Portfolio Management – Page 47

Sorted Weekly Tweets

Posted on 1 June 2013 by David Merkel

Europe

Risk of Bank Failures Rising in Europe, E.C.B. Warns?stks.co/iXnFdgzCpNK1ctKk7ijN/w&pagewanted=all&pagewanted=print Bad scene $$
New BoE chief Carney will devalue sterling, Pimco warns?stks.co/sEin?It’s useless but everyone has 2try2 “beggar thy neighbor” $$
The French Economic Maginot Line: A Very Weak Strongpoint?stks.co/cVlX French economy weakening; 2 big 4 Germany 2 rescue $$
Greek Economy Optimism Seen in Yield-Curve Switch?stks.co/aVsv?Perhaps they r doing better, but what of France & Germany? $$
Hungary Cuts Policy Rate to Record Lowstks.co/sENf?Another nation sucked into the march to global ZIRP; what will break first? $$

Asia

Asia’s Huge Debt Growth Problem: Remember 1997??stks.co/sEsy?Graph on this page is worth a look; could b another Asia crisis $$
Aging Chinese Face a Bleak Picturestks.co/cWG6?This should b no surprise; it is the logical outcome of the 1 child policy $$
China Failure to Grow With $1T Is Warning to Li: Economy?stks.co/jXddNegative Marginal productivity of capital in China $$?#FTL
China’s Xi Comes Calling on Americasstks.co/rEua?Interesting to see the Chinese need 4 products in the Western Hemisphere $$
China Failure to Grow With $1T Is Warning 2 Li: Economy?stks.co/dVzl?10 years from now, they’ll wonder y we worried about China $$
China-Based Cyber Attacks Rise at Meteoric Pace?stks.co/sEco?This is not news. Practice safe computing, & you will be safe. $$
Japanese Housewives Cooling on Aussie Uridashi?stks.co/sEcn?The strong yen is gone,& small investors realize there is no gain $$
Tokyo Shares Down Sharplystks.co/bW4G?Japanese stocks get hit, why should anyone be surprised? BOJ engaged in voodoo economics $$
Japan?s Bond Market Wants BOJ to Purchase More Short-Term?stks.co/gXRpTraders off-balance as BOJ stops giving them easy profit $$
China’s Shuanghui to Buy Smithfield Foods?stks.co/pEdZ?A wise addition to the strategic pork reserve; let the pigs flow west! $$
Japan plays down concerns bond price spike could hurt recovery?stks.co/fXGZKuroda thinks 3% higher interest rates won’t hurt?! $$
Fears over US stimulus highlight Japan?s fragility?stks.co/aVlz?Japan is reaching the limits of what monetary policy can do $$

Rest of the World

Sudan Threatens to Close Pipelinestks.co/cVvE?Two corrupt regimes arguing over oil – a lose/lose situation $$
Bank of Israel Lowers Rate Again After Surprise Mid-May Cut?stks.co/eVoS?Many fringe economies import low rates 2 aid exporters $$
Despite Detractors, Don’t Buy Talk of Dollar’s Demise?stks.co/cVeU?The US is in good shape compared to Japan, Eurozone & China $$
Fringe economies are forced to absorb loose monetary policy, or let exports suffer while hot money tries to get yield in their countries $$

Central Banking

Simon Johnson: Choosing the Next Head of the Federal Reservestks.co/bWEQ?No doubt that Dick Fisher would b a lot better $$
Is the Fed Right to Calibrate Asset Purchases to Economic Data?stks.co/fXYR?Coarse data doesn’t allow 4 fine policy precision $$
US Banks Looking Solid As Bernanke Keeps The Juice Flowing, But Perils Of Financial Crisis Loom?stks.co/pEdg?Low rates will end $$
Fed?s 100-Year Roots Grew From Virginia Congressman?stks.co/sEWJ?Puff piece of secular hagiography fawning over Carter Glass $$
Kuroda Struggles W/Communication as Japan Rates Rise?stks.co/eVkQ?Most central bankers don’t know forces w/which they r toying $$
Also, strong communication skills at central banks r a weakness, not a strength; better 2 move back to the pre-87 era, operate in shadows $$
The more communication a central bank puts out, the more markets become “tightly coupled” w/the CB, thus limiting the effects of policy $$
Stephen Poloz: Top 10 headaches BoC chief faces right off the bat?stks.co/qEKO2 much debt amid a mortgage bubble germinates $$

Market Impact

NYC Pension Chief Seeks $500,000 Managers to Cut Out Wall Street stks.co/eWPZ?Insourcing looks easy; u need bright mgmt 2do it $$
Contrarian Investing in Quality Franchises?stks.co/dWEz?It is not enough 2b contrarian, u have 2b right $$?$STUDY
James DeMasi on Overcoming Adversity to Start and Grow a Value Investment Management Firm?stks.co/eWPVIntelligent stuff $$?$STUDY
Pension-Fund Swings Make Case for Cutting Risk?stks.co/tEuZ?Much as I like ALM, probably the wrong time 2 trade stocks 4 bonds $$
Junk Bonds Having A Bad Week (Down 0.96%) Amid Broader Pullbackstks.co/bWEV?Yet this is small & we need it 2 persist 4 weeks $$
Evaluating 3 Bullish Argumentsstks.co/dW9s?PR better than logic, but he is right that the market is overvalued $$
Sallie Krawcheck: Big Banks Still Don?t Have Enough Capital?stks.co/rEou?No 1 knows how large the ultimate catastrophe could b $$
Morgan Stanley to Downsize Fixed Income?stks.co/dVzj?I think this is a mistake. Wall Street exists 2 sell debt$MS?$$
Record Cash Sent to Balanced Fundsstks.co/eVv4?Hail the humble balanced fund, which has the virtue of keeping panic away 4most $$
SEC Refocuses on Accounting Fraud stks.co/gXI1?With Crisis-Related Enforcement Ebbing, SEC Is Turning Back to Main Street $$
A hedge fund for u & me? Best move is 2 pass?stks.co/eVoW?Sage advice from @ritholtz?| survivor & reporting bias & fees 2 high $$
Goldman Sachs Buyback Orders Reach Highest Level of Year?stks.co/bVkE?Are buybacks part of the voting or weighing machine *now* $$
Margin Debt Hits a Record, Showing Confidence?stks.co/fX96?Confidence or froth, amid a market influenced by aggressive $$ policy?
Beware of ‘Bargain’ Stocks?stks.co/hXKKI disagree for now; look4 strong companies in industries under stress that will survive $$
Defaulted Manhattan Complex Rewards Patient $$?stks.co/iXCC?Sadly, equity & mezzanine were wiped out, patience pays only4 snr debt

Insurance

MetLife cuts 2,500 advisers seen lacking chance of success?stks.co/dWF0?Retail chief says productivity ‘way up;’ costs way down $$
Regarding the prior tweet, I have wondered 4 ~25 years when something like that would happen; has long been needed @ most life insurers $$
$PRU?Takes On?$AFL?in Benefits After Health Law?stks.co/fXpO?Much easier2 “enter” a market than create a sales force $$ FD: +?$AFL
$ENH?CEO steps down, replacement named?stks.co/iXML?Sudden. Former CEO of?$AXS?picked, owns ~1.5%, will own ~4% as comp; FD: +$ENH
The former CEO of?$AXS?was pushed out by his board; he built Axis, but was a bit of a prima donna. What will he do to $ENH?? | FD: +?$ENH?$$
One more note: the competent former CFO of?$PRE?is now CEO of?$AXS?, having been passed over for the CEO job @?$PRE?$$?#musicalchairs

US Politics

Pelosi: ?We have to pass the bill so you can find out what is in it.? The more we find out, the less sense it makes.stks.co/pF0S
GOP senators want IG probe of Sebelius’ ‘Obamacare’ fundraising?stks.co/dWA5Obama administration is more corrupt than Nixon $$
Bible Class in Texas Schools Faulted as Unconstitutional?stks.co/iXnP?Look in the comments 4 bigoted ideas that aren’t American $$
Obamacare Competition Has Roots in Economist?s Passion?stks.co/dW9n?If you believe in neoclassical economics u r deluded $$?#loser
Regulators Want Better Financial Datastks.co/gXjV?Well, duh, but there are costs involved & the government does not bear those $$
When Chinese Walls Come Crumbling Down?stks.co/rEot?There r still conflicts of interest on Wall Street. Be aware & defensive $$
Deposits Guaranteed Up to $250,000?Maybe?stks.co/pEdo?Congress transfers insured deposit risks to the taxpayers & depositors $$
Liberty Reserve Joe Bogus Account Said to Reflect Evasion?stks.co/jXKv?Money laundering goes high-tech; Feds take action $$
Obama Accepting Sequestration as Deficit Shrinks?stks.co/gXIj?Whaddaya know? A policy no one liked actually isn’t that bad $$
Health Law Critics Seek to Gut It by Attacking Exchanges?stks.co/rEO6 Exchanges will only attract sick, will b high costs4all $$
The US Federal Government Spending: a Huge Fiscal Drag http;//stks.co/iXMS Cutting less useful spending it may help, not harm $$
Hollywood Loses Blockbusters as ?Iron Man? Finds Subsidy?stks.co/gXIX?Like building stadiums, except u have to keep doing it $$
Obama Nominates 2 Senate Aides for S.E.C. Posts?stks.co/fX8w?A team 2 assure continued incompetence & weak enforcement $$
Banks’ Lobbyists Help in Drafting Financial Bills?stks.co/pEJH?Basic goals: min capital reqs, max flexibility, weaken regs $$

Other

Cord Cutters Lop Off Internet Service More Than TV?stks.co/hXwv?You can cut your costs, but what does that do to your life? $$
Online Course Providers Reach Out2 Wary Professors?stks.co/jXde?Better to ask the question, “Where is new revenue coming from?” $$
Victor Davis Hanson: Why Some Wars Are So Savage?stks.co/bW4K?Evenly matched wars that take a long time lead to barbarism $$
Mary Meeker is Back With Her 2013 Internet Trends Report Slidesstks.co/pEfP?A lot of interesting information $$ Things change
European Sunscreen Roadblock on U.S. Beaches?stks.co/tENx?If you sunburn like me, maybe European sunscreens will help u $$
Dear Grads, Don’t ‘Do What You Love’ stks.co/hXVe?The solution is 2love what u do; working 4 $$ helps other priorities in life
Death Jolts Texas Investorsstks.co/aVsN?Since his body was found 2 weeks ago, investors say they lent him millions of $$?#badodor
Common Core Education Is Uncommonly Inadequate?stks.co/sENHNational curriculum standards tend 2b dumbed-down; local better $$
Science Can?t Pin Powerful Tornadoes on Global Climate Change?stks.co/eVoUA rare fair article on climate @ Bloomberg. Who knew $$
Noahpinion: Bets do not (necessarily) reveal beliefs?stks.co/dVdu?In which Noah Smith arbs Brad Delong & Patrick Chovanec $$?#FTW
Immunology Gets Turned On Its Headstks.co/jX4P?Discovery may aid vaccine design&begins2explain y gene therapy runs in2 trouble $$
Is This Google X’s Plan to Wire the World??stks.co/hXKJ?Solar powered balloons dot the skies, could last 5 years & upgrade $$

Companies

Buffett’s Safe Bet on Vegas?stks.co/gXjUThe Maestro does it again, takes a marginally profitable company, & refinances it $$
Goldman Upgrades Defense Contractors?stks.co/gXjT?My but how contrarian; won’t there b less cash flowing to defense companies? $$
Berkshire Hathaway Unit to Buy NV Energy for $5.6B?stks.co/dVzk?Another wise move by Buffett; utility earnings make $$ vs funding
Alcoa Cut to Junk by Moody?s as Aluminum Price Declines?stks.co/pEkEAnother sign of economic weakness, but Alcoa will survive $$
Payday Lenders Evading Rules Pivot to Installment Loans?stks.co/eW4q?I like people to have choice, but not 1 that leads2a trap $$
Empire State Building IPO Plan Is Approved?stks.co/fXUM?”The second-largest IPO for a U.S. real-estate investment trust” ever $$
BHP Halts Coal Expansion?stks.co/dVthDownturn in the global economy & thus steel makes demand fall for metallurgical coal $$?$BHP
Newsweek for Sale: IAC Seeks Buyersstks.co/jXKo?The internet changes everything; say goodbye to a dinosaur $$
Utilities Weigh Entering Rooftop-Solar Business?stks.co/sEWA?Sounds dumb; it’s a very different biz in almost every way $$?#FTL
Samsung, Sony Court Indians as Subsidies Fund Factories?stks.co/gXIgIndia gives 25% subsidy4capital costs2setup tech plants. $$

Energy

As US Oil Booms, an Unlikely Word Rises: Depletion?stks.co/dVl5?Wells created by fracking have shorter production profiles $$
U.S. Oil Boom Divides OPECstks.co/pEUQ?Those most dependent on oil revenues want others in OPEC 2 cut, so that they can cheat $$

Replies, Retweets & Comments

I just left a comment in “Energy stocks down, look to end week higher – Energy Stocks – MarketWatch”on.mktw.net/18DiBrm
“I have read both. Buffett made mistakes that cost him, but never such that he could not bounce back?” ? D_Merkeldisq.us/8da393?$$
Commented on StockTwits: Old tweet deleted, new tweet out?stks.co/iXMe
“Don’t forget his purchase of 83% of CVR Energy. Equally good. FD: +$CVI ” ? David_Merkel?disq.us/8d9jmi?cc:@refomedbroker?$$
@AlephBlog?Growth and the Market. Useful piece to help people make sense of seemingly over-valued equity market:wp.me/p3nd6r-4s
Sets up future losses $$ RT@tomkeene: ?Cov-lite? loans soar in dash for yield -?FT.com?on.ft.com/12daxfK
@kurtgodeldabomb?I like your name. Yes, that’s y I said it; I think its the voting machine 4 most companies, & weighing machine 4 a few
“Until the strategy fails, and he asks you to leave.” ? David_Merkeldisq.us/8d97f5?$$
@pope_stephen?Sadly, monetary policy was much better run under Volcker & Martin, & they were not going out of their way 2 explain the Fed $$

FWIW

My week on twitter: 42 retweets received, 2 new listings, 60 new followers, 37 mentions. Via:?20ft.net/p

The Product that Never saw the Light of Day, Part 3

Posted on 31 May 2013 by David Merkel

Maybe I should call this article “the product that saw the light of day, after a long sleep.”? Barron’s had an article last week, “Top 50 Annuities.”? Guess what? Almost all of the annuities they featured were stripped down and low cost.? That’s the way things should be.? If you have time and interest, read the article; it’s a good thing.? Also note at the end the skepticism of investment managers, particularly hedge funds running insurers.? The skepticism is deserved.

That’s all.? A rare short piece.

A Letter to Warren, Part 2

Posted on 31 May 2013 by David Merkel

You might recall my letter to Warren Buffett, and his response to me.? A number of my readers made some very nice offers to help me on this project.? Many thanks to you all, but I found a way to shrink the size of the project.? Look at this table:

NAIC #	Assets	Liabs	Surplus	Name	Group	Notes	Pct
38865	443	199	244	CALIFORNIA INSURANCE COMPANY	AU		0.2%
28258	92	49	43	CONTINENTAL NATIONAL INDEMNITY CO	AU		0.0%
14144	347	322	25	APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.	AU	(2)	0.0%
35246	23	8	15	Illinois Insurance Company	AU		0.0%
21962	11	–	11	Pennsylvania Insurance Company	AU		0.0%
20044	1,083	346	737	BERKSHIRE HATHAWAY HOMESTATE INSURANCE COMPANY	BHH		0.6%
11673	762	336	426	REDWOOD FIRE & CASUALTY INSURANCE CO	BHH		0.3%
10855	1,065	858	207	CYPRESS INSURANCE COMPANY	BHH		0.2%
34630	459	321	138	OAK RIVER INSURANCE COMPANY	BHH		0.1%
11014	11	4	7	BROOKWOOD INS CO	BHH		0.0%
35939	9	2	7	CONTINENTAL DIVIDE INSURANCE CO	BHH		0.0%
34274	335	50	285	CENTRAL STATES INDEMNITY CO OF OMAHA	CSI		0.2%
82880	18	4	14	CSI LIFE INSURANCE COMPANY	CSI		0.0%
22063	19,090	11,072	8,018	GOVERNMENT EMPLOYEES INSURANCE CO	GEICO		6.3%
22055	6,444	3,695	2,749	GEICO INDEMNITY COMPANY	GEICO		2.1%
41491	1,713	1,051	662	GEICO CASUALTY COMPANY	GEICO		0.5%
14137	239	19	220	GEICO SECURE INSURANCE COMPANY	GEICO		0.2%
14139	249	36	213	GEICO CHOICE INSURANCE COMPANY	GEICO		0.2%
14138	249	41	208	GEICO ADVANTAGE INSURANCE COMPANY	GEICO		0.2%
35882	184	70	114	GEICO GENERAL INS CO	GEICO		0.1%
22039	15,533	4,840	10,693	GENERAL REINSURANCE CORP	GenRe		8.4%
27812	15,069	4,637	10,432	COLUMBIA INSURANCE COMPANY	GenRe		8.2%
86258	3,101	2,513	588	GENERAL REINSURANCE LIFE CORPORATION	GenRe		0.5%
37362	748	182	566	GENERAL STAR INDEMNITY CO	GenRe		0.4%
11967	251	69	182	GENERAL STAR NATIONAL INS CO	GenRe		0.1%
38962	190	55	135	GENESIS INSURANCE COMPANY	GenRe		0.1%
12319	176	76	100	PHILADELPHIA REINSURANCE CORP	GenRe		0.1%
32280	130	61	69	Commercial Casualty Insurance Company	GenRe		0.1%
20931	48	26	22	Atlanta International	GenRe	Runoff	0.0%
97764	20	5	15	IDEALIFE INSURANCE COMPANY	GenRe		0.0%
31470	512	363	149	NORGUARD INSURANCE COMPANY	Guard		0.1%
42390	416	316	100	AMGUARD INSURANCE COMPANY	Guard		0.1%
14702	104	71	33	EASTGUARD INSURANCE COMPANY	Guard		0.0%
11981	42	29	13	WestGUARD	Guard		0.0%
11843	3,013	1,938	1,075	MEDICAL PROTECTIVE CO	MedPro		0.8%
42226	586	173	413	Princeton Ins Co	MedPro		0.3%
13589	14	11	3	MedPro RRG Risk Retention Group	MedPro		0.0%
20087	127,340	48,479	78,861	NATIONAL INDEMNITY COMPANY	NI		61.7%
20079	5,597	1,739	3,858	NATIONAL FIRE & MARINE INSURANCE CO	NI		3.0%
62345	10,938	8,700	2,238	BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY OF NEBRASKA	NI		1.8%
13070	1,841	692	1,149	BERKSHIRE HATHAWAY ASSURANCE CORPORATION	NI		0.9%
39136	1,203	487	716	Finial Reinsurance Company	NI	Runoff	0.6%
20052	1,419	705	714	NATIONAL LIABILITY & FIRE INS CO	NI		0.6%
42137	212	70	142	NATIONAL INDEMNITY CO OF THE SOUTH	NI		0.1%
20060	173	49	124	NATIONAL INDEMNITY CO OF MID-AMERICA	NI		0.1%
22276	90	19	71	STONEWALL INSURANCE COMPANY	NI		0.1%
37923	100	55	45	SEAWORTHY INSURANCE CO	NI		0.0%
36048	74	42	32	UNIONE ITALIANA REINS CO OF AMERICA	NI	Runoff	0.0%
11591	63	51	12	FIRST BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY	NI		0.0%
10391	43	32	11	AMERICAN CENTENNIAL INSURANCE CO	NI		0.0%
13795	2	–	2	AttPro RRG Reciprocal Risk Retention Grp	NI		0.0%
25895	675	234	441	UNITED STATES LIABILITY INS CO	USLI		0.3%
26522	434	160	274	MOUNT VERNON FIRE INSURANCE CO	USLI		0.2%
35416	161	59	102	US UNDERWRITERS INSURANCE CO	USLI		0.1%
15962	171	23	148	KANSAS BANKERS SURETY CO	Wesco		0.1%

Total	223,315	95,444	127,871
			106,000	From 10K

This table lists all of Berkshire Hathaway’s domestically domiciled insurance subsidiaries, all 55-56 of them, maybe minus a few intermediate holding companies that are just shells.? The NAIC # uniquely identifies each company for the National Association of Insurance Commissioners.? Then comes the assets, liabilities, and surplus for regulatory purposes.? Then there are the groups that each subsidiary belongs to, and what percentage? of the total statutory surplus each one represents.

The table is sorted by the major subsidiary groups, and then in declining order of surplus.?? Here is the key to the groups:

AU = Applied Underwriters
BHH = Berkshire Hathaway Homestate
CSI = Central States Indemnity
GEICO (what else?)
GenRe = General Reinsurance
Guard = AmGuard
MedPro = Medical Protective
NI = National Indemnity
USLI = United States Liability Insurance
Wesco = Wesco Financial

A number of the companies are not writing new business; they are in what is called “runoff.”? Two companies may have the same name “APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.” but are domiciled in different states.

So, back to my challenge to understand the structure of Berkshire Hathaway.? The above table makes my life easy.? Really, I only need to get the reports of the following companies:

Berkshire Hathaway Homestate
General Reinsurance
GEICO
National Indemnity (really, the one most needed)
Medical Protective

Those five companies cover ~94% of the statutory surplus of? all of Berkshire’s insurance companies.? I can afford to get that data.? But how should I do it?

I can buy it though the NAIC
I could write Warren another letter asking for his approval to ask each company for their statutory statements.
I could ask each subsidiary for their statements, and see how they react.
I could troll the web, and see if they aren’t hiding out there.? One reader suggested that the Statements are out there on some state insurance department websites, but that would surprise me. That hasn’t been true in the past.

I am thinking of doing #2, but am open to advice.

As an aside, note that the sum of $128 billion of statutory surplus is far more than the $106 billion listed in the latest 10-K.? That is because of capital stacking, which is a form of double counting.? Lower lever subsidiaries surplus gets counted in their intermediate parent companies.? But if I eliminate all of the lower level companies, I only end up with $100 billion.

This is a different approach to Berkshire Hathaway, approaching it as a group of? insurance companies that owns businesses.? It is very different, yet successful.? When I get the data, I hope we all learn a lot.

The Rules, Part XLII

Posted on 31 May 201320 June 2017 by David Merkel

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.? I’ve been through it.? He would not bite.

The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.

On Stock Splits

Posted on 25 May 2013 by David Merkel

Mark Hulbert had a recent piece in the Wall Street Journal called How to Use Stock Splits to Build a Winning Portfolio.? I find it curious, because 31 years ago I wrote my Master’s Thesis called, “Predicting Stock Splits: An Exercise in Market Efficiency.”? As far as I know, aside from the unbound copy sitting next to me, the only other copy is in some obscure part of the Johns Hopkins Library System.? If a number of people are really curious about this, I could try OCR and see if that would adequately read the typewritten text.

But anyway, I find it amusing that some are still trying to use stock splits to try to make money.? Quoting from Hulbert’s piece:

But try telling that to Neil Macneale, editor of an investment-advisory service called “2 for 1,” whose model portfolio contains only those stocks that have recently split their shares, holding them for 30 months. Over the past decade, according to the Hulbert Financial Digest, that portfolio has produced a 14% annualized return, far outpacing the 8% gain of the Standard & Poor’s 500-stock index, including dividends.

Mr. Macneale’s track record isn’t a fluke. Several studies have found that the average stock undergoing a split outperforms the overall market by a significant margin over the three years following the company’s announcement of that split. Indeed, Mr. Macneale said in an interview, he got the idea for his advisory service in the 1990s from one of the first such studies, conducted by David Ikenberry, now dean of the Leeds School of Business at the University of Colorado, Boulder.

Research on stock splits goes back to the ’30s.? In the ’50s & ’60s before MPT got into full swing, a few researchers began trying analyze why there were abnormal rises in stock prices two months before a stock split.? Could it be that other factors affecting future value were somehow associated with stock splits?? Many factors pointed toward that, notably prior price increases, prior earnings increases, and increases in the dividend associated with the stock split.? Little did they know that they were anticipating momentum investing.

The consensus by the end of the ’70s was that there was no excess return after the stock split announcement, and few ways if any to capture the pre-announcement excess returns.? If in the present stock splits are providing excess returns for 2.5 years afterward, well, this is something new.

One of the leading stock-split theories?supported by the work of professors Alon Kalay of Columbia University and Mathias Kronlund of the University of Illinois, Urbana-Champaign?is that companies implicitly have a target range for where they would like their shares to trade.

If a firm’s shares are trading well above that range, and management believes that this high price is more than temporary, it is likely to initiate a split in order to bring its share price back to within that range.

This isn’t a new theory — it goes back to the ’50s, if not earlier.? One of the oldest theories was that it improved liquidity, but back in a time of fixed tick sizes, where everything traded in eighths, and higher commissions, that made little sense to a number of economists.? Splits made trading costs rise in aggregate for the same amount of dollar volume traded.

In the present though, there are many venues for execution of trades, commissions are much smaller, and negotiable.? Perhaps today more shares at lower prices does add liquidity, and the way to test might compare the bid-ask spread and sizes pre- and post-split.

The professors late last year completed a study of all U.S. stocks that split their shares by a factor of at least 1.25-to-1 between January 1988 and December 2007. They say the evidence their study uncovered suggests that splits are an “indication of sustained strong earnings going forward.” It therefore shouldn’t be a big surprise that split stocks outperform other high-price stocks that don’t undertake a split.

What this might mean is that stocks that split are examples of price and/or earnings momentum.? A management team splits the stock as a signal that corporate profit growth has been good, and will continue to be so.? If not, the management team runs the risk that if the stock price falls, it looks bad to a management to have a low stock price.? There are some investors who won’t buy stocks below $10, $5, etc.? Why run the risk of lowering your stock price if you think the odds are decent that the price will fall from there?? Low stock prices affect the confidence of many.

Investors looking to profit from the stock-split phenomenon should shun stocks that have undergone a reverse split and focus instead on those that have split their shares. You will have to invest in such stocks directly because there is no mutual fund or exchange-traded fund that bases its stock selection on stock splits.

Fortunately, constructing a portfolio of such stocks needn’t be particularly time-consuming.

For example, there is no need to guess in advance which companies are likely to split their shares?which in any case would be difficult, if not impossible, to do. There even appears to be no need to buy a company’s stock immediately after it announces a split, since research shows that it is likely to outperform the overall market for up to three years following that announcement.

Still, Mr. Macneale recommends that investors be choosy when deciding which post-split stocks to purchase. He cites several studies suggesting that the post-split stocks that perform the best tend to be those that, at the time of their splits, are trading at relatively low price/earnings or price/book ratios. Both are commonly used measures of a stock’s valuation, with lower readings indicating greater value.

I’m going to have to find the papers that say that post-split stocks outperform for the next 30 months.? Doesn’t sound right — a result like that would have been found from the research pre-1980, and no one suggested that; in fact, the evidence contradicted that consistently.

Note that the investment manager in question uses cheap valuation to filter opportunities.? That the stock has split usually indicates strong price momentum.? Value plus momentum is usually a winner, so why should we be surprised that stock splits often do well?

But I know of three papers that focused on predicting stock splits — two in 1973, and mine in 1982.? It’s not that hard.? Most of it is price momentum, and with a balanced set of stocks that would and would not split, the models predict 70% of the companies that would split.

What’s better, is that the formulas to predict stock splits pick good stocks in their own right — they end up being value and momentum, and maybe a few other factors.? I remember my thesis adviser being surprised at how good my models were at picking stocks.

This brings me to my conclusion: stock splits are a momentum effect, but it is larger when companies are still have a cheap valuation.? Perhaps splits have no effect on stock performance — it is all momentum and valuation.? To me, that is the most likely conclusion, and my thesis anticipated quantitative money management by 10+ years.

In one sense it is a pity I didn’t do anything with it, but if I hadn’t become an actuary, I would never have gained many other insights into the ways that the market works.? I’m happy with the way things worked out.

The Rules, Part XXXVIII

Posted on 23 May 2013 by David Merkel

There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

Chasing performance
Over-diversification
Benchmarking / Hugging the index
Over-trading
Relying too heavily on earnings growth
Analyzing the income statement only
Refusing to analyze industries
Buy newsy companies
Relying on the sell-side
Trusting management too much

Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.? I am against regret.? Don?t buy something after you have missed most of the move, as if future stock price movement is magically up.? Unless you can identify why the stock is underappreciated after a strong move up, don?t touch it.

Over-diversification

Most managers hold too many stocks.? There is no way that a team of individuals can follow so many stocks.? Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.? Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.? You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.? Aim for a large active share, differing from the benchmark index.? Make some real nonconsensus investments.???? Show real moxie; don?t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?? More volatility in search of better overall returns is what investors need.? If they can?t bear short-term volatility, they should not be invested in stocks.

Over-trading

We don?t make money when we trade.? We make money while we wait.? Ideas take time to work out, and there are frequently disappointments that will recover.? If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.? For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.? Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.? For value companies, far less so.? Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.? In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.? Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.? One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.? Macroeconomics rarely translates into useful portfolio decisions in the short run.? Even when you are right, it may take years for it to play out, as in the global financial crisis ? the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely ?bottoms up,? and not gaining the broader context of the industry.? As a young investor that was a fault of mine.? As a result, I fell into a wide variety of ?value traps? where I didn?t see that the company was ?cheap for a reason.?

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.? I think most of those companies are overanalyzed, and as such, don?t offer a lot of investment potential unless one thinks the news coverage is wrong.? I actually like owning companies that don?t attract a lot of attention.? Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.? What are the key drivers to watch?? What management teams seem to be building value the best?? This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.? Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren?t.? Who is honest, and who bluffs?? This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever ? you might lose some advantage doing that, but you won?t be tricked by a slick-talking management team.? Trusting management implicitly is the big problem to avoid.? They are paid to speak favorably regarding their own firm.

Summary

This isn?t an exhaustive list.? I?m sure my readers can think of more foibles.? I can think of more, but I have to end somewhere.? My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

Goes Down Double-Speed (Updated)

Posted on 22 May 201322 May 2013 by David Merkel

A little more than two years ago, I wrote Goes Down Double-Speed.? I wrote it after the market had doubled from its lows two years earlier.? I want to update the piece and explain we have learned over the past 2+ years, and maybe discuss what could happen over the next 2+ years.? Anyway, here is the modified table of bull and bear markets:

Since the last piece, the gains have come slowly, validating my comment, “But it would be unprecedented for the market to continue to advance at a 3% [per month] pace from here.”? In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.? Things are coming quickly again now, but who can tell how long it might persist.

Maybe Goldman Sachs can tell us.? After all they increased their price targets for the S&P 500 yesterday.? Now let me republish my updated bull market graphs from the prior piece:

And now look at the cumulative gain:

The predictions of Goldman Sachs are both believable and unbelievable.? Believable: it’s not historically impossible for a rally to last that long, or for it to be so large.? That said the probability historically has been low.

Unbelievable: Unless revenue growth kicks in, that means the profit margin, already at record highs, will soar to an astounding record.? But won’t revenue growth begin again?? That’s hard to say, but if revenue growth starts in earnest, the Fed will start removing policy accommodation, because bank lending will be perking up.? At that point, it is anyone’s guess as to what will happen.? Therefore, I rule out Goldman Sachs’ forecast as a possibility.

The rally continues to get longer in the tooth, and its has been aggressive this year.? I repeat how I ended the original piece: “Consider trimming some of your hottest positions.”

The Rules, Part XXXVII

Posted on 21 May 2013 by David Merkel

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”? So the saying goes for those that blindly follow momentum.? The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.? (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

In 1998-2000, tech and internet stocks were the only place to be.? Even my cousins invested in them and lost their shirts.? People looked at me as an idiot as I criticized the mania.? Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.? This was not, “Buy what you know,” but “Buy what you assume.”
In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.? A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.? Both trades went badly.? Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to? blow up, and the least levered to suffer considerable losses.
2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.? There were earlier shocks around 2002, and the late ’90s.? Those buying them in 2008 and crying foul neglected the lessons of history.? The underlying collateral possessed no significant diversification.? Put a bunch of junk debt in a trust, and guess what?? When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.? Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

The go-go years of the ’60s or the ’20s
The various times the REIT market has crashed
The various times that technology stocks have wiped out
And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.? But recently, there has been some discussion of a possible “safety bubble.”? The typical idea is that investors are paying up too much for:

Dividend-paying stocks
Low-volatility stocks
Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.? It is possible to have one?? Yes.? Is it likely?? No.? Are we in one now?? Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.? But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.? At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.? Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.? They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?? Tenuously, but yes.? Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.? In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market? history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.? When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.? Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.? You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.? You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.? I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.? But with stocks, I would simply say look forward.? Analyze:

Margin of safety
Valuation, absolute & relative
Return on equity
Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.? If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”? Just don’t? compromise margin of safety in the process.

What to Do When Things are Nuts?

Posted on 18 May 201319 May 2013 by David Merkel

I have not been a fan of this rally, and I have been selling into it.? I do have a rule for equity clients — cash never goes above 20%.? I have been close to that recently, and after rebalancing some companies that have hit the top of the weighting band, I have bought those companies with the lowest weights in the portfolio.? I have also added some stable companies in the recent past — Berkshire Hathaway, Ingram Micro, Validus Holdings, AFLAC, and CST Brands.

My next quarterly reshaping comes up next week, and again, I will be looking at neglected industries in the market for areas to purchase.? When the momentum runs this hard, I have to be content to trail (though I haven’t been trailing).? I have to ask where things will be three or more years from now, rather than ponder the next quarter.? The answer to that is more murky than I would want, because of abnormal economic policy.? It makes us all more skittish, and obscures price signals.

I have suggested in the past that a good solution in the face of uncertainty is to do half of what you would like to do. Doing half breaks the psychological stranglehold of fear and greed, because regardless of what happens, part of your decision was a success.

You could also start to make a “shopping list.”? Start looking for names that you would like to buy 10, 20, 30% lower, and set alerts.? Who knows how rapidly things will move when the correction or bear market comes.

You could keep a close eye on the 200-day moving average for the S&P 500, waiting for the index to cross under that as a sell signal, but if you want to be ahead of the crowd, maybe you want to use the 190-day moving average. 🙂

I tend to use industry selection and other factors, like balance sheet strength and reliability of cash flows as my main risk reduction tools rather than outright reduction of equities owned.? In general, I have been a good picker of stocks over the last 13 years, and I want to continue using that advantage.

With bonds, I am playing it safe with short and intermediate corporates, and taking reasoned chances with emerging markets debt.? Beyond that, I am thinking of buying long Treasuries as a deflation hedge.

The equity market is well above where long-term valuation measures like the Q-ratio, and CAPE10 would value it.? Most of that is due to low interest rates and high levels of QE.? How certain are you that both will persist, and for how long?? Personally, I think both will persist for some time, but not forever.? Profits attract competitors, and low rates discourage savers.

Though we don’t know when change is coming, we have to be ready for change.? Whatever you do for defense, make preparations now to be defensive; this era and valuation levels will not persist.

Aside from that, remember that when a system is so artificially supported, it relies on peace & continued support from governments.? Either could vary.? Peace is not certain, and neither is the current set of economic policies.? Be ready, because there can be all manner of surprises.

Full disclosure: long BRK/B, IM, VR, AFL, CST

On News

Posted on 16 May 2013 by David Merkel

I have a saying that when there is no news, the market reveals its true direction.? That applies to individual securities as well as the market as a whole.? Why?

Think of institutional traders, who drive much of the market.? They are so big that they have to spread out their orders over time, or they would move the market against their positions.? On days when there is no news, volume tends to be light, displaying the actions of the big traders.

Valero recently spun off CST Brands, which was their retailing arm, selling gasoline, and things you find at convenience stores.? Seems cheap to me.? Over the last few days it has been rising on no news.? To me that means some institutional investors are buying.

I’ve seen the same thing happen when a stock falls on no news.? That’s usually a bad sign if you are long, because it means someone is selling for a reason you are not aware of.? Now, if you have done your homework, and know more than the seller, a lower price is to you advantage if you want to buy more.? The trouble is, you don’t know how much the seller has to unload.? To use CST Brands as an example again, I received some shares as a result of holding Valero for clients (and me, I get what my clients get), but I estimated how much index related selling had to happen as a result.? I bought a full stake for my clients at the point where the total volume from the prior “when issued” trading, plus actual trading on the first day hit my estimates.? It was close to the low for the day, though someone more enterprising could have picked up shares cheaper during the “when issued” trading, if he was clever.

But sometimes when there is news, you need to try to gauge whether something is an over- or under-reaction.? My favorite example here is RGA, the prominent well-run life reinsurer.? Once every eight quarters or so, they report a lousy quarter.? Why?? Because of the law of small numbers.? The large claims inside a life reinsurer are few, but make a considerable difference to the earnings when a bunch of large policy deaths happen at the same time.? The general public does not get this, so when RGA has a bad quarter, it is usually a good time to be a buyer.

The same applies to P&C reinsurers during crises.? I added to my reinsurance holdings post-Sandy, because I knew that the reinsurers would take relatively few claims because they don’t cover flood for residential, though they might have commercial-related claims.? As it was, none of my insurance holdings had any significant claims from Sandy, and the portfolio did well.

Toss out another example, but Endurance Specialty is one of the leading underwriters of crop insurance.? Crop insurance was a horrible place to be last year, and that put pressure on ENH as a stock.? But that neglected all of the other lines of business of Endurance that were performing well, as well as the risk controls that Endurance placed on its crop insurance business.

Perhaps the broad message here is to know your stocks well, so well that you can gauge whether a? market reaction to news is overdone, underdone, or meh, normal.

Analyzing the reaction to news (or no news) bonds and other assets as well.? When I was an institutional bond manager, I would watch the results of trading on the slow days, because it would give a clue to what the “big guys” were doing.? Also, when an event that has been anticipated occurs, like a ratings downgrade on the bonds of a troubled company, the market reaction says a lot, because often there are many who were waiting to buy once the downgrade happened, so price rises a lot at the downgrade.? (Think of the USA downgrade by S&P.)? The reverse is true for downgrades that are more of a surprise.

In summary, all news is not equal.? The reactions to news, and the lack thereof, can tell us a lot about the intentions of large market actors.? Do your homework well, and prosper off of the knowledge that it gives you regarding reactions, over-reactions, and under-reactions.

Full disclosure: long VLO CST RGA ENH