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Archive for December, 2011

Goodbye 2011

Saturday, December 31st, 2011

I tried to think of a post where I would bring out the best of 2011 economically, but the best I could some up with was, “It could have been worse.” That doesn’t convey much fondness.

2011 was characterized by using debt to “solve” debt problems.  Avoid default, extend the loan.  Or, let a public entity refinance the loan.

2011 was a year of rebellion — more pointedly in the Arab world, late to Russia and China, and lazy in the US.  Lefter then most leftists, like Marx, they assume that a wimpy “protest” will produce change.  Sorry, you have to organize, produce leaders, and either influence existing parties or create a new one, or, fight (of which I am not in favor).  If “Occupy” can’t do that, it ain’t worth a warm bucket of spit.

And personally, I am disappointed in those that have come out in favor of Occupy, not because their many contradictory causes don’t have merit, but because Occupy is so singularly ineffectual.  “You say you want a revolution, weelll you know, we all would like to change the world.”  Talk is cheap.  Disorganized talk and effort is pollution, not cheap; we would pay to have it eliminated.  Either organize, or be gone.

As far as the stock market went, it was volatile, but went nowhere.  As for me, I had my worst relative performance calendar year in 12+ years being down 1% while the S&P 500 was up 2%, with dividends.

The US politics of 2011 was nothing abnormal — we have had other periods of delay and intransigence, but few where we ran such huge deficits, and for so little good.  (Congress has not declared war, after all.)  Personally, I am for Ron Paul, not because I like everything that he stands for, but because his delegates have the best odd of deadlocking the Republican Convention, and leading to the selection of another candidate far better than the midgets currently out there.  Personally, I think primaries are overrated, and think we might be better off with conventions where parties analyze/fight over who would be the best candidate.

Never have we had a world so indebted, where there are so many fixed claims asking to be paid out at par.  The future has ugly surprises awaiting creditors — you won’t get repaid in full, whether by inflation or compromise.  Overages of debt clamor to become equity, and only such a change will heal the global economy.

If you are a lender, analyze your portfolio and adjust it where you can to the strongest borrowers.

But goodybye 2011, it was not a good year for me, and for many.  May 2012 be far better, and may we see orthodox policies triumph, even if prosperity lags.

PS — and eliminate or curb the Fed, please.   If there is dirty work to be done, let Congress do it so we can vote them out.  Would that Ron Paul is our next President with a a compliant Congress that will rip out and eliminate our third failed central bank.  We would have some hard times for a number of years, but once they end, the growth would be strong.

Recent Tweets

Saturday, December 31st, 2011

I’m going to try as an experiment publishing my tweets at my blog.  They highlight significant articles that I have read.  Let me know if you want me to do this regularly.  Alternatively, you can get my tweets via RSS or email, as I described here.

Anyway, here are the tweets:

China’s Top 10 Business Stories in 2011 http://bit.ly/rRN3S0 Patrick Chovanec, professor in China gives his perspectives on a tough year $$

 

Job Creation Is Price for US Health Law bloom.bg/rK5s7R Inflexible mandates on business tend to decrease jobs in the economy $$ #yup

 

Spain says deficit bigger than expected, hikes taxes reut.rs/vF8gLj Spain goes for austerity amid large budget deficits. Surprise! $$

 

Fear Recoupling in ’12, Not the End of the World bloom.bg/unlphk Pesek on dangers from Asian economic 2nd-order effects in 2012 $$

 

Heterodox economics: Marginal revolutionaries econ.st/tGlNai The Economist on the effect economics bloggers have on the mainstream $$

 

Bonds Prove Best Financial Asset in 2011 bloom.bg/tvL3z5 Leave aside Shilling, Hoisington & a few others. Who called this? I didn’t.

 

Major Dubai companies ‘may need bail-outs’ tgr.ph/v00OEW It is usually not wise to lend money on projects that are grandiose. $$ #duh

 

Borrowing From ECB Jumps on.wsj.com/vFlbpR If banks wont lend 2 each other bit.ly/v42Tw7 then CBs must lend 2 banks $$ #liquiditytrap

 

SSgA Files For Short-Term Junk Bond ETF bit.ly/tZFizH A promising idea that will get overdone, leading to losses. Nonrated CP anyone?

 

The Germans have many conflicting goals $$ RT @calculatedrisk: Merkel: “Will do everything to strengthen the euro” goo.gl/fb/vxa3h

 

Maybe 2 cents in dividends? RT @BCAppelbaum: If you put $1 in the S&P 500 at the beginning of the year, you would end the year with… $1 $$

 

TED Spread on Watch for Breakout bit.ly/v42Tw7 Short-term lending getting tight, banks don’t trust each other; CBs 2 the rescue? $$

 

A Margin for Error in Hedge-Fund Filings on.wsj.com/sC7KAO Might some hedge funds b mismarking their less liquid stocks? bonds? X? $$

 

BIS Describes the Exposure of Emerging Markets to Europe bit.ly/vJ3w1a Credit slowing down from EZone 2 emerging markets, GDP slowing

 

Deepening Crisis Over Euro Pits Leader Against Leader on.wsj.com/v1pjlz Tale of how Angela Merkel undercut Berlusconi. Clever lady $$

 

Gloomy Picture for Banks in Europe’s Core on.wsj.com/vQftdv EZone Govt’s & banks depend on each other; 2 drunks holding each other up

 

The Q Ratio and Market Valuation bit.ly/tkbOnp Good article going over the Q ratio, what it means, how to calculate & forecast $$

 

California Barred by Judge From Cutting Medi-Cal Rates bloom.bg/uSFCCX Expect this pattern to repeat in a fight over priorities $$

 

Hospice Turns Months-to-Live Patient Into Addict bloom.bg/s0WCiH Misdiagnosis of time to live can create addicted elderly folks $$

 

Contra: Republicans, Lost in Moderation bloom.bg/vCrabB Did the Republicans win more elections b4 or after conservatives took over?

 

Banks Continue to Stockpile Agency MBS bit.ly/tOMvNz Nice credit-risk free asset to pair against cheap funds from the Fed. $$

 

Tough Markets: Punishing Hedge Funds Since 2003 on.wsj.com/vPf2UN Hedge funds in aggregate r yield hogs & abhor volatility $$

 

End of Corn Ethanol? bit.ly/v599bC US ended a 30Yr subsidy 4 corn-based ethanol that cost $6B/yr & ended tariff Brazilian ethanol $$

 

China is a Closed Communist Economy, concludes research bit.ly/ucMjsH The Party is still in control & directs the use of resources $$

 

What Deleveraging? bit.ly/vj9jmZ What is this deleveraging you continue to babble about . . . ? $$

 

ReformedBroker Downtown Josh Brown

Anytime I get nervous about the US economy, I just look over at how calm and stable China seems to be and I feel much better.

Retweeted by AlephBlog

The public sphere is different, where the ECB takes lower-quality collateral; that seems to be loosening things up a bit for now $$

 

European Bank Worry: Collateral on.wsj.com/sbkgGT In the private sphere, loans can only gotten by pledges of hi-quality collateral $$

 

The most stable, dividend paying sectors have the highest PEs, the most cyclical elements tand to have the lowest PEs now. $$ #fear #yield

 

S&P 500 PE 11.85, Industrials 12.37, Discretionary 13.71, Staples 14.59, Utilities 14.72, Telecom 16.84… do you see the pattern? $$

 

The S&P and Sector P/E Ratios bit.ly/rz4LKA Financials 9.68, Energy 10.26, Materials 11.37, Healthcare 11.46, Technology 11.67 $$

 

Forecasting Asset Price Booms bit.ly/tOwuNN The fool does at the end of the boom what the wise man does at the beginning $$

 

Spikes in Bank Stock Volatility Precede Economic Trouble, suggests research bit.ly/vhMdqz Volatility flows through banks 2 economy $$

 

Forecasting Oil Prices with Economic Data bit.ly/toKHW4 Real crude prices go up when global econ conditions r strong $$ surprise, not

 

Investment Advisers Likely To Bear Cost Of More Oversight on.wsj.com/s3REK0 Could put small advisers like me out of business $$

 

Lure of Chinese Tuition Squeezes Out Asian-Americans at California Schools bloom.bg/scxHZm State schools becoming more like private

 

India to Exceed Its Record Borrowing Target bloom.bg/tiMnMi Too many governments r caught on a borrowing treadmill; can’t get off $$

 

China needs new policy course as capital tide turns reut.rs/vmMWsx China will likely have to reduce the reserve ratio at its banks $$

 

Phantom firms bleed millions from Medicare reut.rs/uJOps5 Looong article on how fraud bleeds a lotta $$ out of Medicare->shell comps

The Rules, Part XXVII, and, Seeming Cheapness vs Margin of Safety

Thursday, December 29th, 2011

The market takes action against firms that carry positions bigger than their funding base can handle.  Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.  After that happens, valuation-motivated sellers appear to offer more at those prices.  The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.  As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”  The short-term proclivities of investors usually have no effect on the long run value of companies.  Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.  One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.  And often, they invested in financials that looked cheap, but took too much credit risk.  Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.  Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.  Every time I read something by him or see a video with him, I think, “Bright guy.”  But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.  Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.  From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.  And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.  Are the assets and liabilities properly stated?  Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

  • Company size (the ability of management to make sure values are accurate or conservative declines with size)
  • Rapidity of the company’s growth
  • Length of the asset or liability
  • Uncertainty over when the asset will pay out, or when the liability will require cash
  • Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”  It is also a question of whether the company will have adequate financing to hold those assets in all environments.  For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”  All financial asset values are relative to the financing environment that they are in.  Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.  Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.  Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.  (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.  Do they try to grow rapidly?  That’s a danger sign.  There is always the tradeoff between quality, quantity, and price.  In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.  Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?  How much do they explain away one-time events?  Are they raising leverage to boost ROE, or are they trying to improve operations?  Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?  Even with good financial companies there are disappointments.  With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.  They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.  What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.  Even the others of his top 10 have not done well, and the fund as  a whole has suffered.  Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.  And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

  • A 9.9% return from inception to 5/31/2011 is hot stuff, and,
  • A 6.0% dollar-weighted return is very good as well.  Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”  Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

  • It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
  • Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
  • When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.  The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.  It can be a negative self-reinforcing cycle for some time.  My one bit of advice would be: focus on margin of safety.  If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

2011 Financial Report of the US Government

Tuesday, December 27th, 2011

There is little to no fanfare for the release of this report, (why do they release at such a distracted time of year, where people will ignore it?) which strips away a lot of the malarkey that the US Government delivers by providing data on an accrual basis, rather than on a cash basis, which is what the politicians argue about.  As a result, the politicians take actions that hurt the future in order to benefit the present.  If we viewed the national budget the way this report does, we would have had very different policies over the last 25 years.

As it is the report gives credit to Obamacare for lowering the costs of Medicare, as if a stroke of the law could reduce the medical needs of the elderly.  If it does decrease actual demands on Medicare, unlikely but good.  If not, we need to revise estimates up, as the alternative scenario on page 134 does. (PDF pg 156)  And perhaps more than that.

Here are the figures for the last three years:

The big shift was the passage of Obamacare, which was funded by a large cut to Medicare Parts A & B.  It’s not as if that law repealed the health care needs of the elderly, but only the rates at which doctors would be paid.  If the ultimate amounts to be paid by the government don’t shift, because we adjust the law & payments to meet undiminished need later, the 2011 Adjusted figures would be low by around $5 trillion.

The 2010 Adjusted figures attempt to strip out the distortions created by Obamacare.  The 2011 figures leave in the adjments from Obamacare, but reflect the Illustrative Alternative Scenario on page 133:

The Medicare Board of Trustees, in their annual report to Congress, references an alternative scenario to
illustrate the potential understatement of costs under current law. This alternative scenario assumes that the
productivity adjustments are gradually phased out over the 16 years starting in 2020 and that the physician fee
reductions are overridden. These examples were developed by management for illustrative purposes only; the
calculations have not been audited; and the examples do not attempt to portray likely or recommended future
outcomes. Thus, the illustrations are useful only as general indicators of the substantial impacts that could result from future legislation affecting the productivity adjustments and physician payments under Medicare and of the broad range of uncertainty associated with such impacts. The table below contains a comparison of the Medicare 75-year present values of income and expenditures under current law with those under the alternative scenario illustration.

Another factor in holding down the 2011 deficit was that measured inflation was low, there were no cost of living adjustments [COLAs], when assumptions expected 2.5% or so.  To the extent that COLAs remain low in future years, there will be further positive adjustments.

In closing, here are two graphs that display the net liabilities  of the US Government and the ratio of that to GDP:

next graph

To pay down liabilities like these would require the permanent allocation of an additional 8% of GDP.  Where would we find the will to do that?  I suspect as a result that we will see real decreases in Medicare benefits — things that won’t be eligible for payment.  Hospice care will be indicated at higher frequency when healing an old person would be costly.

So just be aware that something has to change, either taxes have to rise, or Medicare benefit levels have to fall.

Life With Wife

Saturday, December 24th, 2011

My wife has only given me financial advice twice in my life.  She was totally right both times.  Now, she doesn’t have a financial bone in her body.  She was raised in a household where she never lacked anything, with non-materialistic parents where the father earned a lot as a nuclear physicist.  She was a princess,never having to worry, and married a prince, me, where she never had to worry.

As an aside, the father recently died, and he was quite a guy, but humble.  If you ever get therapy in a hospital that requires a cyclotron or any delivery device that allows positrons or any anti-particle to be used in surgery, my father-in-law was the brains behind it.  He was an amazing man, and though my wife is astounding, one benefit of marrying her was getting to know her father, who was an amazing man.  (Did I tell you he was amazing? ;) )

Anyway, the first time my wife gave me investment advice was when I worked for the St. Paul.  My boss invited me to his officein early 2000, and handed me an envelope.  He said, “This is your bonus, invest it wisely.”  At that point in time, St. Paul was in the tank, and no one liked it much at all.  I took the wad, and put it all on The Saint Paul.  (My wife was amazed at the size of the bonus, but the bonus was given for keeping the company safe, not for making a ton.)

Eventually, it leaked out that I had invested so much in the parent company.  Members of my investment team told me I was a dope, and that the St. Paul was a lousy company to invest in. One told me, “No that’s not value investing, value investing requires a catalyst, and there is no catalyst here.”  (Note: catalysts do not always appear, and they can be expensive.)

Me, a value investor thought that buying a company at 55% of liquidation value, and a single digit multiple of forward earnings would do fine.  After one month, several P&C insurance CEOs announced that they were seeing pricing power, and the stock of the St. Paul rose 30%.  I could not sell, because I was constructively an insider, though I had no insider information.

After another 3 months, the cycle was in full swing, and the St. Paul’s common stock was up 80% from where I bought it.  At that point, my wife came to me and said, “You’ve been talking a lot about the St. Paul over the last few weeks, how important is it to our family?”  I told her, “It is half of our net worth.”  She said, echoing things she had heard me say previously, “Shouldn’t you take something off the table?”  I told her that I would.  I liquidated the whole position at my first opportunity, given my restrictions.  My gain was 95%, over six months.

As it was, after I did this, that many people at the St. Paul came to me saying, “You sly dog, you are a genius, but now we are doing it too; we are in this with you.”  I told them, “Aack, no.  Don’t do this.  You are buying  the top.”  And, wrong again, the price rose for a few more months, only to fall dramatically.

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A few years later, my wife said to me, “You keep talking about Wright Manufacturing, and how well it is doing, but how much do we own of the company?  I said, “You see our house?”

She said, “Of course.”

I said “Well, our holdings are worth a little more than our house.”

Beyond her ordinary ability, she asked, “Okay, David, but would you invest in this company to the degree that you have if it were publicly traded?”

I told her “No.”

She then asked, “then why don’t you take something off the table?”

I was cut to the heart, and I told her I would do so.  I sold half of my shares to the second largest shareholder.He told me that he would meet me at my office at Hovde.  After he got there he was amazed at me and said, “Wait, you are a smart guy, what am I missing here?”  I told him that I needed the money for the college educations of my children, so I needed more liquidity.

That mollified him, and allowed me to sell before the price cratered in 2008-9, as the company nearly failed.

But that’s another story, one where I bought amid distress, but not enough….

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I love my wife.  We just celebrated our silver (25th) anniversary.  She is wonderful in so many ways that I cannot describe here, and her children (and mine), biological and adopted would agree.

Though a princess, she absorbed enough of my ideas to counsel me at two particularly important turning points for the good of our home.  With the St. Paul, I probably would have done the right thing but with Wright Manufacturing, probably not.

So I praise her here for absorbing my wisdom, and applying it to me, when I could not do so myself.

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To bright people in finance I would say pay attention to those near you who don’t have your acumen, if they have been around you long enough.  They may give you cues that you could not ordinarily get, and it might just save your hide.

For me, this gives me an opportunity to praise the second most important person in my life, my wife, who typically has no impact on financial decisions, but at a few critical points did very well for me and the family.  She learned from me.

As for the one most important, that would be Jesus Christ, who many imagine they are honoring at this time of year, even though he never asked that his nativity be celebrated.  Just saying.

Returns on Equity Amid the Financial Crisis, Response

Friday, December 23rd, 2011

I appreciate constructive criticism.  I particularly appreciate comments at this blog, regarding my long article on how return on equity changed during the financial crisis.

The reviewer said,

In a world in which I didn’t have only 20 minutes to read, analyze and write about this paper, I’d like to think through his model choices. I would feel much more comfortable on this point if he accepted the Russ Roberts Science challenge and have a section discussing the process by which he arrived at the process by which he arrived at his conclusions.

Look, I have a policy.  I don’t do specification searches.  If I don’t get reasonable results in the first two tries, I abandon the project.  As it was in this case, I only did one pass through the data.  I was testing for the idea that state or national governmental policy might affect book or market value returns, after adjusting for market sector.

He later commented,

I’d have two comments:

1. What’s the point of decomposing them, then?

2. Can’t you just attribute ALL variance of corporates to ‘historical accident’? Can there be no policy implications?

On point #2, I’d defend Merkel by saying that policy implications need a big enough sample that you can reasonably hold other factors constant. You’d need a dataset of every industry in every state over every conceivable macro-economic environment, then control for those other factors. Same applies for analyzing different countries.

The point of decomposing them is that you don’t know in advance what the result will be.  I only did one pass at the data (please ask academic economists what they do), in this case, it showed that after adjusting for sectors and general economics (time), the states one was in did not matter much, as those that did well did not move to seek lower tax environs.

The piece I did last year did not attribute everything to historical accident.  This year, I was surprised to find that few successful companies had not moved to lower tax/regulation jurisdictions.

I did not know what the decomposition would lead to — that was a major reason for doing it.  If there had been some indication that companies in the US sought lower tax or regulation states, I would have published that, but it was not so, in aggregate.  I does not matter that the result was ordinary.  Once I start the problem, if I come to any understandable result, consensus or non-consensus, I publish it.

Now in truth, I don’t think the paper was one of my best efforts.  I would like to have set error bounds, but I didn’t have access to good software.  I also would have liked to use a better database, like the CRSP database, but that was not available.  Given my lack of resources, it was the best I could do.  Anyway, anyone with more constructive criticisms, I welcome them.

 

Risk-Based Liquidity

Thursday, December 22nd, 2011

When there is financial failure, it comes as a result of illiquidity.  Now, truly, these parties are insolvent, because they took the risk of not being able to pay cash when it was due.  Illiquidity and insolvency are really the same thing, though many obfuscate.

If you can’t pay cash, it doesn’t matter what your assets are worth in “normal” times.  Banks should have planned in advance to make sure liquidity was always adequate, rather than doing the usual borrow short, lend long, that they usually do.

But after reading through the Fed ‘s proposal on bank solvency, I conclude that they may not get the picture.  They spend time on liquidity and other issues.  With liquidity, it is uncertain how they will view repo markets.  To me, those should be view as short-term finance of long dated assets.

During times of crisis, repo markets seize up, with rising repo haircuts.  Maybe I’ve read the Fed’s proposal wrong, but it seems that it neglects repo funding, which had a large effect on the recent crisis.

If banks had to be able to size their activity to survive a rise in repo haircuts equal to half of the highest that we have seen, it would probably be enough to make the issue go away, because the haircuts would be less likely to rise as a result of that restraint.

Now, I appreciate the perspective of this article from Dealbreaker on the topic.  All of the assets of the bank support all of the liabilities. In one sense, there are no assets that are tagged “equity” and others tagged “liability.”

P&C Insurance works a little different.  In that, premium reserves are invested in high quality short-term debt.  Claim reserves are invested in high quality debt similar to the period that claims are expected to be paid out over.  The remainder (the equity) can be invested in risk assets in order to earn a decent return for shareholders.  The idea is this: match liabilities with high quality assets of the same length, and take risk with the remainder of assets, realizing that they might might needed for liquidity in the worst case scenarios.

But really, banks should not be viewed differently.  They should invest like P&C or life insurers.  Invest in high quality assets equal to the terms of their liabilities — deposits (estimate stickiness), savings accounts (same), CDs (the term is known).  After that, take risks with the remaining assets in ways that reflect their comparative advantage, realizing that they might might needed for liquidity in the worst case scenarios.  Illiquid investments (e.g. private equity)  should not be allowed for a majority of of those investments.

If banks don’t engage in asset/liability mismatches aka maturity transformation, most of the risks of bank runs will go away.  And that is what I propose.  Note that if that happens, average people will have to pay some fee each year to have a checking account.  Banks would be liquidity utilities.

This fits under my rubric that the insurance industry is much better regulated than the banking industry.  Were it in my power to do so, I would turn banking regulation over to the states, and leave to the Fed control of monetary policy only.  You would soon see intolerant banking regulation, much like we see in insurance, and defaults would decline.

What could be better?

Returns on Equity Amid the Financial Crisis, Redux

Tuesday, December 20th, 2011

To have a full version of my article, with the equations that explain my reasoning, Returns on Equity amid the Financial Crisis.   Thanks to all who read it.

Returns on Equity Amid the Financial Crisis

Tuesday, December 20th, 2011

I wrote the following for the 2012 Baltimore Business Review.  When it is publicly available on the web, I will highlight it.  For now, I will offer you the unedited version of my paper that will be published there:

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Returns on Equity amid the Financial Crisis

 

Abstract

From 2005-2010, the change in public company returns on book equity [ROE] was wrenching during the financial crisis.  The results were uneven by sectors, and even by geography, for stocks traded in US equity markets.  This paper looks at the differences, and attempts to explain why there was so much variation by sector and geography.  After that, the paper attempts to explain the correlation between changes in ROE and stock returns, by year, sector, and geography.

 

Introduction

 

Since 2005, equity markets have seen a boom, a bust, and a tepid recovery. Financial stocks seem to have had the worst of it, but is that really true?

 

This paper attempts to disaggregate the differing effects of geography (countries/US states), and economic sector over time to try to understand how the boom, bust and recovery have affected public companies.

 

 

Part 1 – Return on Equity

 

Method

 

This study excluded stocks with market capitalizations under $100 million at the end of the study period.  It also excluded miscellaneous financial companies such as exchange-traded products, closed-end funds, and special-purpose acquisition companies, because they don’t have operating businesses.  That left 3,796 companies that trade on US exchanges available for the analysis.

 

Given the tendency for businesses in states and countries to be concentrated in one or two sectors, a minimum was imposed for states and countries to be analyzed individually.  Countries with fewer than four companies trading on US exchanges were placed in the “other” country category, and states with fewer than four companies trading on US exchanges were placed in the “other” state category.

 

Over the years 2005-2010, data regarding book equity, net income, market capitalization, market price, share count, and total returns were gathered, and aggregated by geography (Country if non-US, state if US), sector, and year.

 

Using Ordinary Least Squares Regression, the following relationship was estimated:

 

 

 

Where:

 

  •  is the set of dummy variables for geography.
  •  is the set of dummy variables for sectors.
  •  is the set of dummy variables for the years 2005-2010.
  •  is the contribution to return on equity due to geography.
  •  is the contribution to return on equity due to sector.
  •  is the contribution to return on equity due to year.
  •  is the net income for a given geographic area, sector, and year.
  •  is the book equity for a given geographic area, sector, at the prior year end.
  •  is the error term for a given geographic area, sector, and year.

 

The reasons for using this sort of equation is twofold: first, by using dollar figures rather than earnings per share and book value per share, large companies are given their proper weight versus smaller companies.  Second, it allows for the effects of ROE changes by geography, sector and year to be separated.

 

In an analysis where there are multiple groups of dummy variables, at most one set of dummy variables can be complete if there is no intercept term, and no set can be complete if there is an intercept term.  If not, the regression will fail.  The choice of what to omit is arbitrary, and does not affect the relative relationships within a set of dummy variables.  For the purposes of this paper the sector dummy variables were left complete, and the coefficients on the first geographic area (Argentina) and the first year (2005) were set to zero.

 

 

Results

 

The R-squared of the regression was 55.7%, which has a prob-value of greater than 99.9%.

 

Here are the results of contribution to ROE by country:

 

18.1%

Mexico

16.9%

Chile

15.4%

Other Nations

15.1%

Brazil

14.1%

Australia

13.4%

Spain

13.2%

India

10.6%

Bermuda

10.6%

Hong Kong

7.3%

Greece

7.1%

Russia

6.5%

Taiwan

6.3%

Netherlands

6.3%

Italy

6.3%

Switzerland

6.1%

China

5.9%

Norway

5.8%

Canada

5.1%

Sweden

5.1%

Germany

4.1%

France

3.7%

United Kingdom

2.8%

United States

1.9%

Singapore

1.9%

Israel

1.0%

Cayman Islands

0.6%

Japan

0.1%

South Korea

0.0%

Argentina

-0.2%

Puerto Rico

-1.4%

Finland

-3.1%

Ireland

-3.2%

Luxembourg

-6.3%

South Africa

 

The United States is included for comparison purposes as the weighted average of the contribution to ROE by states.  There was not a separate variable for the US in the analysis.

 

As Latin America moved toward freer markets, with growing middle classes, their contributions to ROE were relatively high.  In general, resource rich nations tended to have higher contributions to ROE.

 

Mexico’s contribution to ROE was led by communication companies Telmex, America Movil, and Grupo Televisa and consumer-oriented companies like Coca-cola Femsa, FEMSA, and Wal-Mart de Mexico.  A growing middle class pushed up demand for these companies.

 

Chile’s contribution to ROE was led by the utilities Enersis and Empresa Nacional de Electricidad, the banks Banco Santander Chile and Banco de Chile, and chemical company Sociedad Quimica y Minera de Chile.  A growing economy boosted demand for electrical power, their banks didn’t make the mistakes made by most of the rest of the developed world, and Sociedad Quimica y Minera was in the “sweet spot” for the chemicals it produced, particularly fertilizers, and lithium which goes into rechargeable batteries.

 

Brazil’s contribution to ROE was led by the energy giant Petrobras, the diversified mining company Vale, and the banks Banco Santander (Brasil), Itau Unibanco Holding, and Banco Bradesco.  Global demand for crude oil, iron ore, and other resources boosted the contributions to ROE with Petrobras and Vale.  Brazil’s banks also didn’t make the mistakes made by most of the rest of the developed world.

 

On the negative side, contributions to ROE in Finland were held down by Nokia, where they fell behind consumer trends with cell phones and other portable wireless devices.  Ireland was held back by banking sector, which lent too much on Irish residential property, amid other errors.  Luxembourg had ArcelorMittal, which slumped with the global steel industry as prices for coking coal and iron ore rose.  South Africa had the worst contribution to ROE as a country because of the heavy weight their economy has in basic materials.  Basic materials was a strong sector, but South Africa was concentrated in one the weakest ROE industries in that sector, gold mining.

 

 

Here are the results of contribution to ROE by US state:

 

18.6%

Washington

16.9%

Arkansas

13.0%

District of Columbia

11.3%

Minnesota

10.0%

Connecticut

10.0%

Oregon

8.9%

Rhode Island

8.2%

New Jersey

7.8%

Kentucky

6.7%

Nebraska

6.6%

Indiana

6.2%

California

6.1%

Georgia

5.5%

Wisconsin

5.4%

Missouri

5.1%

Iowa

5.0%

Texas

4.4%

Tennessee

3.2%

Illinois

3.1%

Florida

2.9%

Maryland

2.8%

US Average

2.5%

North Carolina

1.2%

New York

1.2%

Pennsylvania

1.1%

South Carolina

0.8%

Other

0.6%

Ohio

-0.4%

Utah

-0.5%

Nevada

-1.3%

Louisiana

-2.3%

Arizona

-3.6%

Colorado

-4.6%

Massachusetts

-5.6%

Alabama

-7.9%

Oklahoma

-10.3%

Virginia

-31.9%

Kansas

-83.6%

Michigan

 

To some degree, historical accidents help explain why some states have high contributions to returns on equity, and others low contributions.  Washington State has Microsoft, Amazon, and Costco, all of which started out there.  Michigan has General Motors, Ford, and Chrysler; the automobile industry has long been a big part of the state economy.

 

The contribution to ROE of Arkansas can be entirely attributed to Wal-Mart.  Washington, DC can largely be attributed to Danaher, though Fannie Mae pulled the contribution to ROE down considerably as it failed in 2008.

 

The results of Kansas are dominated by Sprint Nextel, which has been a weak competitor in wireless telephony, though YRC Worldwide also had some impact on the low contribution to ROE as it was too acquisitive heading into a major recession.  Virginia has many strong companies, but Freddie Mac pulled the contribution to ROE down with it failure in 2008.

 

Companies don’t move often, so attributing the differing contributions to ROE to state policies is unlikely.  In the extreme cases listed above, all of the companies listed had been headquartered in their respective states for a long time, and most had been started there.

 

Here are the results of contribution to ROE by sector:

 

25.91%

Consumer Non-Cyclical

23.31%

Basic Materials

20.20%

Energy

18.10%

Health Care

14.59%

Utilities

14.24%

Capital Goods

14.07%

Technology

10.56%

Services

10.20%

Consumer Cyclical

9.52%

Financial

4.72%

Transportation

-5.58%

Conglomerates

 

The end of the first decade of the new millennium was characterized by strong development around the world, with many nations clamoring for resources and non-cyclical consumer goods, which why the contribution to ROE by sector was led by Consumer Non-Cyclicals, Basic Materials, and Energy.

 

Conglomerates are the smallest sector, at 0.3% of total book equity, so it is difficult to draw conclusions about why it had the lowest contribution to ROE.  That said, it is difficult to manage disparate enterprises for organic operating returns.  Increases in energy costs hurt transportation ROEs, which unlike utilities, have a harder time passing the price increases through.

 

Financial stocks saw their contribution to ROE drop because of the financial crisis.  The contribution to ROE includes two great years 2005-2006, two horrible years 2007-2008, and two years of recovery.  The contributions to ROE in the financial sector in 2007-2008 more than erased the gains made earlier in the decade.

 

Contribution to ROE for Consumer Cyclicals were damaged by bad results in the Automobile industry and slumping demand as the economy went into a recession in 2008, and had a rather weak recovery in 2009-2010.

 

Here are the results of contribution to ROE by year:

 

0.00%

2005

2.04%

2006

-1.28%

2007

-18.37%

2008

-8.06%

2009

-3.72%

2010

 

Contribution to return on equity rose 2% over 2005 levels in 2006.  In 2007, as the stock market reached new highs and began to fall in the fourth quarter of 2007, partially because the contribution to ROE fell below 2005 and 2006 levels.

 

In 2008, as the financial crisis arrived, the contribution to ROE plummeted.  Much of the effect was concentrated in financial stocks, but the contribution to ROE for the market as a whole fell 17%.  In 2009 and 2010, as the recovery from the crisis progressed contribution to ROE rose each year, but still remained below the contribution to ROE that existed during the boom years 2005-2007.

 

 

Part 2 – Total Returns

 

 

Method

 

The same stocks as in the first section, and the same methods were used to estimate the following relationship, using Ordinary Least Squares:

 

 

 

Where:

 

  •  is the set of dummy variables for geography.
  •  is the set of dummy variables for sectors.
  •  is the set of dummy variables for the years 2005-2010.
  •  is the contribution to total return due to geography.
  •  is the contribution to total return due to sector.
  •  is the contribution to total return due to year.
  •  is the dollar value of gains or losses for a given geographic area, sector, and year.
  •  is the market capitalization for a given geographic area, sector, at the prior year end.
  •  is the error term for a given geographic area, sector, and year.

 

The dollar value of gains or losses is calculated by the change in market capitalization, plus dividends, less the proceeds of shares issued, plus the cost of shares bought back.

 

Results

 

The R-squared of the regression was 76.7%, which has a prob-value of greater than 99.9%.

 

Here are the results of contribution to total return by country:

 

216.77%

Israel

24.53%

Chile

17.34%

Singapore

12.44%

Other Nations

11.99%

China

11.34%

Australia

10.37%

Hong Kong

8.32%

Mexico

7.62%

Bermuda

7.15%

Brazil

4.14%

Netherlands

3.41%

Germany

3.24%

Greece

2.32%

Spain

1.93%

Norway

1.72%

Italy

1.62%

United Kingdom

1.61%

Cayman Islands

1.30%

US Average

1.24%

Taiwan

1.08%

India

0.86%

France

0.76%

Switzerland

0.74%

Puerto Rico

0.13%

Finland

0.00%

Argentina

-1.44%

Russia

-3.46%

South Korea

-4.16%

Canada

-4.32%

Japan

-4.44%

Ireland

-6.19%

South Africa

-8.72%

Sweden

-17.49%

Luxembourg

 

The United States is included for comparison purposes as the weighted average of the contribution to ROE by states.  There was not a separate variable for the US in the analysis.

 

Looking at the countries at the top and the bottom, Israel benefitted from Teva Pharmaceutical, Check Point Software Technologies, and a scad of little technology companies that soared in value.  Singapore was led by Avago Technologies which has been seeing strong growth in demand for their analog semiconductor devices.

 

Chile, as mentioned above, contribution to total return was led by the utilities Enersis and Empresa Nacional de Electricidad, the banks Banco Santander Chile and Banco de Chile, and chemical company Sociedad Quimica y Minera de Chile.  In addition, Lan Airlines grew their net income by 150% over the whole of the study period, as a growing middle class flew more often.

 

Ireland, Luxembourg and South Africa were low on the contribution to ROE by countries.  Ireland’s contribution to total returns was held back by its banking sector, as mentioned previously.  The same applies to Luxembourg with ArcelorMittal.  And again, South Africa had a low contribution to total returns as a country because of the heavy weight their economy has in basic materials.  Basic materials was a strong sector, but South Africa was concentrated in one the weakest industries for total returns in that sector, gold mining.

 

Sweden had three large companies Ericcson (Telecommunications Equipment), Volvo (Automobiles) and Swedbank (Banking) that underperformed.  Volvo and Swedbank were in weak industries given the financial crisis, while Ericcson underperformed versus competitors in its industry.

 

Note that the order of the lists of contribution to ROE and contribution to total return across are similar.  The correlation of the two sets of coefficients is 1.8% — statistically indistinguishable from zero, but the rank correlation of the two sets is 62.7%, which is significantly greater than zero with 95% certainty.  The high coefficient on Israel’s contribution to total returns throws the ordinary correlation coefficient off; without Israel, the correlation would be 64.5%.

 

Thus it seems that contribution to ROE and contribution to total return are related across countries.

 

 

Here are the results of contribution to total return by US state:

 

19.12%

Oregon

15.18%

Kentucky

13.85%

Iowa

13.28%

Michigan

12.77%

Nebraska

12.53%

Arizona

11.52%

Rhode Island

9.35%

Colorado

9.24%

Texas

8.10%

Alabama

7.18%

Louisiana

7.02%

Oklahoma

6.26%

Illinois

5.58%

California

5.01%

New Jersey

4.58%

Massachusetts

3.49%

Missouri

2.62%

Maryland

2.21%

South Carolina

2.17%

Minnesota

1.56%

Utah

1.40%

Washington

1.30%

US Average

-0.02%

Wisconsin

-0.49%

Connecticut

-1.11%

New York

-1.39%

Arkansas

-2.02%

Indiana

-3.13%

Pennsylvania

-4.49%

Florida

-5.21%

Ohio

-7.04%

Tennessee

-7.76%

North Carolina

-8.19%

Kansas

-8.42%

Nevada

-12.06%

Georgia

-19.45%

Other

-21.02%

Virginia

-33.73%

District of Columbia

 

 

Oregon’s contribution to total return was high because of Nike and Precision Castparts.  Both have been based in Oregon since their founding.  The same can be said of Yum! Brands, Humana, and Brown Forman in Kentucky.  Yum Brands began with Pepsi’s purchase of Kentucky Fried Chicken, which was founded by Colonel Sanders out of home in Corbin, Kentucky in 1930.  Brown Forman was started in Kentucky in 1870 by George Garvin Brown.

 

Terra Nitrogen, LP was an Iowa firm from its founding until its parent company was acquired by CF industries in mid-2010.  It is counted as an Iowa firm for this study, but is now based in Illinois.

 

DC and Virginia have the lowest contributions to total returns because of Fannie Mae and Freddie Mac, respectively.  Georgia had a low contribution to total returns, largely due to SunTrust Banks, which holds the dubious distinction of receiving four installments of bailout cash.  Nevada had a low contribution to total returns because of their high exposure to the casino/gaming industry, which did poorly during and after the financial crisis.

 

All of these companies are historical accidents.  They were based in their states since their founding.

 

The state lists on contribution to ROE and contribution to total return across are not similar.  The correlation of the two sets of coefficients is -10.68% — statistically indistinguishable from zero.  The rank correlation of the two sets is 26.68%, which is also not significantly greater than zero with 95% certainty.

 

It seems there is no relationship at the state level between contribution to ROE and contribution to total return.

 

 

Here are the results of contribution to total return by Sector:

 

34.22%

Basic Materials

33.86%

Consumer Non-Cyclical

33.13%

Conglomerates

30.87%

Transportation

27.49%

Utilities

24.38%

Technology

23.69%

Consumer Cyclical

22.88%

Services

21.94%

Energy

19.80%

Health Care

19.51%

Capital Goods

15.49%

Financial

 

The lists between contribution to ROE and contribution to total return by sector are different.  The correlation coefficient between them is -0.50%, which is virtually zero.  But excluding the two smallest sectors, Conglomerates and Transportation, which have noisy data with only 2% of the total market capitalization, the correlation would be 71.51%, which would be statistically different from zero with 95% probability.  Thus it seems that contribution to ROE and contribution to total return are related across sectors.

 

The low contributors to total return by sector are led by Financials and Capital Goods, both of which did poorly in the recent crisis and the aftermath.  Basic Materials and Consumer Non-Cyclicals led the high contributors to total return by sector, as a growing global middle class created demand for commodities and staple consumer goods.

 

 

Here are the results of contribution to total return by year:

 

0.00%

2005

-5.35%

2006

-11.15%

2007

-67.18%

2008

5.51%

2009

-12.47%

2010

 

The contributions to ROE and contributions to total return by year are very similar, though the contribution to total return is far more volatile.  Also, total return anticipates changes in ROE, exacerbating the fall in 2007 and 2008, and anticipating tougher market conditions in 2011 in the results of 2010.

 

Without adjustment for leading effects, the correlation of the two series is 80.83%, which is different from zero with greater than 95% probability.  Thus it seems that contribution to ROE and contribution to total return are related across years.

 

In a regression of the two series, where ROE contribution by year is the independent variable, and total return contribution by year is the dependent variable, the beta of the regression was 2.86, with a 94% prob-value  for the coefficient and the regression as a whole.

 

That total returns should be levered 2.86 times to changes in ROE should surprise no one.  Markets anticipate, and change disproportionately, because they can’t tell whether changes are temporary or permanent, and so a multiple near 3 splits the difference.

 

 

Avenues for Further Study and Conclusion

 

The researcher did not use the CRSP database, because he had no easy access to it.  This study could be done over far more years and with greater precision.

 

The markets during 2005-2010 rewarded companies the served the growing global middle class, and aided the growth of the developing world.  It punished financial companies, and cyclical companies that did not have significant markets in the developing world.

 

In general, US state policies did not directly affect the financial results.  The best and worst companies by state were generally long term residents of the state in question.  Historical accidents dominate over companies that choose to move to other jurisdictions.

 

In general, contributions to ROE and total returns are related, but contributions to total returns lead contributions to ROE.  Markets anticipate changes in future profits.

 

 

Disclosure: David Merkel and clients of Aleph Investments own shares of Wal-Mart and Petrobras, as of the date this was originally written.

In Memoriam — Ron Smith

Tuesday, December 20th, 2011

My friend Ron Smith has died.  For those that do not live in Baltimore, the Ron Smith show was the leading radio show in Baltimore.  I had the rare opportunity of being on the show three times out of the last three years.  Even better, I was able to do it in the studio with Ron.  The best times that I had when on WBAL were during the commercial breaks, where Ron and I would discuss issues that were far beyond what we were talking about to listeners.

Ron Smith was an intensely bright man.  He was an agnostic, though one that respected religious belief; his opinions outside religion were highly reliable.  He told me that I was doing “God’s work” for raising my eight children.

I will miss Ron.  He was the sort of person that I would have liked to have developed a deeper relationship with, but that was not possible because he was far more busy than I am. We corresponded over a number of issues over the years, and I always learned something from him.

Baltimore will be a poorer place without Ron Smith.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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