Portfolio Management – Page 12

Trying to Cure the Wrong Disease

Posted on 5 March 2016 by David Merkel

Caption from the WSJ: Regulators don?t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would ?interfere with our supervisory judgments.? PHOTO: BAO DANDAN/ZUMA PRESS

Catch the caption from the WSJ for the above picture:

Regulators don?t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would ?interfere with our supervisory judgments.?

Regulators are not required by the Constitution, but Congress, perverse as it is, is the body closest to the people, getting put up for election regularly. ? Of course Congress should oversee financial regulation and monetary policy from?an unelected Federal Reserve. ?That’s their job.

I’m not saying that the Congressmen themselves understand these things well enough to do anything — but that’s true of most laws, etc. ?If the Federal Reserve says they are experts on these matters, past bad results notwithstanding, Congress can get people who are experts as well to aid them in their decisions on laws and regulations.

The above is not my main point, though. ?I have a specific example to draw on: municipal bonds. ?As the Wall Street Journal headline says, are they “Safe or Hard to Sell?” ?For financial regulation, that’s the wrong question, because this should be an asset-liability management problem. ?Banks should be buying assets and making loans that fit the structure of their liabilities. ?How long are the CDs? ?How sticky are the deposits and the savings accounts?

If the maturities of the munis match the liabilities of the bank, they will pay out at the time that the bank needs liquidity to pay those who place money with them. ?This is the same as it would be for any bond or loan.

If a bank, insurance company, or any financial institution relies on secondary market liquidity in order to protect its solvency, it has a flawed strategy. ?That means any market panic can ruin them. ?They need table stability, not bicycle stability. ?A table will stand, while a bicycle has to keep moving to stay upright.

What’s that you say? ?We need banks to do maturity transformation so that long dated projects can be cheaply funded by short-term savers. ?Sorry, that’s what leads to financial crises, and creates the run on liquidity when the value of long dated assets falls, and savers want their money back. ?Let long dated assets that want debt financing be financed by REITs, pension plans, endowments, long-tail casualty insurers, and life insurers. ?Banks should invest short, and use the swap market t aid their asset liability needs.

Thus, there is no need for the Fed to be worrying about muni market liquidity. ?The problem is one of asset-liability matching. ?Once that is settled, banks can make intelligent decisions about what credit risk to take versus their liabilities.

In many ways, our regulators learned the wrong lessons in the recent crisis, and as such, they meddle where they don’t need to, while neglecting the real problems.

But given the strength of the banking lobby, is that any surprise?

A World Deep in Debt…

Posted on 27 February 2016 by David Merkel

Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most coircumstances — Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most circumstances. ?I do support debt-for-equity swaps to delever the system.

Debt, debt, debt…?debt is kind of like a snowflakes. ?A single snowflake is a pretty star, but one quintillion of them is a horrendous mess. ?In the same way, most individual debts are reasonable and justifiable, but when debt becomes a pervasive part of the economic system, the second order effects kick in:

As fixed claims grow relative to equity claims, the economy becomes less flexible, because many are counting on the debts for which they are creditors to be paid back at par.
Economies that are heavily indebted grow slower.
Central banks following untested and dubious theories like QE and negative interests rates try help matters, but end up making things worse. ?(Gold would be an improvement. ?Just regulate the solvency of banks tightly, which was not?done in cases where?the gold standard failed.)
Political unrest leads to dubious populism, and demands for debt cancellation, and a variety of other quack economic cures.
The most solvent governments find high demand for their long debt. ?Long-dated claims raise in value as inflation falls along with monetary velocity.

Thus the mess. ?Bloomberg had an article on the topic recently, where it tried to ask whether and where there might be a crisis. ?I’ve argued in the last year that we shouldn’t have a major crisis in the US over domestic debts. ?There are a few areas that look bad:

Student loans
Agriculture loans
Corporate debts to speculative grade companies that are negatively affected by falling crude oil and commodity prices.
Maybe some auto loans?

But those don’t add up to a debt market in trouble as when residential mortgages were on the rocks.

But what of other nations and their debts, public and private?

Tough question.

That said, the answer is akin to that for a corporation with a tweak or two. ?It’s not the total amount of indebtedness versus assets or income that is the main issue, it is whether the debts can continue to be rolled over or not. ?A smaller amount of debt can be a much larger problem than a bigger amount that is longer. (point 2 below)

Take a step back. ?With countries there are a variety of factors that would make skeptical about their financial health:

Large increases in indebtedness
Large amounts of short-term debt
Large amounts of foreign currency-denominated liabilities (also true of the entire Eurozone — you don’t control the value of what you will pay back)
A fixed, or pseudo-fixed exchange rate (versus floating)
A weak economy, and
Debt and/or debt service to GDP ratios are high

The first point is important because whatever class of debt increases the most rapidly is usually the best candidate for credit troubles. ?Debt that is issued rapidly rarely gets put to good uses, and those that buy it usually aren’t doing their homework.

Under ordinary circumstances, this would implicate China, but the Chinese government probably has enough resources to cover their next credit crisis. ?That won’t be true forever, though, and China needs to take steps to make their banking system sound, such that it never generates losses that an individual bank can’t handle. ?Personally, I doubt that it will get there, because members of the Party use the banking system for their own benefit.

Points 3, 4, and 6 deal with borrowers compromising on terms in order to borrow. ?They are stretching, and accepting?terms not adjustable in favor of the debtor, or can be adjusted against the debtor. ? If you control your own currency, these problems are modified, because of the option to print currency to pay off debt, and inflate problems away. (Which creates other problems…)

By pseudo-fixed interest rates, I take into account countries that as neo-mercantilists make policy to benefit their exporters at the cost of their importers and consumers. ?These countries fight changes in the exchange rate, even though the exchange rate may technically float.

Point 5 simply says that there is insufficient growth to absorb the increases in debt. ?Economies growing strongly rarely default.

Conclusion?

My view is this: the next major credit crisis will be an international one, and will involve governments that can’t pay on their debts. ?It won’t include the US, the UK, and certainly not Canada. ?It probably won’t involve China. ?Weak parts of the Eurozone and Japan are possibilities, along with a number of emerging markets.

And, as an aside, if?this happens, people will lose faith in central banks as being able to control everything. ?I think the central banks and national treasuries will find themselves hard pressed to find agreement at that time. ?QE and negative interest rates might be controllable in a domestic setting, but in an international framework, other nations might finally say, “Why would I want to get paid back in that weak currency?” ?(And what holds that back now is that virtually all of the world’s currencies except gold are involved in competitive devaluation to some extent.)

My advice is this: be careful with your international holdings. ?The world may be peaceful right now, and everyone may be getting along, but that might not last. ?Diversification is a good idea, but don’t forget that there is no place like home, unless the crisis is in your home.

On Investment Charlatans

Posted on 12 February 201613 February 2016 by David Merkel

Photo Credit: Alex Proimos || A bunch of con men attempt to bilk an unsuspecting lady

There are many ways to try to cheat people in the investment world. ?You can promise them:

No risk (an appeal to fear)
High returns (greed)
Secret knowledge (can appeal to either or both fear and greed)
An easy life, free from the worries common to man.
And more…

For virtually every human weakness or sin, there is a road to cheating men. ?This is why it is difficult to cheat a truly honest man, because an honest man is:

Industrious — he knows most ways to improve his lot in life involve considerable work, whether physical or mental.
Skeptical — he knows not everyone is honest, and there are many that pursue ways that harm themselves or others.
Self-controlled — he doesn’t need to become wealthy, but if it comes bit-by-bit, he can handle it.
Unafraid — he doesn’t scare easily, and there are many purported scares out there. ?There are always people trying to make money off of apocalyptic scenarios. ?(Believe me, in a truly apocalyptic scenario, where the government breaks down, or you lose a war on your home soil — no one wins. ?And, there is no way to prepare.)
Studious, and has wise?friends — he doesn’t quickly buy novel reasoning, or unfamiliar concepts without testing them, and running them past his personal “brain trust.”
Patient — he can’t be rushed into something, and he can walk away.
Virtuous — when he does commit, he holds to it, and makes good on what he promised. ?He expects the same of others, and does not deal with those of bad reputation.

There’s more, and I don’t hold myself out to be perfect here, but that is a part of what I aim for. ?If you are like this, you will be very difficult to cheat.

With that wind-up, here is the pitch: I ran across a video while doing my usual work, when I saw a picture of Buffett. ?Now, everyone wants to invoke Buffett because he is a genuinely bright guy on all affairs affecting money and wealth. ?Many who do so twist what Buffett has done for their own ends. ?You can see the graphic used to the left.

So this guy posits that Buffett got rich off of “Guaranteed Income Certificates.” ?You can listen to the whole 39-minute video, and never learn what a?Guaranteed Income Certificate is. ?This is a tactic to make you think that the video-maker has hidden knowledge. ?He does not lie, per se, but dances around what it is and how Buffett has used them. ?I figured out what he was talking about in a about two?minutes, but only because the language was so discursive, with many rabbit-trails.

So what is the vaunted?Guaranteed Income Certificate?

Preferred stock.

Preferred stock?

Yes, preferred stock, that hoary creation that gets wiped out when most firms go into bankruptcy. ?There are few cases where the preferred stock is worth anything in a crisis. ?It is far from guaranteed. ?It has all of the disadvantages of a bond, with none of the countervailing advantages of common stock, which can provide strong returns.

Geek note: why is preferred stock called preferred? ?Three, maybe four reasons:

Its dividend payment can only be unpaid if the common dividend is unpaid first. ?It has a dividend payment priority.

If the dividend is eliminated, preferred stockholders as a group typically gain representation on the Board of Directors.

In bankruptcy, they receive preference over the common shareholders when the company is recapitalized or liquidated. ?That said, in bad scenarios, their claim is the second lowest of all claims — behind the secured creditors, the government, lawyers, general creditors, bank debt, and unsecured bonds. ?Believe me, that preference on common shareholders is not a big protection.

The preferred dividend is usually, but not always higher than the common dividend.

All preferred stock is is a promise to pay dividends if the company can do so without going broke, and ahead of the common shareholders. ?Like all risky investments, you can lose it all. ?Average recovery in bankruptcy for?preferred?stock is?around 5 cents on the dollar, versus 40 cents for most bonds,and 80 cents on bank debt.

Now, Buffett has done some clever things with preferred stock that is convertible into common stock, or alongside common stock or warrants. ?Occasionally he has bought some regular preferred stock as an income vehicle for his insurance companies. ?But Buffett almost never plays merely for income, he wants the gains that come from stocks.

Now, I didn’t listen to the whole video — after five minutes of the beautiful voice dancing around the issue, I stopped it, right clicked, downloaded it, and went?to the end. ?As is common with these sorts of videos, it makes it sound easy, as if infinite income could be yours if you just buy this service. ?They sell you on what your dream life will be like: you will have more than enough money for vacations, you’ll never have to work again, you can spend as much time visiting the faraway grandchildren…

The guy who put the video together, and sells his service, was big on hiding things behind new names that he concocted:

Preferred stock becomes Guaranteed Income Certificates
Venture Capital / Private Equity becomes Doriot Trusts
Master Limited Partnerships?become Secret Oil income Streams
Royalty Trusts are treated as a novel investment, rather than the backwater that it is.

The presentation is also expert in lying with true statistics, making the ordinary sound extraordinary. ?It also has the “but wait, there’s more!” pitch, where they throw in a bunch of old reports to make the deal seem sweeter. ?The cost of the newsletter if saved for the very end — beware of those that won’t tell you the cost up front. ?Good deals will always show you the price early. ?Charlatans hide the price.

There are no secrets. ?There is no easy road to an easy, wealthy life. ?I want to end this post ?the way I ended a similar post called “On the 770 Account,” which was a code name for permanent life insurance. [Sigh. ?Oddly, that post still gets a lot of hits, probably because no one has stepped forward to call that one out.]

Final Note

THERE ARE NO SECRETS IN MONEY MANAGEMENT! ?THERE ARE NO SECRETS IN MONEY MANAGEMENT! ?THERE ARE NO SECRETS IN MONEY MANAGEMENT!

There is no secret club. ?There are no secret formulas. There are a lot of clever lawyers, accountants, and actuaries that the wealthy employ, but for average people, the high fixed costs won?t make it work.

If you want to be wealthy, you have to run your own firm, run it well, providing value to many. ?Don?t listen to those who say they have an easy way to wealth. ?They are lying, and are looking to make money off of you. ?Those who give you free advice are using you in some way. ?(Wait, what does that make me to be? Sigh.)

Signing off, your servant David, who does this for his own reasons?

Our Growing World

Posted on 4 February 2016 by David Merkel

In general, I tend not to go in for macro themes. ?Why? ?I tend to get them wrong, and I think most investors?also get them wrong, or at least, don’t get them right consistently.

I do have one macro theme, and it has served me well for a long time, though not over the past two years. ?I was using the theme as early as 2000, but finally articulated it in 2006.

At that time, I was running my equity strategy for my employer, as well as in my personal account. ?They used it for their profit sharing plan and endowment. ?They liked it because it was different from what the firm did to make money, which was mostly off of financial companies, both public and private. ?They didn’t want employees to worry that their accrued profit sharing bonuses would be in jeopardy if the firm’s ordinary businesses got into trouble. ?In general, a good idea.

At the end of the year, I needed to give a presentation to all of the employees on how I had been managing their money. ?Because my strategies had been working well, it would be an easy presentation to make… but as I looked at the prior year presentation, I felt that I needed to say more. ?It was at that moment that the macro theme that i had been working with became clear to me, and I called it: Our Growing World.

The idea is this: in a post-Cold War world where most economies have accepted the basic idea of Capitalism to varying degrees, there should be growth, and that growth should create a growing middle class globally. ?This middle class would be less well-off than what we presently see in America and Western Europe, at least not initially, but would manifest itself in a lot of demand for food, energy, and a variety of commodities and machinery as the middle class grew.

Now, I never committed everything to this theme, ever. ?Maybe one-third of the portfolio was influenced by it, on averaged. ?Most of what I do was and still is more influenced by my industry models, and by bottom-up stock-picking.

That said, the theme has a cyclical bias, and cyclicals have been kicked lately. ?I still think the theme is valid, but will have to?wait for overinvestment and overproduction in certain industries to get rationalized globally. ?Were this only a US problem, it might be easier to deal with because we’re far more willing to let things fail, and let the bankruptcy process sort these matters out. ?Governments in the rest of the world tend to interfere more, particularly if it is to protect a company that is a “national champion.”

But the rationalization will take place, and so until then in cyclical industries I try to own financially strong companies that are cheap. ?They will survive until the cycle turns, and make good money after that. ?That said, the billion dollar question remains — when will the cycle turn?

More next time, when I write about my industry model.

Cheapness versus Economic Cyclicality

Posted on 30 January 201631 January 2016 by David Merkel

Photo Credit: Paul Saad || What’s more cyclical than a mine in South Africa?

This is the first of a series of related posts. ?I took a one month break from blogging because of business challenges. ?As this series progresses, I will divulge a little more about that.

When I look at stocks at present, I don’t find a lot that is cheap outside of the stocks of companies that will do well if the global economy starts growing more quickly?in nominal terms. ?As it is, those companies have been taken through the shredder, and trade near their 52-week lows, if not their decade lows.

Unless an industry can be done away with in entire, some of the stocks an economically sensitive industry will survive and even soar on the other side of the economic cycle. ?At least, that was my experience in 2003, but you have to own the companies with balance sheets that are strong enough to survive the through of the cycle. ?(In some cases, you might need to own the debt, and not the common equity.)

The hard question is when the cycle will turn. ?My guess is that government policy will have little to do with the turn, because the various developed countries are doing nothing to clear away the abundance of debt, which lowers the marginal productivity of capital. ?Monetary policy seems to be pursuing a closed loop where little?incremental lending gets to lower quality borrowers, and a lot goes to governments.

But economies are greater than the governments that try to milk them. ?There is a growing middle class around the world, and along with that, a growing need for food, energy, and basic consumer goods. ?That is the long run, absent war, plague, resurgent socialism, etc.

To give an example of how markets can decouple from government policy, consider the corporate bond market, and lending options for consumers. ?The Fed can keep the Fed funds rate low, but aside from the strongest?borrowers, the yields that lesser borrowers?borrow at are high, and reflect the intrinsic risk of loss, not the temporary provision of cheap capital to banks and other strong borrowers.

It’s more difficult to sort through when accumulated organic demand will eventually well up and drive industries that are more economically sensitive. ?Over-indebted governments can not and will not be the driver here. ?(Maybe monetary policy like the 1970s could do it… what a thought.)

So, what to do when the economic outlook for a wide number of industries that look seemingly cheap are poor? ?My answer is buy one of the strongest names in each industry, and then focus the rest of the portfolio on industries with better current prospects that are relatively cheap.

Anyway, this is the first of a few articles on this topic. ?My next one should be on industry valuation and price momentum. ?Fasten your seatbelts and don your peril-sensitive sunglasses. ?It will be an ugly trip.

Seven Thoughts on the Markets

Posted on 16 December 2015 by David Merkel

Photo Credit: t m || Seven sisters sitting on the hill

1) I started in this game as an amateur, and built up my skills gradually, reading widely. ?My academic studies ended at age 25, and it was after that that I began learning the practical knowledge. ?Though I had investment-related jobs, I never held a position in investing, until I was 38, and I never wrote on investing for the public in any significant way until I was 42, when Cramer invited me to write for RealMoney. ?I’m now 55, and I think I am still growing in my knowledge of investing.

i write this to simply say that you don’t have to take a traditional path into the investment business. ?I am grateful that I want through the circuitous path through the insurance industry, because it deepened my perspective on investing. ?All of the asset-liability modeling, where I often tried to challenge existing paradigms, helped me to understand why often the conventional wisdom is true. ?Where it is not true, there is usually an anomaly to profit from.

The other reason that I write this, is that it is possible to get significant knowledge as an amateur, and on a book basis, as good as many professionals. ?You won’t get the respect from professionals until you are a professional, but who cares? ?You can do better for yourself in investing. ?Just don’t get arrogant and forget to put risk control forst.

2) After all of the political fights are over, OPEC nations will once again agree that they will cut production as a group. ?Remember, much of OPEC has a low cost of production, and so when production decreases in a coordinated way, profits will rise for almost all OPEC nations.

In the long run, economics triumphs over politics. ?The challenge comes in the short-run from trying to figure out who cuts how much from what baseline. ?Even after that, discipline takes a while to achieve, because the incentive to cheat is high.

I stand by the view that in the intermediate term, crude oil prices will be around $50. ?Demand for crude oil is growing globally, not shrinking, and marginal supplies would price out at around $50/barrel, if OPEC nations act to maximize their profits, rather than engage in a market share war. ?(Prices would be higher still ?if OPEC nations acted to maximize the present value of their long-run profits, but I doubt that will happen until the profligate producers deplete their reserves.

3) The ferment in high yield bonds is unlikely to peak before there are significant defaults. ?It’s possible that we get a rally from here in the short run — yield spreads are relatively wide compared to earnings yields on stock. ?At this point, it doesn’t pay so well to borrow money and buy back stock. ?That isn’t stopping many corporations from doing their buybacks. ?Buybacks should be tactical rather than constant. ?Only buy back when there is a significant discount to the fair market value of the firm.

That said, it’s unusual for a large amount of credit stress to go away without defaults. ?It’s rare to see a credit problem work out by firms growing out of it. ?Thus what might be more likely than a junk rally is a fall in stock prices. ?Perhaps the most optimistic scenario would be that only energy is affected — it has defaults, and the rest of the market continues to rally. ?Not impossible.

4) Regarding F&G Life — congrats to holders, you won. ?A dumb aggressive foreign buyer jumped on the grenade for you. (Now let’s see, has that ever happened before to F&G Life?) ?Be grateful and sell. ?Let the arbs take the risk of the deal not going through.

5) One phrase that all investors should learn is, “I missed that one.” ?You can’t catch every opportunity. ?Some will pass you by despite your best efforts. ?Rather than jump on late, it is better to look for the next opportunity, lest you buy high and sell low.

On the opposite side of timing, if you tend to get to opportunities too early, maybe consider waiting until the price breaks the 200-day moving average from below. ?Let the market confirm that it agrees with your thesis, and then invest.

6) Regarding the Fed, I think too much is being made out of them for now. ?I will be watching the yield curve for clues, and seeing if the curve flattens or steepens. ?I expect it to flatten more quickly than the market currently expects,?limiting the total amount of Fed tightening.

As it is, every time the Fed tightens, the short interest-bearing deposits at banks reprice up, with some lesser amount pass-through to lending rates. ?I would expect bank profits to be squeezed.

Aside from that, most of what the FOMC will say tomorrow will just be noise. ?They don’t have a theory that guides them; they are just making it up as they go, so they wander and try to discover what their goals should be.

7) I’ve sometimes commented that at the start of a tightening cycle that those who have been cheating blow up, like Third Avenue Focused Credit, which bought assets far less liquid than the shares of its mutual fund. ?At the end of the tightening cycle, something blows up that would be a surprise now, which sometimes jolts the FOMC to stop tightening. ?The question here is: what could that group of economic entities be? ?China, Brazil, repo markets, agricultural loans, auto loans, or something else? ?Worth thinking about — we know about energy, but what else has issued the most debt since the end of 2008?

(As an aside, the recent moves to make China more integrated with the global economy also make it more subject to financial risks that are global, and not just local, of which it has enough.)

How Much is that Asset in the Window? (III)

Posted on 12 December 2015 by David Merkel

A: How are you doing? Are you here for more enlightening banter?

Q: Not so well. ?Have you heard of the Third Avenue?Focused Credit Fund [TFCIX]?

A: Uh, the one that is in the news?

Q:?Come on.

A: Yes, I know about it, but not much more than I have recently read. ?Of all of Third Avenue’s Funds I know it least well.

Q: Weren’t you a bond manager who liked to take concentrated positions though? ?You should be able to say something about this mess.

A: I dealt mainly with investment grade credit. ?What’s more, I had a real balance sheet behind me at the life insurance company. ?An ordinary open-end mutual fund has investors that can leave whenever they want — often at the worst possible time for them, or in this case, those that could not get out.

The main difference was that I could never be forced to sell, under most conditions. ?I could buy and hold, and if the eventual credit of the borrower was good, my client would receive all that he expected. ?TFCIX faced significant redemptions, and increasingly had mostly bonds that could not be quickly sold, and thus, were difficult to value. ?That’s why they cut off redemptions — they couldn’t?liquidate assets to give cash to customers on a favorable basis. ?Personally, I think setting up the liquidation trust was the best that could be done. ?That will allow Third Avenue to negotiate with interested buyers of the bonds without being rushed by redemptions. ?The remaining fundholders should be grateful for them doing this now, though it would have been better to act sooner.

Q: But I own shares in?TFCIX and need the money now. ?What can I do?

A: Oh, my. ?My sympathies. ?You can’t do?much. ?There might be some off the beaten track lenders out there that might take it off your hands, but they wear “panky rangs,” as a mortgage borrower once said to me.

Q: Panky Rangs?

A: Pinky rings. ?He was from the deep South. ?I.e., no one is going to give you a decent bid for your shares, even if you could find someone willing to do so. ?First, the value of the bonds is questionable, and the timing of the sales are?uncertain.

In some ways, this reminds me a little of The London Whale incident.

Q: How is that relevant?

A: JP Morgan became too great of a part of the indexed credit derivatives market, and as a result, they lost the ability to value their positions, because they were too big relative to the market in which they traded. ?Their very buying and selling had a huge impact on the pricing. ?Though a value was placed on the positions, the entire situation was impossible to value accurately; ?you couldn’t assemble a group to buy it all.

Some clever hedge funds took note of it, and began taking the opposite positions, thinking that they were overvalued, and fed JP Morgan more of what it was already bloated with. ?Now maybe, if there hadn’t been so much press furor over it, together with the accounting questions that affected the financials of JP Morgan, they could have found a way out. ?JP Morgan’s balance sheet was big enough, and if you left them alone, they would have all self -liquidated. ?They might not have made the money they wanted that way, but it could have been done. ?As it was, they were forced to liquidate more rapidly, and if I recall, they even called upon one of the opposing hedge funds to help them.

In any case, the forced liquidation led to losses. ?Most forced liquidations do.

Q: So, what do think my shares are worth?

A: They are worth the liquidating distributions that you will receive.

Q: That’s no help.

A: Is the Federal Reserve willing to step up and buy the assets as they did with?the Maiden Lane Trusts? ?No one has a bigger balance sheet than they do, oh, oops. ?Maybe they can’t do that anymore… who know where those emergency lending rules go…

Look, I’m sorry that you are stuck. ?The Madoff “investors” were stuck also. ?They had to wait quite a while. ?In the end, they got paid more than most imagined they ever would. ?Subject to credit conditions,?I would suspect that the more time Third Avenue takes to liquidate, the more you will get.

Q: But that’s dribs and drabs over time, and I need it now.

A: Patience is a virtue. ?Make other adjustments; sell something else; scale back plans… it’s no different than most people have to do when they have a loss. ?It happens.

Q: I guess… but it would help to know what it was worth, so that I could estimate tradeoffs.

A: yes, it would, but the timing and amount of liquidations are uncertain, and the “market prices” don’t really exist for the underlying — they are too influenced by Third Avenue’s holdings.

Maybe they could have converted it into a closed-end fund, ?but that would have cost money, and there still would have been the valuation issue. ?People could have gotten paid now if that had happened, but I bet they would have blanched at the size of the unrealized losses. ?I would just accept the payments as they come, that will probably give the best return, subject to future credit conditions.

Q: Do we have to modify?your statement was true when we first started this discussion:

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

After all, if it is worth the liquidating distributions if I wait, maybe you should add, “or the cash flows you receive over time.”

A: I will do that, and that is part of what I have been arguing for here, but the price here and now is not that. ?Just because you can’t sell it now doesn’t mean it doesn’t have value… we just don’t know what that value is.

Anyway, lunch is on me today, because there is another thing that you can’t sell that has value.

Q: What’s that?

A: Me. ?A friend.

Q: Let’s go…

The Limits of Risky Asset Diversification

Posted on 11 December 2015 by David Merkel

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. ?First, I don’t like infographics or video. ?I want to learn things quickly. ?Give me well-written text to read. ?A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem. ?Do you want to reduce?the volatility of your asset portfolio? ?I have the solution for you. ?Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard. ?Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” ?In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. ?Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

Growth stocks
Midcap stocks (value & growth)
Small cap stocks (value & growth)
REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
Developed International stocks (of all kinds)
Emerging Market stocks
Frontier Market stocks
And more…

And initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Not much. ?The diversification from investor behavior is largely gone (the liability side of correlation). ?Different sectors of the global economy don’t move in perfect lockstep,?so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets? ?Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

Timberland
Real Estate
Private Equity
Collateralized debt obligations of many flavors
Junk bonds
Distressed Debt
Merger Arbitrage
Convertible Arbitrage
Other types of arbitrage
Commodities
Off-the-beaten track bonds and derivatives, both long and short
And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what? ?Much the same thing happened here as happened with non-“blue chip” stocks. ?Initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Some, but less. ?Not everyone was willing to do all of these. ?The diversification from investor behavior was reduced?(the liability side of correlation). ?These don’t move in perfect lockstep,?so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are some?that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. ?Many of those blew up last time. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again? ?Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. ?Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder. ?Think of cash, which doesn’t earn much or lose much. ?Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time. ?Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). ?This isn’t a call to go nuts and sell all of your risky asset positions. ?That requires more knowledge than I will ever have. ?But it does mean having some dry powder. ?The amount is up to you as you evaluate your time horizon and your opportunities. ?Choose wisely. ?As for me, about 20-30% of my total assets are safe, but I?have been a risk-taker most of my life. ?Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. ?You will have to wait for those ideas to be forgotten. ?Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

Book Review: The Devil’s Financial Dictionary

Posted on 10 December 2015 by David Merkel

This book is not what I expected; it’s still very good. Let me explain, and it will give you a better flavor of the book.

The author, Jason Zweig, is one of the top columnists writing about the markets for The Wall Street Journal. ?He is very knowledgeable, properly cautious, and wise. ?The title of the book Ambrose Bierce’s book that is commonly called The Devil’s Dictionary.

There are three differences in style between Zweig and Bierce:

Bierce is more cynical and satiric.
Bierce is usually shorter in his definitions, but occasionally threw in whole poems.
Zweig spends more time explaining the history of concepts and practices, and how words evolved to mean what they do today in financial matters.

If you read this book, will you learn a lot about the markets? ?Yes. ?Will it be fun? ?Also yes. ?Is it enough to read this and be well-educated? ?No, and truly, you need some knowledge of the markets to appreciate the book. ?It’s not a book for novices, but someone of intermediate or higher levels of knowledge will get some chuckles out of it, and will nod as he agrees along with the author that the markets are a treacherous place disguised as an easy place to make money.

As one person once said, “Whoever called them securities had a wicked sense of humor.” ?Enjoy the book; it doesn’t take long to read, and it can be put down and picked up with no loss of continuity.

Quibbles

None

Summary / Who Would Benefit from this Book

If you have some knowledge of the markets, and you want to have a good time seeing the?wholesome image of the markets?skewered, you will enjoy this book. ?if you want to buy it, you can buy it here: The Devil’s Financial Dictionary.

Full disclosure:?The author sent a free copy?to me via his publisher.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.

We Eat Dollar Weighted Returns ? VII

Posted on 8 December 2015 by David Merkel

I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch. ?As he said in his blog post at The Wall Street Journal’s The Experts blog:

WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance.? ?No problem,? you might think?buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.?s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn?t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund?s performance and what the typical fund investor actually earned can be explained by the ?behavioral return gap.?

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund?s sound long-term process, the ?dollar-weighted? returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

That’s why I wanted to write this post. ?Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions. ?As such, his investors buy high and sell low with his funds. ?The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database. ?The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data.

The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports. ?This is all public data, but somewhat difficult to aggregate. ?I do it by hand.

I use annual cashflows for most of the calculation. ?For the buy and hold return, i got the data from Yahoo Finance, which got it from Morningstar.

Note the pattern of cashflows is positive until?the financial crisis, and negative thereafter. ?Also note that more has gone into the fund than has come out, and thus the average investor has lost money. ?The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance.

This would be an ideal fund to rebalance. ?Talented manager, will do well over time. ?Add money when he does badly, take money out when he does well. ?Would make a ton of sense. ?Why doesn’t it happen? ?Why doesn’t at least buy-and-hold happen?

It doesn’t happen because there is a Asset-Liability mismatch. ?It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short. ?If you underperform for less?than a few years, they yank funds. ?The poetic justice is that they yank the funds just as the performance is about to turn.

Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in. ?It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out. ?The more volatile the fund, the more rapidly that happens. ?And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months.

Pretty astounding I think. ?This highlights two main facts about retail investing that can’t be denied.

Asset prices move a lot more than fundamentals, and
Most investors chase performance

These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees. ?remember as well that passive investing does not protect retail investors from themselves. ?I have done the same analyses with passive portfolios — the results are the same, proportionate to volatility.

I know buy-and-hold gets a bad rap, and it is not deserved. ?Take a few of my pieces from the past:

If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets. ?If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets. ?Rebalance to those percentages yearly. ?If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon. ?(Why 120? ?End of the mortality table. 😉 Take it from an investment actuary. 😉 We’re the best-kept secret in the financial markets. 😀 )

Okay, gotta close this off. ?This is not the last of this series. ?I will do more dollar-weighted returns. ?As far as retail investing goes, it is the most important issue. ?Period.