Category: Classic

Classic: Wrecking Ball Looms for Big Housing Spec

Classic: Wrecking Ball Looms for Big Housing Spec

Posted on by David Merkel
Photo Credit: Rhys A.

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I thought this old post from RealMoney.com was lost, never to be found again.? This was the important post made on November 22, 2006 that forecast some of the troubles in the subprime residential mortgage backed securities market.? I favored the idea that there there would be a crash in residential housing prices, and the best way to play it would be to pick up the pieces after the crash, because of the difficulties of being able to be right on the timing of shorting could be problematic.? In that trade, too early would mean wrong if you had to lose out the trade because of margin issues.

With that, here is the article:

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I have tried to make the following topic simple, but what I am about to say is complex, because it deals with the derivative markets. It is doubly or triply complex, because this situation has many layers to unravel. I write about this for two reasons. First, since residential housing is a large part of the US economy, understanding what is going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it is unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.

 

There are a lot of players trotting out the bear case for residential housing and mortgages. I’m one of them, but I don’t want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is no small potatoes; it actually comprises several billions of dollars’ worth of bets by aggressive hedge funds — the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.

 

A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it’s worth understanding just how this “arcane-sounding” market works.

 

I said I might expand on that post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots dragged in a Reuters article and a blog post on the topic. I’ve seen other writeups on this as well, notably in Grant’s Interest Rate Observer (a fine publication) and The Wall Street Journal.

How a Securitization Works (Basically)

 

It’s difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?

 

First, mortgage originators originate home equity loans, Alt-A loans and subprime loans. They bring these loans to Wall Street, where the originator sells the loans to an investment bank, which dumps the loans into a trust. The investment bank then sells participation interests (“certificates”) in the trust.

 

There are different classes of certificates that have varying degrees of credit risk. The riskier classes receive higher interest rates. Typically the originator holds the juniormost class, the equity, and funds an overcollateralization account to give some security to the next most junior class.

 

Principal payments get allocated to the seniormost class. Once a class gets its full share of principal paid (or cancelled), it receives no more payments. Interest gets allocated in order of seniority. If, after paying interest to all classes, there is excess interest, that excess gets allocated to the overcollateralization account, until the account is full — that is, has reached a value equal to the value of the second most junior class of trust certificates — and then the excess goes to the equity class. If there’s not enough interest to pay all classes, they get paid in order of seniority.

 

If there are loan losses from nonpayment of the mortgages or home equity loans, the losses get funded by the overcollateralization account. If the overcollateralization account gets exhausted, losses reduce the principal balances of the juniormost certificates — those usually held by the originator — until they get exhausted, and then the next most junior gets the losses. There’s a little more to it than this (the prospectuses are often a half-inch thick on thin paper), but this is basically how a securitization works.

 

From Hedging to Speculation

 

The top class of certificates gets rated AAA, and typically the lowest class before the equity gets rated BBB-, though sometimes junk-rated certificates get issued. Most of the speculation occurs in securities rated BBB+ to BBB-.

 

The second phase of this trade involves credit default swaps (CDS). A credit default swap is an agreement where one party agrees to make a payment to another party when a default takes place, in exchange for regular compensation until the agreement terminates or a default happens. This began with corporate bonds and loans, but now has expanded to mortgage- and asset-backed securities.

 

Unlike shorting stocks, where the amount of shorting is generally limited by the float of the common stock, there can be more credit default swaps than bonds and loans. What began as a market to allow for hedging has become a market to encourage speculation.

 

With CDS on corporate debt, it took eight years for the notional size (amount to pay if everyone defaulted) of the CDS market to become 4 times the size of the corporate bond market. With CDS on home equity asset-backed securities, it took less than 18 months to get to the same point.

 

The payment received for insuring the risk is loosely related to the credit spread on the debt that is protected. Given that the CDS can serve as a hedge for the debt, one might think that the two should be equal. There are a couple reasons that isn’t so.

 

First, when a default happens, the bond that is the cheapest to deliver gets delivered. That option helps to make CDS trade cheap relative to credit spreads. But a bigger factor is who wants to do the CDS trading more. Is it those who want to receive payment in a default, or those who want to pay when a default occurs?

How It Impacts Housing

 

With CDS on asset-backed securities, the party writing protection makes a payment when losses get allocated to the tranche in question. Most protection gets written on tranches rated BBB+ to BBB-.

 

This is where shorting residential housing comes into the picture. There is more interest in shorting the residential housing market through buying protection on BBB-rated home equity asset-backed securities than there are players wanting to take on that risk at the spreads offered in the asset-backed market at present. So, those who want to short the market through CDS asset-backed securities have to pay more to do the trade than those in the cash asset-backed securities market receive as a lending spread.

 

One final layer of complexity is that there are standardized indices (ABX) for home equity loan asset-backed securities. CDS exists not only for the individual asset-backed securities deals, but also on the ABX indices as well. Those not wanting to do the credit work on a specific deal can act on a general opinion by buying or selling protection on an ABX index as a whole. The indices go down in quality from AAA to BBB-, and aggregate similar tranches of the individual deals. Those buying protection receive pro-rata payments when losses get allocated to the tranches in their index.

 

So, who’s playing this game? On the side of falling housing prices and rising default rates are predominantly multi-strategy and mortgage debt hedge funds. They are paying the other side of the trade around 2.5% per year for each dollar of home equity asset-backed securities protection bought. (Deals typically last four years or so.) The market players receiving the 2.5% per year payment are typically hedge and other investment funds running collateralized debt obligations. They keep the equity piece, which further levers up their returns. They are fairly yield-hungry, so from what I’ve heard, they’re none too picky about the risks that they take down.

 

Who wins and who loses? This is tricky, but if residential real estate prices fall by more than 10%, the buyers of asset-backed securities protection will probably win. If less, the sellers of protection probably win. This may be a bit of a sideshow in our overly leveraged financial markets, but the bets being placed here exceed ten billion dollars of total exposure. Aggressive investors are on both sides of this trade. Only one set of them will end up happy.

 

But how can you win here? I believe the safest way for retail investors to make money here is to play the reaction, should a panic occur. If housing prices drop severely, and home equity loan defaults occur, and you hear of hedge fund failures resulting, don?t act immediately. Wait. Watch for momentum to bottom out, or at least slow, and then buy the equities of financially strong homebuilders and mortgage lenders, those that will certainly survive the downturn.

If housing prices rise in the short run (unlikely in my opinion), and you hear about the liquidations of bearish hedge funds, then the best way to make money is to wait. Wait and let the homebuilders and mortgage finance companies run up, and then when momentum fails, short a basket of the stocks with weak balance sheets.

Why play the bounce, rather than try to bet on the success of either side? The wait could be quite long before either side loses? Do you have enough wherewithal to stay in the trade? Most players don?t; that?s why I think that waiting for one side or the other to prevail is the right course. Because both sides are levered up, there will be an overshoot. Just be there when the momentum fails, and play the opposite side. Personally, I?ll be ready with a list of homebuilders and mortgage lenders with strong balance sheets. Though prospects are not bright today, the best will prosper once the crisis is past.

Classic: The Ins and Outs of Stable Value Funds

Classic: The Ins and Outs of Stable Value Funds

Posted on by David Merkel

The following article was published at Realmoney.com in 2004. ?Rates were lower then but the issues remain the same.

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My 401(k) plan has a stable value fund that currently pays a preannounced annual rate of 5.30 percent. ?The fund enters into guaranteed investment contracts (GICs) with insurance companies which invest in government and corporate bonds and mortgages.
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I’ve heard that stable value funds can now be purchased outside of retirement plans.? Does anyone know of any fund families or brokers that offer these funds to individual investors?

— Reader Question from M. J.

 

In my career, I have run a GIC (Guaranteed Investment Contract) desk at an insurer, designed one stable value fund, and helped administer and invest for several others.? I know stable value funds, respect them, invest in them when it makes sense, but I am still a skeptic at some points.

Legal Risks Lead to Elimination of Non-401(k)-type Stable Value Funds

Last year, there was a big scandal over mutual fund pricing, and non-401(k)-type stable value funds came under the microscope because of the obvious difference between the value of the assets and the stated NAV of the funds.? The SEC made an inquiry about the accounting for the funds in December 2003.? Since then non-401(k)-type mutual funds have died a slow death. ?There is one left, and they are probably going to turn the fund into a short term bond fund, as the others did.? Their reason for existence has gone away, and now they are expensive short-to-intermediate term bond funds.

Your opportunity to invest in stable value funds outside of 401(k)/defined contribution world has gone away, but given that there is over $200 billion invested in stable value funds, and not much has been written on them from a third party point of view, I?ll describe them in more detail.

Defining the Investment

So what?s a stable value fund?? It?s a short-to-intermediate term fixed income pool that has some agreements on the side to allow the assets to be accounted for at book value, so that the investment accrues at a positive rate.? It looks like a savings account to the investor, not a short-to-intermediate term bond fund.? Because it invests at longer maturities than money market funds, they deliver higher yields than money market funds, except in years worse than 1994, where yields rise rapidly and the yield curve inverts.? (Stable value funds did not exist in the 1979-1981 era; perhaps money market yields would have been higher than stable value yields would have been then.? The precursor to Stable value funds, initial participation guarantee funds, ran into trouble then.? That trouble led to the development of GICs.)

A stable value fund invests in insurance contracts, money markets, and highly rated (usually AAA) short-to-intermediate term bonds.? Insurance contracts are always valued at book value, unless in default, which we saw a little of in the early 90s.? Among major GIC writers, default has not been a problem since 1994.? (General American gave us a scare in 1999; Metlife bought them, and all payments were made.)

The bonds held in stable value funds can?t be valued at book value because accounting rules require that they be held at market.? The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value.? The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book value loss.? Typically, wrap agreements are only done on the highest rated bonds (AAA), so credit risk is not covered by most wrap agreements.? With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped.? The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool?s credited rate.

Since wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10%/year of assets wrapped.? The only risk a wrapper faces is that the interest rate-related losses on a bond in a rising interest rate scenario is so severe that the losses can?t be repaid out of the yield of the wrapped bond.? In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change.? There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value.? When the stable value fund has a higher market value than book value, typically it pays an above market yield.

There is a risk that in an environment where interest rates have risen sharply, that a stable value fund would have a lower market value than book value, with a below market yield.? In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields.? If that happens to a high degree, it will worsen the gap between the market value and book value of assets, which will be covered by the wrappers in the short run, but will reduce the fund?s yield as they pay the wrappers back.

It is unlikely, but possible to get a death spiral here, if more and more shareholders leave the pool and the yield sags to zero.? It hasn?t happened yet, so this is theoretical for now.? In theory, the wrappers would keep paying once the funds credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation.? There would likely be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability.? In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral are further reduced, but not eliminated.

Asset Default Risks

As an aside, for the most part, stable value funds take little credit risk, but (little known) this is not universally true.? Some of them buy corporate bonds, or other riskier structured product bonds.? Some of them take credit risk in hidden ways.? Here?s an example: there are some exotic, asset- or commercial-mortgage backed interest-only bonds that are rated AAA by the rating agencies.? The agencies rate them AAA because they can?t lose principal; they have no principal to lose.? But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened.? The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA.

If an asset in a stable value fund defaults, the fund will likely temporarily suspend withdrawals while it pursues one or two courses of action.? If the loss is small, they might buy a wrap contract for the loss, which will haircut the yield on the stable value fund for the life of the wrap contract.? If the loss is big, they will reduce the NAV, and attempt to keep the NAV stable from there.? Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn?t rely on that.

Summary

There are two main risks: asset default, and severely rising interest rates.? In exchange for those risks, what do you receive?? In most circumstances, you get a higher yield than a money market fund, with nonguaranteed stability of principal.

If you need a good yield, and stability of principal with modest risk, a stable value fund can be a good place to get it. That said, if you can live with fluctuations in the NAV over the intermediate term, it would be better to use a short-to-intermediate-term bond fund, and thus avoid the wrapper and high asset manager fees.? Stable value manager fees are typically higher than those for bond funds.? Over a five-year period (or so), your total return should be better.

Classic: Changes in Corporate Bonds

Classic: Changes in Corporate Bonds

Posted on by David Merkel

This was a two part article that was published at RealMoney July?19-20, 2004:

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Two changes have taken place in the corporate bond market in recent years. The first change deals with credit default swaps, which I’ll discuss in today’s column. In Part 2 I’ll talk about how corporate bonds are analyzed differently now.

Surviving the Loss of a Major Class of Investor

There used to be a tendency for Wall Street to hold a supply of corporate bonds to sell to the buy side. That changed when credit default swaps were, or CDS, developed. A credit default swap is a transaction where one party buys protection against the default of a corporate credit from another party. The party selling protection receives a constant payment over the life of the transaction so long as the corporate credit does not default.

These swaps were developed in the mid-1990s, but they remained somewhat tangential to investment banks until the negative side of the credit cycle hit in 2000-2002. Many banks did a huge business in CDS, but they traded cash bonds and CDS separately. Typically, the cash bond side of the house was net long corporate bonds, and the CDS side was typically flat credit risk. From late 2001 through 2002, a major change rippled through the “bulge bracket” firms on Wall Street. They got the bright idea to trade cash bonds and CDS together as a group.

This had several desirable outcomes:

  • It enabled them to hold a larger inventory of corporate bonds with less risk.
  • It enabled them to be flat the corporate bond market in a period of severe stress. (However, it must be noted that most of those that instituted programs like this had the trough of the corporate bond market.)
  • It allowed them to trade more rationally. There were new trades that could be done by comparing the cash bond market and CDS market, going long one and short the other. (Note: Here’s how to make money on corporate trading desks: You have more flow in the market than most people you trade with. When clients offer you mispriced trades in your favor, you trade with them and then buy or sell the offsetting positions in the intradealer market at a fair price. With CDS, you have more options for laying off the risk.)

This had the unfortunate effect of removing a seemingly natural buyer from the corporate bond market at a time when the corporate bond market could least afford it. It is my guess that that?was part of the reason why the corporate bond market bottomed out in October of 2002, rather than July of 2002. Pressure on the corporate bond market from CDS-related selling did not abate until mid-November of 2002.

As a result, there is only one major buyer of long-term corporate credit risk left in the U.S. economy: life insurance companies. Pension funds play a role in this market, as do foreign institutional buyers. So when corporate bonds do badly or well, life insurance companies are disproportionately affected.

In one sense, we are in a brave new world for both life insurance companies and the corporate bond market because the life insurance industry alone is not big enough to purchase all of the corporate bonds outstanding. Perhaps foreign institutions have filled the gap at present; if so, it will be interesting to see whether foreign capital is as patient as the life insurance industry if we have another downturn in the credit markets.

An Additional Implication of CDS

CDS unify the debt capital structure of debt-issuing companies. In the old days, companies that borrowed money from banks, or issued debt, did so in marketplaces that were separately priced. That separation allowed corporations a greater degree of wiggle room when financial times got tough. Even if the bond market temporarily shut down after a company was downgraded to junk, typically banks would still lend to them, even if the terms were more onerous.

But with the advent of CDS, the banks might lend, but they will lay all the risk on the CDS market. As more risk gets laid off, the credit default swap spreads rise. As the credit default swap spreads rise, an arbitrage opportunity appears against cash bonds.

This leads the corporate bond market default in tandem with rising credit default swaps spreads. Finally, because of arbitrage between equity prices, equity volatility, corporate bond spreads and credit default swap spreads, even a dislocation in the equity markets can lead to trouble in the debt markets and vice versa.

Here is an example of how the world has changed. In late 2000, Xerox (XRX) was under threat of downgrade from both ratings agencies. A downgrade from either agency would make Xerox unable to sell commercial paper, which it needed to finance its deteriorating business. The company tried to issue more commercial paper, but the auction failed, which forced it to exit the commercial paper market. To make up for the cash flow shortfall, Xerox went to its banks to tap its CP backup credit lines. The banks, distressed that what was previously considered free money for them was actually going to be put to use, went to hedge their risks in the CDS market as the CP backup lines got drawn down. The massive buying demand for Xerox CDS led the CDS spreads to widen, which spread into the corporate bond market through arbitrage and eventually led the price of Xerox common equity downward. This happened in a matter of a few days, although the effects rippled for weeks afterward.

Thus, in a panic situation, every market that provides capital to corporations fights against the corporations in a unified manner. This is very different from how the markets behaved 10 years?ago. The implication for equity investors is that if you’re buying the equity of debt-issuing corporations, you must be aware that in a crisis they will be more volatile than they were in the past.

Since the bottom of corporate bond market in the 2002, corporations have enjoyed stronger profits and free cash flow. Many corporations have deleveraged. This would be reason alone for corporate spreads to tighten. But there is another factor at play here that is less known outside of the corporate market.

Two Methods of Analysis

There are two distinctly different ways to analyze corporate bonds. The first way is the old standard, which relies on fundamental analysis of a company’s financial statements. The second way relies on contingent claims theory (options theory, Merton’s model) and primarily uses market-oriented variables like stock prices and option volatility.

The basic idea behind the latter method is that the unsecured debt of a firm can be viewed as having sold a put option to the equity owners. In an insolvency, the most the equity owners can lose is their investment. The unsecured bondholders (in a simple two-asset-class capital structure) are the new “de facto” equity holders of the firm. That equity interest is most often worth far less than the original debt. Recoveries are usually 40% or so of the original principal.

Under contingent claims theory, spreads should narrow when equity prices rise, and when implied volatility of equity options falls. Both of these make the implied put option of the equity holders less valuable. Equity holders do not want to give the bondholders a firm that is worth more, or more stable.

So what’s the point? Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively; others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads.

Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has happened. I would say that the decline in implied volatility, and deleveraging, has had a larger impact on spreads than improved profitability has.

Wider Implications for the Markets

Contingent claims models are not perfect, but they are quite good. To ignore them is foolish, but understanding their weaknesses is helpful.

Contingent claims models have a tendency to overestimate the risk of default with corporations that are overleveraged but have a long maturity debt structure. In many of these cases, the indebted corporation has a great deal of “breathing room” and often can maneuver its way out of the situation. This can offer real opportunities for buy-and-hold investors because they can buy the debt or equity at depressed levels and hold it through the apparent crisis. Doing this requires careful fundamental analysis, so if you invest in any of these situations, make sure you do your homework thoroughly.

Finally, the combination of contingent claims theory and the existence of CDS can produce other anomalies. It becomes theoretically possible to hedge CDS against common equity. Some hedge funds do this. They analyze bank debt, corporate bonds, convertible bonds, preferred and common stocks, options, warrants and other financing instruments, to find the cheapest aspect of a company’s credit structure and buy it, and find the richest aspect and sell it.

The full set of implications for the asset markets from this is unknown, partly because funds that do this are small relative to the markets as a whole. If the hedge funds that did this were too large for the markets, it would create too many feedback loops that have not yet been tested, which would have a tendency to amplify price moves in a crisis.

I can’t tell where such a crisis might lurk. The markets are relatively optimistic now. But being aware that these feedback loops could exist, can give you an edge in a crisis. The main upshot is this: Having a strong balance sheet is worth more today than it was in the past. It’s one of many reasons why I continue to focus on higher-quality companies in my equity investing.

Classic: Investing Is About the Whole Portfolio

Classic: Investing Is About the Whole Portfolio

Posted on by David Merkel

I wrote the following article for RealMoney in August 2005. ?I don’t like handing out individual stock ideas. ?I would rather teach people how to think about stocks and other assets, because my individual ideas will be wrong 30% of the time, and I will garner a lot of complaints from them. ?I will get few thanks from the 70% I got right. ?The ratio corresponds to that which Jesus had healing the lepers.

That said, those that invested in this portfolio for two years did well. ?Okay, read on:

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I’m not crazy about giving individual stock ideas on?RealMoney?because all investing is best viewed in a portfolio context. Individual stock ideas are important, but I believe portfolio construction and management are more important.

Too many investors are looking for the next hot company when they should really be looking for a consistent theory of how to produce reliable returns while minimizing downside risk.

In my column?Evolution of an Investment Style, I tried to describe how I achieve above-average returns while trying to squeeze out risk. This is not an easy process, but it is achievable if you think about investing in the same way an intelligent businessman thinks about his own firm.

That’s what my seven rules from that column are all about.

One of the first things you’ll notice is that there doesn’t seem to be any rhyme or reason to the order in which the stocks are listed. There is a logic here, but the order is based on the timing of initial purchases. Stocks that I have held the longest are on top, and stocks that I have bought for the first time most recently are at the bottom.

This helps me see on a day-to-day and week-to-week basis, which group of ideas are doing well. If my newest are doing well, there may be some mean-reversion happening in valuations.

If my oldest are doing well, there may be a bit of momentum happening for those that have already reverted to the mean. Because I tend to make shifts to the portfolio quarterly in groups of four or so stocks, I can see themes working out as I look at performance in the order that stocks were purchased.

The Current Portfolio

Listed below are the stocks in my portfolio. They are roughly equal-weighted.

 

Value With a Twist
David Merkel’s current holdings
Name Aug. 10 Close P/E Yield Market Cap P/E (This Year) P/B P/S
Cemex (CX:NYSE) 46.94 6.99 2.51 16.80 8.98 1.83 1.45
Dycom (DY:NYSE) 23.50 21.08 – 1.15 20.98 2.01 1.13
Cytec (CYT:NYSE) 48.25 14.87 0.83 2.22 14.26 1.81 1.18
Ameron (AMN:NYSE) 37.25 21.08 2.14 0.32 10.35 1.14 0.49
Allstate (ALL:NYSE) 58.04 11.62 2.04 38.79 9.33 1.74 1.13
Unilever PLC (UL:NYSE) 41.19 19.40 3.51 66.36 13.18 6.90 1.32
Liz Claiborne (LIZ:NYSE) 41.80 14.18 0.54 4.57 13.71 2.43 0.94
Fresh Del Monte (FDP:NYSE) 25.46 10.80 3.91 1.47 10.97 1.37 0.46
Montpelier (MRH:NYSE) 34.27 11.12 4.08 2.17 7.53 1.49 2.36
PartnerRe (PRE:NYSE) 62.92 7.43 2.26 3.47 8.84 1.00 0.84
ConocoPhillips (COP:NYSE) 65.64 9.66 2.07 91.39 8.42 2.00 0.71
SPX Corp. (SPW:NYSE) 45.36 3.75 2.22 3.41 17.43 1.21 0.76
Canadian National Railway (CNI:NYSE) 67.44 16.43 1.26 18.57 15.36 2.44 3.23
Petro Canada (PCZ:NYSE) 79.42 18.95 0.74 20.83 12.13 2.78 1.67
Stone Energy (SGY:NYSE) 53.71 9.63 – 1.44 7.86 1.51 2.34
Barclays PLC (BCS:NYSE ADR) 42.39 12.67 4.22 68.39 11.54 2.20 2.85
Valero Energy (VLO:NYSE) 90.77 10.74 0.49 23.30 10.14 2.92 0.37
Toyota (TM:NYSE ADS) 78.42 11.93 1.24 128.10 11.12 1.53 0.75
Sappi (SPP:NYSE ADS) 10.88 51.92 2.78 2.46 90.00 1.13 0.50
Apache (APA:NYSE) 71.93 11.09 0.46 23.61 9.46 2.48 3.60
Premcor (PCO:NYSE) 81.05 9.80 0.08 7.24 9.91 2.75 0.38
Ryerson Tull (RT:NYSE) 19.37 6.05 1.28 0.49 5.13 1.05 0.10
Jones Apparel (JNY:NYSE) 29.03 13.14 1.79 3.44 12.10 1.31 0.70
Neenah Paper (NP:NYSE) 31.45 20.09 0.93 0.46 20.09 2.40 0.63
Johnson Controls (JCI:NYSE) 57.46 12.39 1.70 11.03 12.83 1.91 0.39
Japan Smaller Capitalization Fund (JOF:NYSE) 11.81 5.20 – 0.19 50.00 0.98 108.19
Pfizer (PFE:NYSE) 26.39 20.04 3.43 196.20 13.39 2.92 3.70
Sara Lee (SLE:NYSE) 20.02 13.31 3.83 15.76 13.51 4.61 0.80
Repsol (REP:NYSE) 29.61 14.95 2.19 36.15 8.98 2.00 0.80
Premium Standard (PORK:Nasdaq) 14.76 6.70 0.41 0.46 9.07 1.10 0.40
Anglo American (AAUK:Nasdaq ADR) 26.72 11.68 2.62 39.62 10.32 1.59 1.53
ABN AMRO (ABN:NYSE) 24.73 11.54 7.52 41.28 10.25 1.78 1.61
Gold Kist (GKIS:Nasdaq) 18.93 8.60 – 0.97 7.86 2.46 0.90
Dana (DCN:NYSE) 15.01 11.73 3.12 2.26 12.92 0.98 0.24
SABESP (SBS:NYSE) 17.14 8.00 4.52 1.95 10.05 0.54 0.98
11.68 2.04 4.57 10.97 1.81 0.90
Source: David Merkel, Yahoo!

 

This Portfolio Is Weird

Even though I manage this portfolio the same way that a “long-only” mutual fund manager would, because my portfolio is diversified by country and capitalization, it doesn’t fit any of the neat classifications common to mutual funds. I’m not running a mutual fund for which I’m anxious to gather assets, so this doesn’t bother me. Given that, I will now describe the way the portfolio breaks down by country, capitalization, sector and industry.

 

Sector Mix
The makeup of this portfolio defies easy categorization
Source: David Merkel

A notable characteristic of the portfolio is that 34% of it is non-U.S. Even adding back the two Bermuda reinsurers (which only trade in the U.S.), the percentage foreign is 29%. This is high enough that it would be hard to call this a domestic fund, but low enough that it can’t be an international or global fund. Why do it this way? Because I believe it offers the best returns to a U.S. investor. I try to buy stocks that operate in stable parts of the world, with reasonable legal systems. I consider information, war and expropriation risks. When something outside the U.S. seems too cheap, I buy it, but I don’t force myself to stay inside or outside of the U.S.

My approach to market capitalization is not as idiosyncratic. I am “all capitalization,” which is done by a number of mutual funds. I am probably more large-cap now than I have been in years. Small-caps generally don’t offer the valuation discount that I like to see when buying something off of the beaten path. Mid-caps I normally like best, because they typically have the stability of large-caps, but still have enough potential to grow, like some small-caps do. At present, many large-caps seem quite cheap, so I have more of them than normal.

The most important thing to look for in market capitalization is rule No. 4 from the column I mentioned above: “Purchase companies appropriately sized to serve their market niches.” Some businesses need scale in order to be profitable. Other businesses favor the entrance of smaller competitors following a niche strategy. “Is the business the right size in order to prosper?” is a question that intelligent investors ask.

Sector/Industry Mix

Looking at both the sector and industry mix, Jim Cramer would probably gong me in his radio show’s “Am I Diversified?” segment. Well, no, I’m not diversified, at least not by sector and industry. I can hear the comments: Where’s the tech and telecom??Pfizer?is not enough for health care. Only one utility, and that one’s in an emerging market? You’re too overweight in materials and energy. Agriculture has been a loser for years. You’re joking, right?

I’ve always run an undiversified portfolio, because intelligent sector rotation can add value. Industries tend to trend in the short run and revert to the mean over the intermediate term. I try to analyze where the pricing power of industries is as I evaluate companies for investment. There are two things that get me primed for purchase:

  • Things are abysmal and no one wants to invest there. (Think of auto parts.)
  • Or, stock prices have not caught up to the industry pricing cycle. (Think of energy.)

That’s how I view it. I want to be in industries that are underrated, whether that’s due to a bruising bear market in an industry, or because of an abundance of skepticism in the face of improving fundamentals.

Valuation Parameters

The summary statistics of my portfolio are shown in the table below.

 

The Numbers at a Glance
Category Median Value
P/E last year 11.7x
P/E this year 11.0x
P/E next year 10.4x
P/Book 1.8x
P/Sales 0.9x
Yield 2.00%
Range 72%
ROE 18%
Source: David Merkel

You can tell that my portfolio broadly fits into the “traditional value” style. I like my modified form of Graham and Dodd, with tweaks from Marty Whitman and a number of other notable value investors. That said, it’s my unique synthesis, and it has paid off for me in performance. Buying them cheap is critical to both good performance and risk control.

You might adopt my style or you might not; it takes some effort to do well with it. But the important thing is thinking through your portfolio management process to make sure that it’s fundamentally sound, businesslike, intelligently contrarian and something that fits into the way you live your life. Life is broader than investing, and management techniques must be small enough in time use for them to be a part of a broader, well-balanced life. You have my best wishes as you work out your own investment management style.

 

Full disclosure: still long VLO, IBA, JOF

Classic: Choosing an Insurance Company?

Classic: Choosing an Insurance Company?

Posted on by David Merkel

This was published in the “Ask Our Pros” column at RealMoney. ?I don’t know when, and I don’t have the actual question, but looking at my answer, I think I know what was asked.

I’ve been cheated in the past by insurance companies. ?How can I choose an insurance company that won’t cheat me?

This is a question after my own heart.? I worked in the life insurance business as an actuary for 17 years, serving in almost every area that life insurance companies have.

Life insurance agents and products have a bad reputation in the financial press.? Much of that bad reputation is deserved.? Products are often sold that pay agents well, but do not meet the needs of clients.? Agents influence the flow of information between the company and policyholder, and sometimes tell different stories to each side.

The life insurance industry has tried over the years to control the sales process better, so that only suitable products get sold.? Regulators have demanded it, industry groups want a better reputation, and individual companies have learned that writing bad business is unprofitable.? There are regulatory rules, industry conduct codes, etc.? It is difficult to root out bad apples among agents, which can flit from company to company; companies with bad records tend to get disciplined by the regulators and the courts.

Life insurance and annuities are products that are generally sold, not bought, excluding fancy tax reduction schemes used by high net worth individuals.? Typically, though, they get sold to people who will not plan for their own financial well-being, and would not save, invest, and protect their families on their own.? It is an expensive way to invest, but it is better than not investing at all.

There is a need for agent-sold financial products to help those that will not plan for themselves.? This provides a real service, though never as good as what an intelligent investor would do for himself, if he had the time to research everything out.

Disability and health insurance often get a bad rap over claims payment practices, often deservedly so.? Part of the reason for that is that people don?t want to pay the full price of these products; companies respond with lower priced products and get more hard-nosed about claims.? Part of the research that any person should do about an insurance company is their claims payment practices.? State insurance commissioners keep a record of which companies get complaints, and which do not.? Insurance fraud further pushes up costs, and makes companies scrutinize claims more.? Trial lawyers further push up costs by making medical malpractice expensive through exorbitant tort claims.

Auto and home insurance usually don?t draw the same level of complaints as the above areas.? There are some companies that try to be too sharp about claims practices; this is something to watch out for in any insurance company.? Auto insurance (or the equivalent) is mandatory; mortgage companies require home insurance.? The market is regulated, and usually highly competitive.

Another area of complaint is private mortgage insurance [PMI].? PMI benefits the lender, but is paid for by the homeowner.? The benefit to the homeowner is that he can buy a home, and not make a down payment of at least 20%.? The lenders require PMI when the ratio of the first mortgage to the appraised home value is greater than 80%.? New laws require PMI to go away when the ratio drops below 78%.? Homeowners can petition the lender when the ratio is at 80%.? (The lender will probably require a new appraisal.)

Now all this said, insurance companies have had a lower return on equity in the past 20 years than all other companies on average.? Insurance companies don?t make all that much money.? So where does the money go?? 1) Agents.? 2) Benefit payments.? 3) Home office expenses.? Investment income usually subsidizes insurance companies; they lose money on underwriting on average, and when the pricing cycle is weak, they lose substantial amounts.? Since the inception of health insurance, the insurance industry may have lost money in aggregate.

In Summary:

  • Plan your investment and protection needs yourself, or find a trusted advisor to help you.? Investment knowledge pays its own dividends.
  • Study a company?s claims paying practices before buying.
  • Review expense and surrender charges and other contract terms.
  • Choose an insurance company off its reputation, and not price only.
Classic: Know Your Debt Crises: This Too Shall Pass

Classic: Know Your Debt Crises: This Too Shall Pass

Posted on by David Merkel

The following was published at RealMoney on August 6th, 2007:

Editor?s Summary

The illiquid debt instruments at the heart of the current crisis are subject to regime shifts.

  • ?We?re in a periodic repricing of illiquid debt instruments.
  • Look for the time when the bulk of the losses will be reconciled.
  • Stick with the companies that have strong balance sheets.

I appreciated Cramer’s piece Friday morning, which picks up on many themes that I have articulated for the last four years here on RealMoney.? Here are a few:

  • Hedge fund-of-funds demand smooth returns that are higher than that which a moderate quality short-term fixed-income fund can deliver.
  • This leads to the creation of hedge funds that seek yield through arbitrage strategies.
  • And the creation of hedge funds that seek yield through buying risky debts, unlevered.
  • And the creation of hedge funds that seek yield through buying less risky debts, levered.
  • And the creation of hedge funds that seek yield through buying risky debts, levered.

In the short run, yield-seeking strategies work.? If a lot of players pursue them, they work extra-well for a time, as late entrants to the trade push up the returns for early entrants, with greater demand for scarce, illiquid securities with extra yield.? Pricing grids are a necessity for such securities, because the individual securities don’t have liquid secondary markets.? The pressure of demand raises the value not only of the securities being bought, but also of those securities that are like them.? (Smart managers begin to exit then.)

I’ve been through regime shifts in the markets for collateralized debt obligations (CDOs), asset-backed securities (ABS), residential-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).? Something shifts at the back of the chain that forces everything to reprice.? For example:

1989-1994: After the real estate boom of the mid-1980s, many banks, savings & loans and insurance companies get loose in their lending standards and real estate investment, leading to a crisis when rent growth can?t keep up with financing terms; defaults ensue, killing off a great number of S&Ls, some major insurance companies and a passel of medium and small banks.

Late 1991-early 1993: The adjustable-rate mortgage market, fueled by demand from ARM funds, overbids for ARMs in an effort to provide a high floating rate yield.? As the FOMC loosens monetary policy, higher than expected prepayments force losses onto the ARM funds

Late 1993-late 1994: The FOMC threatens to, and does, start raising interest rates, which throws the residential mortgage-backed market into crisis.

Mid-1998-mid-1999: Long Term Capital Management blows up, forcing all manner of exotic ABS, CMBS and RMBS into the market for bids.? The bids back up, until the entire market reprices and then tightens in the space of one year.

1998-1999: Home equity ABS blow up, as defaults threaten to, and then do, emerge at levels far higher than anticipated.? Almost no originators survive.

1999-2001: Cruddy high-yield bonds reveal their true value as defaults threaten to, and then do, emerge.

2002-2003: The manufactured-housing ABS market blows up, as originators don?t take initial losses but roll borrowers over into new loans that reduce payments and extend payment terms, technically keeping the loans current.? The system collapses when the buildup of bad debts and repossessed homes becomes too great to roll over.

(Of the existing large securitization markets, only the CMBS market so far has not faced a real crisis, partly due to the influence of the B-piece buyers cartel: six or so firms that buy the junk-rated debt of deals and enforce credit quality standards on the individual loans by kicking out poorly underwritten loans.? But who knows?? Even that could be overwhelmed under the right circumstances.)

In each of these situations, there was a boom-bust cycle.? The markets did not adjust slowly and evenly to changing conditions; the transitions between ?boom? pricing, and ?bust? pricing were swift.? This is the nature of markets, particularly when enough debt is employed to amplify the process.

There is no conspiracy necessary to make the shift happen (though often the media will make it seem like there was one); the bubble pops when the financing proves insufficient to carry the assets.? After the bubble pops, it becomes a question of what the underlying assets can be liquidated for, allocating losses mercilessly according to the loan documents and bankruptcy priority.

Today the crises are nonprime lending, leveraged buyouts and other high-yield debt and over-leverage in the CDO market.? These will get worked out, as all other crises do, handing losses to those who speculated unwisely and allowing those who financed properly to prosper on the other side of the crisis.

As you invest, look for the time when more than half of the losses will be reconciled.? That will be near the bottom for homebuilders and housing finance.

That time may not come for another two years or so, but there will be money to be made once the crisis is mostly reconciled.? Just stick with the companies that have strong balance sheets.

Classic: Ways to Cut Risk

Classic: Ways to Cut Risk

Posted on by David Merkel

This was published in late 2007 at RealMoney. ?I don’t know exactly when.

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I came into the investment business through the back door as an actuary and a risk manager. For more than a decade, I worked inside several large life insurance companies creating investment products. My team?s dirty secret? We just wanted to clip a smallish profit on the assets, without taking much risk ourselves. If we could do that, and produce a reliable investment result for our clients, we were happy.

That was my job then; in a different sense, it is my job now.? My goal as a writer, commentator, and independent money manager is to take much of the risk out of personal investing while retaining most of the profit potential.

Nobody can avoid every up and down in the market. What you can do, however, is to ensure that you don?t get crushed when the market rolls over. My own portfolio is a case in point. Over the last seven years, starting in September of 2000, my investment process has yielded an annualized return of 20% a year.? I manage to a long horizon, so I don?t try to cut losses in the short run.? I am willing to take pain if I feel that the underlying fundamentals are intact.? I had only one losing year in that time, but it was a doozy. During four months in 2002, my portfolio lost 32% of its value.? I was shaken, but I scraped together my spare cash and invested. Over the next 16 months, my portfolio rallied 86%, which I found about as astounding as the 32% loss.?

The experience taught me that risk control works. Oddly enough, though, risk control doesn?t get a lot of attention. The most popular books and websites on investing spend nearly all their time focusing on the prospect of big returns; they rush over the matter of how to avoid big losses or how to deal with these losses when they happen. The result? Many people sour on investing because they take risks they don?t intend and lose a lot of money. They conclude that the investment game is rigged against them and they leave investing.

 

It doesn?t have to be that way. Let me suggest five simple ways you can control your worst tendencies, reduce your risk and become a happier investor.

Spread your bets around. The most basic rule of risk control is to diversify your investments. It is also the most neglected rule.

Perhaps the neglect is because most people don?t understand what diversification means. For starters, it means building a buffer against all the stuff you would prefer not to think about?unemployment, sickness, a horrible bear market, etc. Before you start investing, you need three to six months of living expenses set aside in bank deposits, money market funds and short-term bond funds. Having this cushion protects you from having to sell investments in an emergency, which in turn allows you to take risk with your remaining assets.

On top of your emergency funds, your portfolio should include a dollop of high quality bonds that mature in anywhere from two to 10 years. For older people, bonds cushion the downside of the total portfolio and ensure that you can?t be devastated by a stock market downturn. For younger people, bonds provide an additional benefit?you can sell them to buy stocks or other investments if the market plunges and you spot tempting bargains. So how much of your portfolio should you devote to bonds? As little as 20% of your portfolio if you?re in your twenties and a risk taker; 50% or more if you?re above 65 or naturally cautious.

Once you?ve got your emergency funds and your bonds stowed away, it?s time for stocks?and, once again, diversification should be your starting point. You don?t want to bet your entire future on a handful of stocks or on one industry or even on a single country. The easiest way to ensure that you?re widely diversified among many different stocks is to invest in a mutual fund or exchange-traded fund that holds scores of individual stocks, representing a multitude of different industries.

If, like me, you prefer to buy individual stocks, you have to balance your desire to be widely diversified against how much money you have to invest and?just as important?how much time you have to spend researching companies. My minimum for reasonable diversification is 15 stocks. When I started investing as a serious amateur back in 1992, I started with 15 stocks in my portfolio, and I bought $2,000 of each of them. Since then I?ve made maybe a dozen serious investing mistakes, but because I had my money diversified among many companies, none of my mistakes ever cost me more than 2% of my total capital.

These days I?m even more diversified: I run with 35 stocks, which is close to the maximum an individual can hope to track and research. Generally I devote an equal amount of money to each of my stocks?an equal weight, in investment jargon?because usually I can?t tell what my best ideas are. When a position gets more than 20% away from its target weight, I consider whether I should bring it back to equal weight or sell the whole thing.? Occasionally I deviate from equal weighting, but only when I have a very safe stock that is grossly undervalued. I never go above a double weight, which means that a single stock rarely accounts for even 6% of my overall portfolio.

 

The final way I diversify my portfolio is intellectually. I try to listen to as many viewpoints from as many different people as I can. I do this because the ideas of all but the most careful investors are internally correlated. They reflect some idea of what the economy is likely to do in the future, and they lean toward companies that fit that view. Some investors love companies with high P/E multiples and incredible growth stories. Other investors?and I?m one of them?love companies in distressed industries that are going for a song. You should listen to both camps. Doing so insures that you learn to think about investments from a wide number of perspectives. It makes investing more businesslike.

Here?s one trick you might find handy. As I gather my ideas from a wide number of sources, I print them out, and place them in a pile next to my computer.? I try to forget who gave me the idea, which forces me to look at the idea fresh, without the biases that come from trusting an authority figure.

Follow the cash. Most investors pay a lot of attention to how much a company earns; few investors realize how easily management can manipulate those earnings with fancy accounting. To reduce risk in the stocks you buy, keep an eye on a company?s cash flow as well as its earnings.

Your first step should be to look with a questioning eye at the non-cash, or accrual items, on the company?s financial statements. These include entries for such things as depreciation, inventory adjustments, or bad debt allowances. Cash is certain, but non-cash items such as these are anything but. Earnings can be thrown up or down by how quickly management decides to write down the value of a new factory or by how much it estimates its inventory of rotary-dial phones is really worth. The accounting industry tries to set guidelines for accruals, but management still has a lot of leeway.

For non-accountants, the easiest way to sniff out possible trouble is to compare the earnings statement with the cash flow statement?specifically the top segment of the cash flow statement, which shows ?cash flow from operations.? This is the amount of cold hard cash the company?s operations are generating, before making any payouts to lenders or shareholders, or investing in new equipment. In most cases, if a company?s earnings are growing, its cash flow from operations should also be going up, since higher earnings just about always mean more cash going through the business. So what if a company says its earnings are growing, but its cash flow isn?t?? You should be very, very wary. The financial statements aren?t necessarily bogus, but you have to puzzle out how a company?s earnings can be rising without throwing off more cash.

Sometimes there is no good answer to this puzzle. Remember Sunbeam, the small-appliance maker that hired ?Chainsaw Al? Dunlap to goose its business? I owned the stock in 1996 when Dunlap came on the scene. But after two earnings reports I became suspicious. ?All of these restructuring efforts are improving earnings, but they?re not producing cash from operations,? I thought. ?What gives?? I concluded something fishy was going on, so I sold for a nice gain. Over the next six months, the stock rose by 60%?then plunged 90% as it became clear that most of Sunbeam?s increase in earnings was the result of accounting shenanigans, not real business gains.

Love the unloved. Most people avoid industries that are under stress.? Who can blame them?? The industry outlook is horrible; there can?t be anything good here.?

I take a different view. I believe that some of the safest plays you can make consist of buying financially strong names in weak sectors. These companies are usually cheap in comparison to their earnings and to their book values. You can find out more about how to spot undervalued companies by visiting the website of Tweedy Browne, the famous value-investing firm, and reading their excellent paper on What Has Worked In Investing (http://www.tweedy.com/library_docs/papers/what_has_worked_all.pdf).

In addition to the standard measures, I look for companies with good bond ratings.? The ratings agencies are out of favor now, because of the current furor over securitization, but they produce the best single measure of a company?s creditworthiness. The raters award the best ratings to companies that can generate cash well in excess of what is needed to pay all their creditors and that possess a low ratio of debt to assets.

 

Once I?ve bought a stock, I try to be patient, because the payoff is usually not instantaneous. In 2001, when steel stocks looked horrible, I bought Nucor, the soundest company in the industry. Steel companies dropped like flies in 2002 and the stock did nothing?until the end of the year, when enough steel-making capacity had been closed down that steel prices began to rise. Nucor flew, and I made a nice profit.

The key to making this contrarian strategy work is to not overdo it. Some industries?newspapers, say, or fixed-line telecom companies?truly do have questionable futures. You have to analyze each situation on its own merits.? At present, my favorite industries are insurance, energy, agriculture/food processing, cement, and chemicals.

 

My value-hunting approach means that most of the stuff I buy is not popular. I veer away from firms that are pioneering new technologies or markets. Such companies are easy to get enthusiastic about, but difficult to value because there are so many unknowns.

When I talk about the companies I own, the response is often, ?You invest in obscure stuff.? What do you think about Google?? I don?t have an opinion on Google.? I can?t tell you whether it will produce enough profits over the years to justify its current price or not.? So much depends on future tastes and competition. I?d rather own cement companies; they are very difficult to make obsolete.

Take emotion out of it You should look over your portfolio two to four times a year. In my own case, I follow a very structured process. I take all of the investment ideas that I have gathered up since my last portfolio pruning, and rate them on valuation, momentum, and accounting quality to arrive at a composite measure of their overall desirability. I compare these ideas to the companies that are already in my portfolio.

This sounds complicated and so it is. But exactly how you do your ranking is less important than having a system for comparing the stocks in your existing portfolio to the alternatives that the market is offering you. Your goal should to take some of the emotion out of investing. You don?t want to fall in love with the companies that you already own. To avoid this, I try to pinpoint what companies in my ideas list are better than the median idea in my portfolio.? These become purchase candidates and I do further research on them.

I also look at the companies in my portfolio that are below the median in desirability, and I ask why I?m keeping them. In many cases, the companies are less desirable because they?ve gone up in price and are no longer as cheap as the once were. In other cases, they?re less desirable for the opposite reason? the company?s business has deteriorated and shows no signs of turning around. Every three to four months, I typically sell two or three companies from my 35-stock list and replace them with more promising companies from the ideas list. I typically hold a stock for three years.? Many of my ideas go against me at first, but often turn and make money for me later.

 

Smart money is slow money. If a stockbroker or financial planner tells you that you?ll miss a huge opportunity if you don?t buy right now, ignore them. A smart investor moves at his or her own pace.

To make sure that you don?t get pressured into buying something, it?s nearly always a good rule to avoid salespeople. Stockbrokers, financial planners, mutual fund salespeople and even the experts on the television all have financial incentives that can pull them in directions opposite to what?s in your best interest. Before buying any stock or any financial product, you should do a bit of background reading so that you understand what you?re buying and how much rival products cost. In many cases?insurance is a good example?you?ll find that the simplest product is your best buy. Complexity in insurance, and many other investments, is usually a cover for increased fees.

Especially when it comes to buying stocks, patience is your best friend. If an idea seems like a sure thing, sit on it for a month.? If the idea is still a good one, you will usually still have time to act on it.? If the idea is a bad one, the extra time will help you do further research and may make its problems evident.

One of the best ways to make money is to avoid losing it. When I approach new ideas, I try to ask how likely it is that I will lose money, and how much I could lose if I am wrong. I lose about 20% of the time. Six times in the last 15 years, I have lost half my money on an investment. Those are actually pretty good numbers. I can?t avoid all losses, but if I wait, take my time and do my research, I can limit my losses, and make money on the rest of my ideas.

Classic: The Fundamentals of Real Estate Market Tops

Classic: The Fundamentals of Real Estate Market Tops

Posted on by David Merkel

I’ve mentioned before how all of my old articles at RealMoney were lost.? This was the draft version of Real Estate’s Top Looms published on 05/20/05.? I followed it up with? Housing Bubblettes, Redux on 10/27/05 and? September 2005 — The Residential Real Estate Inflection Point on 02/14/06.? Also, there was Wrecking Ball Looms for Big Housing Spec on 11/27/06, where I explained why it was likely that the subprime residential mortgage market was likely to blow up (can’t find the draft of that one).

But those links above no longer work — a real pity, and the one link below is corrected to point to the republished article at my blog.? Anyway, enjoy this if you want, because it outlines my thinking on how to recognize whether you are getting near the end of the bull phase of a market.

(Note: the italicized, indented portions, quote the original article The Fundamentals of Market Tops.? Much of what I write compares how residential real estate is similar to and different from stocks.)

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About a year and a half ago, I wrote a piece called The Fundamentals of Market Tops.? It was an important piece for me because I received a lot of positive feedback from readers.? It was also important because it disagreed with the view of the firm that I worked for, and nearly led to my termination there, because they encouraged me to stop writing for RealMoney.? Neither termination happened, but it was touch-and-go for a while.

This piece unofficially represents the views of the firm that I work for, because my views of macroeconomics have become the firm?s views, but I don?t directly control our investment actions.? What I will try to accomplish here is to try to apply the logic of my prior article to the residential real estate market.? As opposed to my earlier article, I will try to show why I think we are close to a market top in residential real estate.? There is reason for pessimism.

The Investor Base Becomes Momentum-Driven

Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

This is what I see in many residential real estate markets now: panicked buyers are saying ?this is my last chance,? and buying houses using risky forms of financing.? At the same time, I read stories of despair as some potential buyers give up and say that a house is out of their reach for now; they waited too long.? Occasionally, I see a few articles or e-mails regarding people who seem to be bright selling their homes and renting, but this is a minority behavior.

In the face of this, residential real estate prices continue to rise, particularly in the hot coastal markets, which tells me that the price momentum can continue a little while longer until it fails because there is no incremental liquidity available to expand the bubbles.

You’ll know a market top is probably coming when:

  1. The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.

  2. Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

  3. Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.

  4. The recent past performance of growth managers tends to beat that of value managers. (I am using the terms growth and value in a classic sense here. Growth managers attempt to ascertain the future prospects of firms with little focus on valuation. Value managers attempt to calculate the value of a firm with less credit for future prospects.) In short, the future prospects of firms become the dominant means of setting market prices.

  5. Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.

  6. Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.

  7. Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Houses aren?t like stocks for several reasons:

  1. Unlike stocks, houses are used by their owners every day.
  2. We can short stocks, but we can?t short houses.? (Personally, I hope no one comes up with a clever way to do so.? We have enough volatility already.)? The most someone can do is sell his home and rent.
  3. Perhaps the equivalent of a long-only manager is someone who owns his property debt-free, like me, and doesn?t see the need to lever up by moving up to a larger home.? Measured against the standard of ?what might have been? is a terrifying taskmaster from an investment standpoint.? I avoid it in equity investing, and in home ownership.
  4. I am aware of a number of people (I have been assured that they are not mentally incompetent) who have sold their homes and started renting.? This to me is the equivalent of going totally flat in equities, or other risky assets.? Not that one faces negative carry, because the ratio of rent to in the hot markets is pretty low.? In many markets, you can earn more off the proceeds than you pay in rent (leaving tax consequences aside).? This leaves aside the issue of appreciation/depreciation of housing values, but when one can rent more cheaply than buying, it is a negative for the housing market.
  5. My point about momentum strategies is definitely pertinent here.? With the existence of contract-flipping, a high level of amateur investment (seemingly under the guise of ?buy what you know?), and a high level of investor interest (10%+), there is a lot of momentum in real estate investment.? People buy because prices are going up.? Some buy because it is ?the last train out,? and they have to jump rather than be stranded.? Nonetheless, momentum tends to maintain in the short run, and the slowdown posited last fall definitely has not occurred.
  6. Value vs. Growth does not exactly apply here, but in the housing market, people are paying up for future prospects more than they used to, which is akin to growth investing.
  7. This is just an opinion, but those who are making money in residential real estate today are inexperienced and less rigorous than most good businessmen.? They see the potential for profit, but not the possibility of loss.
  8. Unfortunately, it is difficult to partially own a home.? Home ownership is largely a discrete phenomenon.
  9. Using a concept from value investing we can look at the earnings yield that residential real estate is throwing off.? Compare the rents one could receive from a property versus the cost that it would take to finance the property on a floating rate basis.? What I am seeing is that more and more hot coastal markets earn less from rents than they require in mortgage payments.? Property price appreciation is no longer a nice thing; it is required to bail out inverted investors.? Contrast this with those that invested in tech stocks on a levered basis in early 2000; they paid cash out to hold appreciating positions, before they paid cash to hold depreciating positions, before they blew the positions out in panic.

Corporate Behavior

Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.? Here are ways that corporate behaviors change near a market top:

  1. The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
  2. Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
  3. Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
  4. There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
  5. Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
  6. Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
  7. Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

  1. Every time a new home is sold, a privately placed IPO is held, with one buyer.
  2. When rates are low, it is no surprise that the homebuilders try to take advantage of the situation, and provide supply to meet the demand.? But if it is only rate-driven, rather than from growth in real incomes in the economy, the quality of the new buyers will be low, because now they can just barely finance the house they could not previously.? If their income level falters, they will not have any safety margin allowing them to hold onto the house.
  3. Private investors in residential real estate have multiplied at present.? This is akin to an increase in venture capital.
  4. Leverage for new buyers has never been higher.? This occurs through second and third mortgages, as well as subprime mortgages.? Interest only mortgages are commonplace among new mortgages.? Beyond this, investors hide themselves so that they can get the cheap rates associated with owner-occupied housing.
  5. With housing, making the earnings estimate means being able to pay the mortgage payment each month.? The degree of slack here is less than in the past.

Other Gauges

These two factors are more macro than the investor base or corporate behavior but are just as important.? Near a top, the following tends to happen:

  1. Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.
  2. The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.

One final note about my indicators: I have found that different indicators work for market bottoms and tops, so don’t blindly apply these in reverse to try to gauge bottoms.

?There is no options market for residential housing, but the Federal Reserve is still a major influence in the housing market.? When the Fed is withdrawing liquidity from the system, the price of housing tends to slow down, if not reverse.? Like the equity market, this is not immediate but follows a six- to 18-month lag.? This is another case of ?Don?t fight the Fed.?

No Top Now

There are reasons for concern in the present environment. Valuations are getting stretched in some parts of the market. Debt capital is cheap today. There are an increasing number of momentum investors in the market. Making the earnings estimate is once again of high importance. Nonetheless, a top in the market is not imminent, for these reasons:

  • The Fed is on hold for now. Liquidity is ample, perhaps too much so.
  • Actual price volatility is muted.
  • Since all of the accounting scandals of the last few years, many corporations have cleaned up their accounting and become more conservative.
  • Cash flow from operations comprises a high proportion of current earnings. More dividends are getting paid.
  • Leverage has not declined, but most corporations have succeeded in refinancing themselves in a low interest rate environment.
  • Conservative asset managers have not been fired yet.
  • Most IPOs don’t seem outlandish.

Not all of the indicators that I put forth have to appear for there to be a market top. A preponderance of them appearing would make me concerned, and that is not the case now.

?Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me out of the trouble in 1999 and 2000. I hope that I — and you — can achieve the same with them as we near the next top.

The current market environment is not as favorable as it was a year ago, but there are still some reasonably valued companies with seemingly clean accounting to buy at present. Right now, being long the market is more compelling to me than being flat, much less short.

I would retitle this the ?The Top is Coming Soon.?? The reasons that I mentioned to be worrisome remain:

  • Valuations are getting stretched in some parts of the market.
  • Debt capital is cheap today.
  • There are an increasing number of momentum investors in the market.
  • Making the earnings estimate is once again of high importance. (Gotta pay my mortgage!)

But there is more that makes me even more bearish:

  • The Fed is on the warpath, and liquidity is scarce.
  • Appraisals overstate the value of property that financial institutions lend against.
  • Homeowners have a smaller margin of safety than they have had in the past.
  • Leverage has increased for the average homebuyer.
  • People are paying more than they ought to for new and existing homes.

I am decidedly a bear on housing prices (at least in the hot coastal markets) at present, but I recognize that momentum can carry prices far beyond sustainable levels.? That?s the way markets work.

Nonetheless, I am still a bear on those who build homes, and those who finance them.? We are at an unsustainable place in the ability to finance the residential hosing market.? Either an increase in interest rates or a decrease in ability to pay for housing can derail the market.? This is the inflection point that we are at over the next year.

Classic: Financials are Different

Classic: Financials are Different

Posted on by David Merkel

The following was published at RealMoney in March 2006:

When you are a corporate bond manager, one of the lessons that you learn early is that financial companies (or, financials) are different from industrials or utilities.? Why?? First, the novice manager wants to buy a lot of financials, because they yield more at equivalent ratings.? Second, you have a staff of analysts, and you realize that only a few of them can do financials, whereas almost all of them can do industrials or utilities.? Again, why?? Here are a number of related reasons:

  • Tangible assets play only a small role in a financial company.? What constrains the growth of an industrial company?? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year.? With services, workers? Finally, demand is the ultimate limiting factor, but this affects financial, industrial, and services businesses alike.? With a financial company, sometimes the limits are akin to a service business (?If only we had more trained sales reps!?), but more often, capital limits growth.
  • The cash flow statement plays a big role with industrials and utilities, but almost no role with financials.? One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow.? Free cash flow is the amount of cash that the business generates in a year that could be removed, and the business is as capable of functioning as it was at the start of the fiscal year.? Deducting maintenance capital expenditure from EBITDA often approximates free cash flow.? Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks.? Capital is released as business matures.? In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
  • Sadly, the change in required capital is not disclosed anywhere in a typical 10K.? Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on.? Sometimes the federal or state regulators provide the most constraint; this is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers.? For entities that raise their capital in the debt markets, or do business that requires a strong claims paying ability rating, the ratings agencies could be the tightest constraint.? Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures.? Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
  • Financial institutions are generally more highly regulated than non-financial institutions.? There are several reasons for this: the government does not want the public exposed to financial risk, systemic risk, guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.), and defaults are costly in ways that defaults of non-financials are not.? The last point deserves amplification; in a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy.? Confidence can not be allowed to fail.? Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
  • Rapid growth is typically a negative; financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality.? In normal situations, a financial institution can get only two out of three.? In bad times, it would be only one out of three.
  • Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions.? Typically, borrowing occurs at the holding company; the regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company.? This makes the common stock more volatile.? In a crisis, the regulators only want to assure the safety of the operating company; they don?t care if the holding company goes bust, and the common goes to zero.? They just want to make sure that the guaranty funds don?t take a hit, and that confidence is maintained among consumers.

All of these factors together lead to the following conclusion: financials are more complex than other types of companies, and are not correctly analyzed in the same way as non-financials.? Earnings quality is hard to discern, and growth is not always a positive thing.? Bankruptcies are rare, but when they happen, recoveries are poor for common stockholders and holding company debtholders.? Finally, management conservatism and competence are paramount, given the less certain nature of accrual accounting at financial companies, and the inability to calculate free cash flow with any precision.

In part 2 of this two-part series, I will give my approach to analyzing a sector of the insurance space in order to demonstrate some of these ideas.

Classic: The Correlation Trade Gone Wrong

Classic: The Correlation Trade Gone Wrong

Posted on by David Merkel

The following was published at RealMoney on May 23rd, 2005.? It’s a little obscure, but indicative of what can happen when too much money pursues an obscure arbitrage.? If nothing else, the piece tries to explain a complex concept to those with moderate market knowledge.

Because of the market dislocations last week, I want to give a primer on the class of derivatives that really jolted the markets this week: Indexed Synthetic CDOs.? First, some definitions:

1)????? CDO – Collateralized Debt Obligation.? A trust that owns bonds, loans, or credit default swaps.? The ownership in the trust is hierarchical.? There are several classes of certificates that have different interests in the trust, which get defined by which class receives losses from defaults first, second, third, etc.? The earlier that a class (or tranche) receives losses if they occur, the higher the yield a class of certificates receives.

2)????? Synthetic ? a term used in opposition to ?cash.?? One who transacts in corporate bonds participates in the cash market.? The synthetic market in corporate credit is composed of credit default swaps.? It is called ?synthetic? because it transacts in corporate credit risk without making loans to corporations.

3)????? Credit default swaps ? A market participant who buys default protection on a given corporation through the credit default swap market gains the right to deliver a certain amount of defaulted bonds in exchange for the par value of the bonds, when an event of default occurs for the class of bonds covered by the agreement.? In exchange for this privilege, the buyer of protection pays the seller a fixed fee for the term of the swap, which is usually five years, but can vary.

4)????? Spread ? That fixed fee is called the spread.? When the spread falls, the value of a credit default swap to someone who has previously sold protection becomes more valuable, in the same way that a bond price rises when its yield falls.

5)????? Indexed ? A third party puts together a seemingly diversified (or focused) list of companies so that investors can invest in a liquid pool of similar companies that they want exposure to, whether on a debt, synthetic, or equity basis.

Indexed Synthetic CDOs gather together the risk of debt default for a group of corporations, and parcel the risk of default out in a concentrated form to those who hold the ?first loss? certificates, in exchange for a high yield.? Those who hold other certificates in the loss priority get lesser yields commensurate to the risk of taking losses.

Setting the Stage

The Indexed Synthetic CDO market rallied until March 2005.? In most cases, the more risk an investor took, the better that investor did.? The indexes were rallying.? Those willing to offer protection against the default of a wide number of corporations were willing to do so at smaller and smaller spreads.? As I stated previously on RealMoney, those spreads were too small to compensate for the possibility and severity of losses.

Also, until March of 2005, the decline in spreads was fairly uniform.? There weren?t many credits within each index that were not moving in tune with the rally.? This was significant, because it meant that results were particularly good for the ?first loss? investors.? What hurts ?first loss? investors are credits going into default.? If the spread on the index as a whole improves (goes lower), but a small minority of credits diverge (get wider) and then default, the ?first loss? investor can get hurt, while investors with greater loss protection can still do well.

What Happened Last Week

Last week, not only did spreads rise in general, but some credits related to the auto and auto parts industries widened disproportionately.? This wouldn?t have been such a problem, except that a large number of hedge funds participated in the Indexed Synthetic CDO market doing an esoteric arbitrage trade, where the hedge funds when long the ?first loss? piece, and short 2.0-2.5x the ?second loss? piece.? This trade was sometimes called the ?correlation trade? for reasons I will talk about in a moment.

Why do such a trade?? The lure of free money is inexorable, and the trade had been free money for a while.? So long as movements in the spreads of credits in the index remained closely correlated, the hedge would hold between the ?first loss? and ?second loss? pieces, and the hedged investment would earn a high riskless yield, which to a hedge fund is the holy grail; a lot of hedge fund of funds will throw money at a strategy like that.

All arbitrages boil down to buying and selling two similar securities, and attempting to profit from the price or yield spread over the anticipated time horizon of the transaction.? Arbitrages can be intelligent or foolish depending on whether the anticipated total return is large enough to compensate for the negative results if the convergence anticipated in the arbitrage does not occur.

Last week, conditions for the hedge did not hold as the credit default swap spreads on automotive-related credits rose, leading the ?first loss? pieces to fall in value.? Surprisingly, the ?second loss? pieces actually rose in value, as a number of players moved to close out their hedges, which put downward pressure on the prices of the ?first loss? pieces, and upward pressure on the prices of the ?second loss pieces.? This became self-reinforcing for a while until the close on Tuesday.? On Wednesday, hedge funds and investment banks poured fresh capital into the trade, since the risk reward ratio on the hedged trade was now more attractive, bringing the market back to a more normal state.

Effects on the equity market

This put a damper on the equity market for several reasons: first, some players feared that some of the investment banks were caught on the wrong side of the trade, or had lent to those on the wrong side of the trade.? My guess is that?s not true, but if true, it could raise systemic risk issues, which lowers equity values, as it did in 1998 during the LTCM crisis.? The risk controls at the investment banks are far superior to those at most hedge funds now, and far superior to what they were at the investment banks during LTCM.? That doesn?t mean there can?t be crises, but the preparations for a crisis are better now.? The investment banks have laid off more risks to other market participants.? The other main effect on the equity market was that yields on riskier corporate bonds rose, which usually correlates with lower stock prices.

In closing, just be aware that there are other big markets such as the credit default swap market, both in its single-credit, and indexed forms, that can have a big effect on the equity markets.? There is a lot of leverage around, and ?bets gone wrong? can be big enough to knock some confidence out of the markets.? But I offer this hope: so long as the effects of the ?bets gone wrong? do not affect major institutions such as investment banks, commercial banks or insurance companies, the effects on the markets should be transitory, as they were after LTCM.

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