EFII EMC ENWV ESST ESV EXAR EXTR FLEX FNF FNM FRE FSII GCA GLW GPC GS GSIT GSK GW HAS HCC HCSG HD HIG HILL HMC HOC HOG HOLX HPQ IDTC INAP INFN INSP INT INTC IRE ISSI JCG JCP JEC JRT JWN KEM KFT KSS LINE LM LOOK LRW LUV LYG MAN MAS MDC MHK MHP MHS MMC MNST MTSC MTW MU MUR MVC MW MWA NOV? NSH NSR OII OMX ORI OXY PCZ PDC PDE PDII PDS PHLY PNCL PNRA POL PROS PTEN PVSW RAMR RAVN RGA RIG RNIN RNWK SCMR SGP SIMG SKS SKSWS SKX SLXP SNY SPN SSTI SSW STC STI SU SWK T TECH TECUA TEX TGI TLGD TMTA TM TNB TOT TRID TRLG TSO TWB UFS UNP URBN USG VFC VMC VNR VPHM WAG WCG WDC WHQ WLL WSM WSTL WU WWW XL XTEX XTO

PS — Though I don’t feel like doing it, I didn’t feel like doing it in the Fall of 2002 either,and some of my best picks came then.? So, discipline before feelings.

Politics and the Fed

Politics and the Fed

Posted on by David Merkel

I do not share the view that the Fed is above politics.? The Fed was created by politicians.? They appoint/approve many of its governors.? They set the rules for what the Fed is authorized to do, whether the Fed follows that or not.? The politicians can change the rules if they want.

Beyond that, there is the formal and informal lobbying from businessmen, bankers, and speculators, who might implicitly argue for preservation of purchasing power, or stimulation of the economy.

There is also the interaction of the Fed with the Department of the Treasury.?? So, from all of this, I view the Fed as an implicitly political institution, which is why my analyses of the Fed stem largely from the economics of the situation, but do not end there.? I engage in “game theory” analyses of prospective Fed actions, asking myself how different scenarios would be received politically.? The Fed lives to protect itself.

So, when I read articles that suggest an apolitical Fed, I come to two possible conclusions:

  • The truth is being stretched, and what you hear serves a political goal, or,
  • The Fed governor speaking does not care about reappointment.

Politics abhors idealists, outside of semi-revolutionary moments.? Being the art of the possible, politics favors compromisers.? As I see it here, the Fed is under a lot of political pressure to stimulate the economy, and not under a lot of pressure to restrain inflation.? Should it surprise us if the Fed continues to loosen, perhaps aggressively?

Pandora and the Fair Value Accounting Rules

Pandora and the Fair Value Accounting Rules

Posted on by David Merkel

I’ve been involved in financial reporting for a large amount of my career, so even though I’ve never had an accounting course in my life, I’ve had to work with some of the most arcane accounting rules out there as an actuary, and later as an investor.? Over the years, the direction that the FASB and IASB have gone is in the direction of presenting the statement of financial position (balance sheet) on more and more of a fair market value basis.? (Please ignore the treatment of goodwill, advertising,? R&D, you get the idea though…)? To soften the blow on the income statement, changes in the value of many balance sheet items don’t get run through net income, but through accumulated other comprehensive income, so that income can reflect sustainable earnings power, in theory.? Now, I agree with Marty Whitman’s critique on these accounting issues.? We may be getting more accurate on individual companies (if the accounting is done by angels, for humans we are granting too much freedom), but we are losing comparability across companies.? What an item means on the balance sheet of one company may be considerably different than the value at another company.
The hot topic today is SFAS 157 and 159.? I would point you to Dr. Jeff’s article this evening on the topic.? I would like to give my perspective on this, becaue I have had to work with these accounting rules, and ones like them.

At one company that I managed money for, I originated a bunch of long duration high quality assets that did not trade.? At year end, our incentive payment was based on the total return that we generated.? Interest rates had fallen through the year, and so my high quality illiquid assets had yields well in excess of where new money could be deployed.? What were those assets worth?? Historic cost?? The cash flow streams were fixed.? As a conservative measure, though spreads over Treasury yields had fallen for those instruments, we kept the spreads from the issue, and accounted for the price change due to the move in Treasury yields.? (If spreads had risen, I would have argued that we move the spreads up as a conservative gesture.)? Now this was prior to SFAS 157, but it illustrates the point.? How do you calculate the value of illiquid instruments?? Worse, under SFAS 157, you can’t be conservative; you have to try to be realistic.

Now, that was a simple example.? Almost every moderate-to-large life insurance company has a variety of illiquid privately placed bonds for which there is no market.? What is the fair value?? Who can tell you?? Well, the broker(s) that brought the deal are supposed to provide continuing “color” on the bonds, and what few trades might transpire.? Typically, they don’t move the prices much as the interest rate and spread environments change, and third party pricing services are loath to opine on anything too illiquid.? Though the rating agencies night give a rating at issue, they might not update it for some time.? What’s the fair value?? The life insurer has a hard time determining that for that small minority of assets.

Now let’s take it to a yet more difficult level.? If we are talking about many asset-backed securities, they are generic enough that pricing models can determine a spread to Treasury or Swap yields for tranches with a given vintage, maturity, originator, and rating.? Yes, there will be many assets that “trade special,” but those are deviations from the model that the traders feel out.

With CDOs, things get more difficult, because aside from indexed CDOs, there is no generic structure.? The various tranches are bought and held.? They rarely trade.? Projecting the cash flows is a difficult talk, because there are many different bonds in the trust, with many different scenarios for how many will default, and what recoveries will be obtained.? The best a good simulation model can do is to illustrate what a wide variety of possibilities could be, and look at the average of those possibilities.? Even then, the modeler has an expected cash flow stream.? What’s the right discount rate to use?

There is no good answer here.? One can try to infer a rate from what few trades have happened in the market with similar instruments, but that can be unreliable as well.? During a bear market, the sellers will be more incented than the buyers, particularly if they are trying to realize tax losses.? One can try to look at the scenarios across the tranches, and see which tranches have cash flows that behave like bonds, equities, and warrants, and apply appropriate discount rates like 6%, 20%, and 40% respectively.? Some explanation:

  • Bonds: pays interest regularly, and principal within a narrow window.? Few deferrals of interest.
  • Equities: high variability of payoffs.? Pays something in almost all scenarios, but the amounts vary a lot.? Timing and existence of principal repayment varies considerably.? Interest deferrals are common, but rarely last long.
  • Warrants: many scenarios have very low or zero payoffs.? Some scenarios have significant payoffs.? Interest deferrals last a long time, many never end.? Principal payments are rare.

Estimating fair value in a case like this is tough, if not impossible.? But a fair value must be estimated anyway.? Management teams may try to make the third party estimator come to a certain value that fits their accounting goals.? Given the squishiness of what the discount rate ought to be, management teams could say that once the market normalizes a low discount rate will prevail, and our models should reflect normalized, not panic conditions.

Well, good, maybe.? The thing is, once we open Pandora’s box, and allow for flexibility in valuation methods, subject to auditor sign-off (now, who is paying them?), our ability as third party investors to evaluate the value of illiquid assets and liabilities declines considerably.? There’s a great argument here for avoiding companies that own/buy complex assets in an era where fair value accounting reigns.? There is too much room for error, and human nature tells us that the errors are not likely to yield positive earnings surprises for investors.

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