David Merkel – Page 288 – The Aleph Blog

Fighting Illiquidity in my Nonsponsored ADRs

Posted on 14 November 2007 by David Merkel

I own three nonsponsored ADRs, and the liquidity of them is relatively poor: Royal Bank of Scotland [RBSPF], Dorel Industries, and Lafarge SA.? I have an opportunity now to improve the liquidity of Royal Bank of Scotland now.? They have recently created a sponsored ADR [ticker RBS].? I wrote Investor Relations at RBS to see if I could exchange my nonsponsored ADR shares for the new sponsored shares.? This is what they wrote back:

Dear Mr Merkel,

Thank you for your email regarding your RBS shareholding.

In order to convert your RBSPF ADRs your broker will need to contact our US depositary and paying agent, the Bank of New York who can transfer your shares to their CREST account and issue you with new ADRs. Contact details for the Bank of New York conversion desk are as follows:

Jaswinder Goraya or Rubely Marte – tel no 212 815 4502 / 2724

Your broker will also need to advise the Bank of New York’s Manchester office of the deposit into their CREST account.

Contact details:

Luke Owen or Mike Ashcroft – tel no. 0161 725 3433 / 3438

Please note that Stamp Duty Tax will need to be paid on each share as well as an ADR conversion fee. With the US share price currently at US$9.24 the conversion fee would be 4 cents per ADR (Please see attached Standard Fee schedule).

If you require further information please do not hesitate to contact me.

So, I contacted Fidelity, and we are doing this.? One down, two to go.? Perhaps my next move is to contact Dorel Industries and see if I can exchange my illiquid ADRs for shares that trade in Toronto.

Full disclosure: long RBSPF, DIIB, and LFRGY (pink sheets all)

Boing!

Posted on 14 November 2007 by David Merkel

Okay, so we got the bounce.? Or, at least the start of it; the market is not short-term oversold anymore.? The reasons behind the rally are a lot smaller than the run we had today; chalk it up to a previously oversold market.

So where do we go from here?? I’m not sure.? None of the long term problems that the market faces have changed, but neither has the relatively low yields of investment grade corporate debt.

One stock that lagged today was National Atlantic.? After the close they announced that they had appointed Bank of America to look into strategic options.? Not sure why they chose BofA; Citigroup brought them public, and kept coverage on them amid their stumbles, not like some.? National Atlantic should jump a little tomorrow.? (Boing!)? Personally, I view the odds of an outright buyout as low, but who can tell here?? The discount to book is significant, and I regard the DAC and tax assets as valuable; they should be included in tangible book.? At this point also, the reserves are clean; they’ve been scrubbed every which way, and should be regarded as sufficient.

National Atlantic is my largest position, and I expect to realize something over $10 before this is done.? Be aware that the stock is illiquid, and that operating results have been uneven over time, to put it mildly.

Full disclosure: long a very illiquid little stock, NAHC

Getting Closer to a Bounce

Posted on 13 November 2007 by David Merkel

Over at RealMoney.com, Jim Cramer occasionally talks about the “oscillator” during times of market stress.? Well, I will offer you my guess at what the oscillator is: a 10-day moving average of NYSE & Nasdaq up volume, less NYSE & Nasdaq down volume.? When that figure gets too high, the market is short term overbought, and when that figure gets too low, the market is short term oversold.? We are close to that oversold level now.

That doesn’t mean that the market is a long-term buy, but that sellers are getting short-term tired.? As the market has fallen, my own cash position has shrunk from 17% of assets to 11% of assets.? I have added gradually to out-of-favor positions, and will add more if the market declines further.

Miscellaneous note: some readers asked what relative strength figure I use.? Typically, I use 14-day RSI.? Why?? It’s the default on Bloomberg.

Value Investing is Dull

Posted on 10 November 2007 by David Merkel

In The Art of War, Sun Tzu makes a great deal out of concealing one’s intentions, even to the point of making it look like you are dumb.? Value investing has elements of that, though we are not trying to deceive anyone.

Most investors fall for the idea that rapidly growing companies will produce greater returns.? Sadly, that’s not true most of the time, because investors usually overpay for growth.? That leaves investors like me puttering over companies that have grown slowly and have modest valuations.? They are in boring industries: cement, insurance, shoe retailing, etc.

This is a major reason that I like value investing.? It doesn’t appeal to most people.? Buying exciting companies with great stories is a lot more fun than buying slow-growing companies at modest multiples of earnings.? Sad, but the growth investor will earn less over the long haul.

My way of managing money will go out of favor someday.? That’s the nature of money management, though for the last seven years I have been immune to troubles.? I keep applying my strategy, because over the long run it will out perform indexes.? Courage is most needed, and least available, during the bear phase.

Gone for Two Days

Posted on 9 November 2007 by David Merkel

Sorry, but off on church business for two days.? As a parting shot, this is what I wrote on RealMoney yesterday:

		David Merkel
		What Do You Say When You Are Wrong?
		11/8/2007 5:34 PM EST

Well, I say I was wrong, then. Wrong about National Atlantic. Ordinarily, reserving at short-tail insurers is hard to mess up, because the claim cash flows quickly reveal mistakes. This is one of the exceptions to the rule.I hate losing money; the only thing I hate more is losing money for others. My sympathies to anyone who has lost along with me. I am still playing on this one, because the company is valued as if it will never make money again, and my opinion is that they will make money again, or, there might be M&A activity.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: still long NAHC, longer even

		David Merkel
		How Do You Minimize The Costs Of Being Wrong?
		11/8/2007 6:40 PM EST

You diversify. Even with National Atlantic, my portfolio was even with the market today. Though it was my largest position, it was still only one of my positions, at less than 5% of the portfolio. Diversification is underrated, and we neglect it to our peril.Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long NAHC

Contemplating Life Without the Guarantors

Posted on 8 November 2007 by David Merkel

Here’s another recent post from RealMoney:

		David Merkel
		Contemplating Life Without the Guarantors
		11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.? On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.? MBIA reinsures Ambac, and vice-versa. ? RAM Holdings reinsures all of them.? The guarantors provide a type of “branding” to obscure borrowers in the bond market.? Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.? In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.? Mark to market losses don’t affect them, they can just pay along with cash flow.? The only trouble comes if they get downgraded, and new deals become more scarce.? Remember CAPMAC?? MBIA bought them out when their AAA rating was under threat.? Who will step up to buy MBIA or Ambac?? (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.? Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.? This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.? If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).

Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.? Also, stable value funds are big AAA paper buyers.? They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.?? All in all, this is not a fun time for AAA bond investors.? A lot of uncertainties are surfacing in areas that were previously regarded as safe.? (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.? Keep your eyes open, and evaluate guaranteed investments both ways.? I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.

Holding My Nose, Still

Posted on 8 November 20078 November 2007 by David Merkel

Three companies of mine reported after the bell, Flagstone, Deerfield, and National Atlantic. I’ll take them in that order.

Flagstone beat handily, as I would have expected a property-centric reinsurer to do in this environment. Let’s see what optimism tomorrow brings. At 96-97% of book value, it seems cheap, but I can’t imagine property reinsurance rates will be that robust next year.

Deerfield is a little more tricky. They took a loss due to mark-to-market events in their portfolio. REIT taxable income is reasonable at 50 cents/share, and much of the writedown is a GAAP anomaly that shaves $1.20 off of the current book value. Economic book value is $11.84, which provides some support to the stock. The dividend of 42 cents is still intact. There is reasonable excess liquidity, even after the increase in repo margins during the third quarter. Let’s see what the market thinks.

Now for the problem child, National Atlantic, which takes an 83 cent loss. Here’s the main offending paragraph from the press release:

“For the three months and nine months ended September 30, 2007, reserves have increased by $17.6 million and $9.4 million, respectively, principally as a result of the strengthening of the reserves for bodily injury claims. During the third quarter it was determined that the Company’s policy related to claims handling procedures and reserving practices were not applied consistently, primarily within the bodily injury claims unit. As part of the resolution of this matter, the Company retained an independent claims consulting firm.”

For a company the size of National Atlantic, these are huge reserve changes, particularly for a short-tail line like auto. What I am about to write here is only a guess, but this likely was building up since sometime in 2006. One of the reasons I am willing to be a little more bullish on short-tail insurers is that it is a lot harder to get the reserve wrong. Looks like I am getting one of the rare events that teaches greater caution. (That said, my average cost is $8.85, so I’m not that badly hurt.) Given the large reserve change this period, ordinarily, the decks are cleared for future periods, but who can tell for sure? Also, this places the combined ratio since 2002 at 103.7%. It makes me think that the company will do well to eke out any underwriting profit.

I’ll be listening to the call tomorrow. What’s the endgame here? Given the marginal ability to earn underwriting profits, perhaps the company would best be reconciled by merging with another firm. That wasn’t my opinion over the past three years, but it is my opinion now. There are many firms that could have an interest at the right price, which probably approximates the book value of $13.28. That said, many of them may have kicked the tires already and passed, some probably thinking that a bid at book value would not be honored. All I can say is, give it a shot. Rumor is that Commerce wasn’t offering more than book, so if you want a greater presence in NJ personal lines, it may be available at a reasonable price.

Full disclosure: long FSR DFR NAHC

Circuit Breakers, but no Curbs

Posted on 8 November 2007 by David Merkel

Posted today at RealMoney:

		David Merkel
		Bye-bye to Trading Curbs
		11/7/2007 2:37 PM EST

When the NY Composite fell 2% today, no trading curbs kicked in. Program trading went on unfettered by a need for upticks. Around 1:20, when the curbs would have kicked in, the market fell a little, stabilized, and began to rally. So much for the curbs. Now all that remains are the circuit breakers, which kick in when the DJIA is down 10% and 20%. The circuit breakers only came into existence in 1987, and to the best of my knowledge, have never been triggered. (Anyone else know for sure? I don’t have intraday data.)

Using closing data since 1900 (again, I don’t have intraday), the circuit breakers would have been triggered 5 and 2 times each. That’s once every 21 and 54 years, respectively. To me, that’s not frequent enough to have a rule in place, even if intraday data would double the frequency.

Position: none

As it was, the market finished down nearly 3% today.? I suspect that curbs wouldn’t have helped much, but who can tell.? The market is a lot more game-friendly than it used to be; far fewer rules to observe (or flout).

On an unrelated note, here are my two REIT charts from yesterday, in thumbnail form, for those who had a hard time with them yesterday.

Mortgage REITs

Equity REITs

Personal Finance, Part 4 — Health and Disability Insurance

Posted on 7 November 2007 by David Merkel

With health insurance, the main idea is that you should be covered in the event of a catastrophe.? First dollar coverage is nice if your employer is a sugar daddy (be sure and thank him, but not too effusively, lest he realize how much he is paying…), but insurance is not really effective at claims management; it is far more effective at risk-bearing.

To that end, high deductible plans can be effective for those that have to buy insurance privately.? Just make sure that you fund the deductible. Health Savings Accounts are triple tax free, and can be a particularly sweet deal.

Though this also applies to health insurance, with disability insurance, consider the claims-paying record of the insurer.? This is not a coverage where lowest premium payment wins.? Good companies do their underwriting on the front end, and pay legitimate claims.? Bad companies don’t do their underwriting on the front end, and deny legitimate claims.? This usually shows up in the complaint statistics at you state insurance department, so review those before buying disability insurance.

Also, with disability insurance, note the distinctions between “own occupation” and “any occupation” coverage.? With “own occ,” a surgeon who loses his steady hand could make a claim, but could not under “any occ.”? He could go flip burgers.? Also, note total and partial disability terms.? Under what conditions will they pay, and how much?

If you do become disabled, the insurance company may attempt to buy out your claim with a lump sum.? Don’t take the lump sum; they typically lowball the offers; claimants would receive a lot more over time if they were patient and took the payments gradually.

Now, not everyone needs disability insurance.? If you’re in a low-risk occupation, like me, odds are that you won’t be disabled to where you can’t earn money.? Analyze your own willingness to take risk in this area if you decide not to buy disability insurance.? Some risks are best self-insured.

Buying Cheap and Holding My Nose

Posted on 7 November 20077 November 2007 by David Merkel

How comfortable would you be buying National Atlantic Holdings?

Or Deerfield Triarc?

Or YRC Worldwide?

I could go on, after all, recently I bought some Redwood Trust, and a number of smaller cap value names that don’t seem to be getting much respect right now. Value as a strategy is lagging now, and I am feeling that in my performance. Financials that deal with mortgages are out of favor also.
So why mortgage REITs now? Take a look at this chart of the 10-year Treasury yield less that on mortgage REITs:

Yields are pretty high relative to “safe” Treasuries, comparable with 1990 and mid-2002 spreads. Only the bad old days of 1974 surpass the yield spreads of this era by a significant amount. As I recall, REITs had a really bad name in the late 1970s after the mid-decade shellacking. I remember technical terms like “fraud,” but then, I was an impressionable teenager with an active imagination. 🙂

Now consider this chart of the 10-year Treasury yield less that on equity REITs:

The result is closer to fair value. I certainly would not call equity REITs as a group cheap; future returns rely on property price appreciation, which doesn’t seem likely to me at present.
Now, I’m not endorsing all mortgage REITs. Review funding structures and excess liquidity; you want excess cash flow and conservatism at this point. Heroics offer more downside than upside here.

As for YRC Worldwide, trucking is needed in our economy, and even with some slowdown, YRC should still make money, just not as much. On National Atlantic, I would only say that it seems that there is a forced seller in the name now, and when he is exhausted, the stock will lift. It is difficult to destroy a personal lines insurer with a conservative balance sheet. At 60% of a conservative book value, I can live with adverse outcomes.

Remember, do you own due diligence here. Just because it looks cheap does not mean it can’t get cheaper.

Full disclosure: long RWT NAHC DFR YRCW