Portfolio Management – Page 51

A Bond Deal Requiring Caution

Posted on 21 March 2013 by David Merkel

Recently, a company for which I once managed bond money announced a bond offering.? An odd bond offering that I would not buy regardless of pricing.You might say, “No such thing as bad assets, only bad prices.”? Mostly I believe that, but not here.? There are some assets you should not want to take the chance on.? This is one of them.

Here is the biggest weakness: you are lending to an intermediate holding company.? When I was a bond manager, I would lend to the uppermost holding company, knowing that the stockholders did not want to hand their profitable company over to me.? I would also lend to subsidiaries that I knew a parent company would not want to lose.? But I would not lend to intermediate holding companies — owned by the parent, and owning a subsidiary not directly responsible for the debt.

I inherited such a debt in the portfolio, and it took me months to sell it at a halfway decent level.

Here is the second weakness: they will take two-thirds of the proceeds, and give it to the life insurance subsidiary in exchange for a surplus note, with similar terms compared to the note sold.? Surplus notes are weak, because state insurance departments can forbid payment of interest and principal.? The ability to repay the bond is weak.? The subsidiary borrowing does not have any significant cash flow to repay, aside from dividends from its insurance subsidiary.

Third, I do not appreciate the affiliated reinsurance.? That is just a scam, with no economic difference to the enterprise as a whole.

Fourth, I do not appreciate reinsurance recoverables larger than common equity.? There is some credit risk there… how much do you rely on your reinsurers to pay claims in full?? The operating insurance subsidiaries look like they are adequately capitalized, but with that level of reinsurance, you really can’t tell for sure.

Also, some of the reinsurance agreements are specifically targeted to eliminate pesky reserves that make Statutory (regulatory) accounting more conservative than GAAP.? That’s not all that unusual with financial reinsurance, but it does lessen future statutory cash flow, which is what is needed to service the debt.

Fifth, 25% of the offering will be paid as a dividend to the parent company, which further weakens ability to repay.

Sixth, there are related party transactions within the Harbinger Group.? Harbinger Group has been through tough times and liquidity is tight.? You only do moves like this when things are desperate. Reminds me of Southmark.? The operating insurance subsidiaries have made loans to EXCO Resources, a Harbinger subsidiary, buys asset-backed securities that other Harbinger subsidaries originate, and has a large reinsurance agreement with a Harbinger subsidiary in the Cayman Islands.? I respect most reinsurers in Bermuda.? Other foreign domiciles like Ireland, Cayman Islands, etc., are more questionable.? Regulation is more lax.

Seventh, Here are some of the points from the risk factors:

Our Reinsurers, Including Wilton Re, Could Fail To Meet Assumed Obligations, Increase Rates, Or Be Subject To Adverse Developments That Could Materially Adversely Affect Our Business, Financial Condition And Results Of Operations.

Our insurance subsidiaries cede material amounts of insurance and transfer related assets and certain liabilities to other insurance companies through reinsurance. For example, a material amount of liabilities were transferred to Wilton Re pursuant to the Wilton Transaction in 2011. See ?Business?The Fidelity & Guaranty Acquisition?Wilton Transaction? below. However, notwithstanding the transfer of related assets and certain liabilities, we remain liable with respect to ceded insurance should any reinsurer fail to meet the obligations assumed. Accordingly, we bear credit risk with respect to our reinsurers, including our reinsurance arrangements with Wilton Re. The failure, insolvency, inability or unwillingness of Wilton Re or other reinsurers to pay under the terms of reinsurance agreements with us could materially adversely affect our business, financial condition and results of operations.

As noted above, reinsurance is a source of credit risk, and is a type of leverage.? Companies that use a lot of it are less strong than they seem.

Our Insurance Subsidiaries? Ability To Grow Depends In Large Part Upon The Continued Availability Of Capital.

Our insurance subsidiaries? long-term strategic capital requirements will depend on many factors, including their accumulated statutory earnings and the relationship between their statutory capital and surplus and various elements of required capital. To support their long-term capital requirements, we and our insurance subsidiaries may need to increase or maintain their statutory capital and surplus through financings, which could include debt, equity, financing arrangements or other surplus relief transactions. Adverse market conditions have affected and continue to affect the availability and cost of capital from external sources. We and HGI are not obligated, and may choose or be unable, to provide financing or make any capital contribution to our insurance subsidiaries. Consequently, financings, if available at all, may be available only on terms that are not favorable to us or our insurance subsidiaries. If our insurance subsidiaries cannot maintain adequate capital, they may be required to limit growth in sales of new policies, and such action could materially adversely affect our business, operations and financial condition.

There is kind of a pathology to insurance companies that rely on reinsurance for capital.? It fronts expected statutory profits from the future, reducing future statutory income, but increases capital.? It’s kind of an addiction.

We Operate In A Highly Competitive Industry, Which Could Limit Our Ability To Gain Or Maintain Our Position In The Industry And Could Materially Adversely Affect Our Business, Financial Condition And Results Of Operations.

We operate in a highly competitive industry. We encounter significant competition in all of our product lines from other insurance companies, many of which have greater financial resources and higher financial strength ratings than us and which may have a greater market share, offer a broader range of products, services or features, assume a greater level of risk, have lower operating or financing costs, or have different profitability expectations than us. Competition could result in, among other things, lower sales or higher lapses of existing products.

They are up against much stronger competition with better balance sheets.? In a crisis, they would have less flexibility, and have a harder time raising capital than most competitors.

The Issuer Is A Holding Company And Its Only Material Assets Are Its Equity Interests In FGLIC. As A Consequence, Its Ability To Satisfy Its Obligations Under The Senior Notes Will Depend On The Ability Of FGLIC To Pay Dividends To The Issuer, Which Is Restricted By Law.

The issuer is a holding company with limited business operations of its own. Its primary subsidiaries are insurance subsidiaries that own substantially all of its assets and conduct substantially all of its operations. Accordingly, the repayment of interest and principal on the senior notes by the issuer is dependent, to a significant extent, on the generation of cash flow by its subsidiaries and their ability to make such cash available to the issuer, by dividend or otherwise. The issuer?s subsidiaries may not be able to, or may not be permitted to, make distributions to enable it to make payments in respect of the senior notes. Each subsidiary is a distinct legal entity and legal and contractual restrictions may limit the issuer?s ability to obtain cash from its subsidiaries. While the indenture governing the senior notes will limit the ability of the issuer?s subsidiaries to incur consensual restrictions on their ability to pay dividends or make other intercompany payments to the issuer, these limitations are subject to certain qualifications and exceptions. If sources of funds or cash from the issuer?s subsidiaries are not adequate, we may be unable to satisfy our obligations with respect to the senior notes without financial support from the issuer?s parent, which is under no obligation to provide such support.

(snip)

The issuer intends to use $195.0 million of the proceeds from the senior notes to purchase a surplus note from FGLIC. The interest rate and tenor of the surplus note will be substantially similar to those of the senior notes.

As pointed out above, owners of this bond would be lending to an empty shell from which it will be difficult to extract value if there is financial stress.

We And Our Subsidiaries May Be Able To Incur Substantially More Debt And Other Obligations.

We May Not Be Able To Generate Sufficient Cash To Service All Of Our Obligations, Including The Senior Notes, And May Be Forced To Take Other Actions To Satisfy Our Obligations, Which May Not Be Successful.

The Senior Notes Will Not Be Secured And Will Be Effectively Subordinated To Future Secured Debt To The Extent Of The Value Of The Assets Securing Such Debt.

The Issuer May Not Be Able To Repurchase The Senior Notes Upon A Change Of Control, And Holders Of The Senior Notes May Not Be Able To Determine When A Change Of Control Giving Rise To Their Right To Have The Senior Notes Repurchased Has Occurred Following A Sale Of ?Substantially All? Of Our Assets.

Our Principal Shareholder?s Interests May Conflict With Yours.

Lest this post go from “too long” to “way too long,” I am summarizing off of the headings of five more risk factors.? The first three show the weakness of the position of the holders of the notes, in that you can be diluted or subordinated.?? The fourth shows how the notes themselves would complicate a sale of insurance subsidiary assets.

The fifth tells you that Phil Falcone has different interests than you.? If things go well, he may do very well, while you get repaid early because of call provisions, and must reinvest.? If things go badly, recoveries on a bond like this could be very low.? When surplus notes stop paying interest and principal, they trade near zero if it looks permanent.? Remember, the Maryland Insurance Administration has every reason to be conservative about making surplus note payments if the operating insurance subsidiary is under financial stress.

Eighth, if it’s not obvious get, I eschew complexity in debt agreements.? I’m not crazy about:

Reserving on indexed and variable products
Complexity of financial operations
Liabilities that can run easily — I don’t have the data for that, so I don’t know how big that is, I would have to look at the Statutory books to know for sure.
Deferred tax assets as a part of Statutory Capital — again, I would have to look at the Statutory books to know for sure.

Ninth and Last, the covenants protecting the notes are weak, and exceptionally verbose.? I have a rule that the longer and more detailed covenants are, the less protection they usually give note owners.? It’s kind of like Proverbs 10:19, “In the multitude of words sin is not lacking, But he who restrains his lips is wise.”

For a corporate bond prospectus, this one is really long, ~320 pages, longer than some securitizations that I used to buy as a mortgage bond manager.? I assume that most of the investor interest here would be institutional, but if you give your broker some discretion over an account in which he purchases individual bonds, you might ask him to avoid this deal.? It will be a tempting bond to buy, because it will come with a fat yield in this yield-starved environment, if the deal gets completed.

As one friend of mine once said to me, “This bond deal is horrid, but it has one sweet YTNJ.”

Me: “YTNJ? Haven’t heard that one.”

Friend: “Yield to next job.”

Be like Will Rogers, the return of the money is more important than the return on the money.? Be wise, stay safe.

PS — The opinions of Moody’s & Fitch

On the CFA Institute’s “Future of Finance”

Posted on 19 March 2013 by David Merkel

All hail the CFA Institute.? They are trying to inject more ethics into the market through their “Future of Finance” initiative.? I largely agree, but think they are overly optimistic in some areas.

Here are their basic ideas: http://www.cfainstitute.org/learning/future/about/Pages/statement_of_investor_rights.aspx

Here are their dreams: http://www.cfainstitute.org/about/vision/serve/Documents/integrity_list.pdf

My main problems are with the dreams.? Yes, I eventually want every investor to work with someone who has a fiduciary interest in his well-being.? But many people don’t want to take the time to find the people who have their best interests at heart.? There are many things we can overcome, but we cannot overcome the laziness of investors, both retail and professional.? This laziness is part of the nature of man; a few cure it through consistent effort, but most don’t.

To that end, some blame belongs to the unintelligent investors who barge into a market without sufficient knowledge.? That’s how it should be, because in many areas of business those that try to compete with insufficient knowledge lose vitality because they don’t know the basics of the business.

You can’t protect people from stupidity.?? Fraud is another matter.? Deception is different from dumb agreement.

But here is my main challenge to the CFA Institute: where do your ethics come from? Why are they right?? Are they God-given, or merely an agreement among men?

This matters a great deal, because if it is merely an agreement among men, many men will say, “So what! Why should I listen to you?”? If they are God-given, even if men argue with them, the answer comes back from God, “You are a sinner in many ways, including this.? When will you humble yourself to me, and trust in the sacrifice of my Son, which was the largest event in history?”

Ethics aren’t neutral; people disagree about what is right and wrong to a high degree.? Even in finance, there are considerable disagreements in what is the correct behavior:

Active vs Passive mangement
Value vs Growth
Does Technical Analysis work?? (Is there truly a single discipline there?? I don’t think so.)

That’s a considerable reason why it would be difficult to enforce the views of the CFA Institute over the markets.? There is no commonly agreed-upon view of how the markets work.? The views of the academics are ridiculous, and do not reflect market realities. But many asset allocators trust them, even though their results are poor.

Don’t get me wrong, I largely favor what the CFA Institute is proposing.? I just think it will be hard to turn it into public policy because of the large disagreements over how finance actually works.? Also, the degree to which neglectful parties buy into the markets through the persuasion of sellers, because they won’t look out for their own best interests directly.

So, look at what the CFA Institute is up to.? They are part of the “White Hats” in the market, like me, who argue for the good of investors.? My only difference with them is that their model of the market is not fully accurate.? Nor do they understand how men can err, even with detailed ethics codes.

Sorted Weekly Tweets

Posted on 15 March 2013 by David Merkel

US Politics & Economic Policy

Employers Blast Fees From New Health Law http://t.co/FfuBRO2HQp Phases in the added costs of covering sick people previously uninsured $$ Mar 15, 2013
Conservative Groups Warn GOP Lawmakers About Deals With Obama http://t.co/vui4GOINCw If this were a 2-player game, would have been solved $$ Mar 15, 2013
Gundlach: Investors are asking the Wrong Question http://t.co/xA1UgvCica ht: @ReformedBroker QE as a permanent affair w/which we have 2 live Mar 15, 2013
New Group Pushes Corporate-Tax Overhaul http://t.co/P3dwgqQON6 Trying 2 End Double Taxation of foreign profits. Hasn’t worked so far $$ Mar 14, 2013
The Almighty Dollar Is Back http://t.co/F3iP3Zblyk Skeptical. Waiting for the Fed to announce increase of QE to send the $$ back down Mar 14, 2013
GIs Fighting Nazis Last Time Factory Workers Toiled Longer http://t.co/pVMlMGFRQ0 This is optimistic for new hiring $$ Mar 14, 2013
Grand Bargain Taxes, Entitlements Cuts Await Deal Makers http://t.co/gJZ2c4Uc17 My sense is that we r heading 4 another deadlock $$ Mar 14, 2013
Refusal to Expand Medicaid May Cost Employers $1 Billion http://t.co/kpxJmCeZvT Pressure is going to grow to eliminate PPACA & Medicaid $$ Mar 14, 2013
US Growth = Inventories http://t.co/dOIp5n9sPH Much of the presumed growth in the US is just rebuilding of inventories to a peak level $$ Mar 12, 2013
GOP Budget Establishes Contrast With Democrats http://t.co/ocLQndOvsP No chance of it being passed, but gives an idea of where 2 sides r $$ Mar 12, 2013
SEC Charges Illinois Over Pension Funding http://t.co/MxEF6hPYPy This is how it should be. No one gets punished in the slightest. $$ Mar 12, 2013
Note from last tweet: a lot of ppl want to punish bankers, what about state officials who lie – they r much bigger, where is the outcry? $$ Mar 12, 2013
Fed mulls putting a ‘not for sale’ sign on its assets http://t.co/uZAcaHmLeO A sign of weakness from the Fed; they know they r trapped $$ Mar 10, 2013

Roman Catholic Church

Jesuits Had Past Struggles With Popes http://t.co/P8Vy8YEifr In the RC church, they have top liberation theologians &their top opposition $$ Mar 14, 2013
Ten things you probably didn?t know about the Jesuits http://t.co/tFijZNMkV9 If the Church have defined anything to be black… amazing $$ Mar 14, 2013
The sins of the Argentine church http://t.co/FTzKlsq1I7 New Pope may have been complicit w/Military Dictators killing their enemies. $$ Mar 14, 2013
The Changing Church http://t.co/mDPol6orR5 Interesting 2c change in locations of Cardinals. Size of RC church overstated, many not active $$ Mar 14, 2013
How Is the Pope Elected? http://t.co/j8p5L9dB5I A little late, but I thought this was an interesting infographic on papal elections $$ Mar 14, 2013
African Catholics Look to Black Pope to Safeguard Tradition http://t.co/vxZrJJDgvv US Media does not get how traditional most Catholics r $$ Mar 13, 2013
Black Smoke Signals No New Pope http://t.co/9qp8nzlbRb More & less unity in RCC than commonly thought. More: Europe, Less: elsewhere $$ Mar 12, 2013

Financial Markets

To all of the fixed income followers out there: someone asked me today to recommend good bond blogs. What would you recommend? Mar 15, 2013
Highest Bond Yield at Auction in a Year Could Be Sign of Things to Come http://t.co/fShhD5iAlp Or it could be a buying opportunity $$ Mar 15, 2013
$OAK Founder Knows How to Get an Edge in Investing http://t.co/TaRQSiK5gI “Experience is what u get when u didn’t get what u wanted.” $$ Mar 14, 2013
Smallcap Stock Volatility Index Hits All-Time Low http://t.co/l6tCXV7VS4 Complacency is the rule of the the day among small cap stocks $$ Mar 14, 2013
5 ways Warren Buffett invests that you don?t http://t.co/AeCs8fqe6g Good job describing what parts of Buffett’s strategies can b mimicked $$ Mar 14, 2013
Team Alpha Retirement Portfolio: Dividend Investing Vs. Annuity Purchasing http://t.co/HNHqI40vDP Example of y I don’t read Seeking Alpha $$ Mar 14, 2013
New Carlyle Group Fund Lowers Bar for Investors http://t.co/xiCTwy07Zk As @reformedbroker aptly put it, “Muppet Bait” Avoid. Avoid. $$ Mar 14, 2013
Fidelity to Expand ETF Relationship With BlackRock http://t.co/d4PIiCb7oh Fidelity says “Me 2,” by partnering with $BLK . No value added $$ Mar 14, 2013
moving down-market http://t.co/qP0YSWKubG @researchpuzzler has it right, inviting small accounts in means opportunities r getting worse $$ Mar 14, 2013
Historical S&P 500 Price to Sales (P/S) Chart http://t.co/dm2ZhDDgtE Useful little chart – around avg now, but profit margins r a record $$ Mar 13, 2013
SP500 Bull and Bear Factors – Not so Fun Damentals! http://t.co/5OjwvLbLPw Bull factors: QE, Buybacks, Yen. Bear: Econ data, Earnings mo $$ Mar 13, 2013
Gold Sales From Soros Reveal 12-Yr Bull Run Decay http://t.co/ze7DSsdIkN Makes me want 2 do a piece on $$ weighted vs time weighted on $GLD Mar 13, 2013
Why (Most) People Hate Good Financial News http://t.co/PZcf1usKD1 Regret is a strong force in psyche of amateur investors: missing out $$ Mar 12, 2013
How Much Of The Stock Market?s Growth Is Caused By Its Shrinking? http://t.co/Kfxipqvr1Y I would be skeptical here; capital changes weak $$ Mar 12, 2013
Securities Lending: Worth The ?Risk? http://t.co/AZxSKFzM2T When done right, sec lending is almost free money, the risks r low. $$ Mar 12, 2013
New ETF Underway for Distressed Debt http://t.co/Wp3ZPwaZqj Bad idea. Creating indexes for distressed bonds will be hard, Won’t attract $$ Mar 12, 2013
Firms Send Record Cash Back to Investors http://t.co/n0vNv0ppei A sign of economic weakness; there are few places to invest for growth $$ Mar 10, 2013

Wrong

Wrong: Amazon Preparing Bid For Barnes And Noble? http://t.co/qYB3yE6u8U Combination would not be allowed by the FTC $$ Mar 13, 2013
Wrong: Why Insurers May Be Unprepared for the Next Big Storm http://t.co/WuJIpvtVBj Most P&C insurers have more than adequate reserves $$ Mar 13, 2013
Wrong: The US can?t afford a Chinese economic collapse http://t.co/9vskptvxvx We can afford it; China won’t affect much in the US $$ Mar 12, 2013

Rest of the World

China s Next Potential Bubble: Hello, Anybody Home? http://t.co/IstgcTQZCN Trapped. Potential sellers need prices 2 stay high, buyers low $$ Mar 15, 2013
Embrace consumption, IMF’s Zhu urges China http://t.co/TAc5toyktZ Easier said than done. Party not ready to give people more freedom. $$ Mar 15, 2013
Nordic Testicular Cancer Mystery Prompts Chemicals Probe http://t.co/LqwH8klTLq Interesting, might be a combo of genetics & environment $$ Mar 15, 2013
Jeffrey ??s Japan Stocks http://t.co/lvhM6LFXAv?s-japan-stocks/?utm_source=dlvr.it&utm_medium=twitter Weak yen drives Japan stocks up $$ Mar 15, 2013
Recent cyberattacks could be part of a Chinese military strategy started nearly 20 years ago http://t.co/NxZ99g2ZKo Explains what is up now Mar 14, 2013
Brazil?s Richest Family Forging $13 Billion Niobium Dream http://t.co/2MHbOkhHPd Stronger flexible steel from a Brazilian tech company $$ Mar 14, 2013
Even Berlusconi Can?t Slow Bulls Boosting Euro View http://t.co/PV2mGvfHRr Great 4 core Eurozone, bad news 4 the fringe Eurozone $$ Mar 13, 2013
Chinese inflation hits 10-month high http://t.co/rGZJHoZsqj The end of the cycle comes when Chinese inflation gets out of control $$ Mar 13, 2013
Snow Causes European Travel Chaos http://t.co/tz3afCLET9 That’s one thing about weather & climate, constantly changing & always will $$ Mar 13, 2013
Should You Bond With Azerbaijan? http://t.co/gpE429eGa8? by @jasonzweigwsj | Emerging market govts are better run than developed govts $$ Mar 12, 2013
Norway Fund Flees Currencies Tainted by Stimulus Addiction http://t.co/X7YasIGkKn Rational response2 depreciating currencies: hail Norway $$ Mar 12, 2013

Banks

JP Morgan’s Jamie Dimon showed too much hubris and too little humility http://t.co/4feQB2Q6Jx @moorehn highlights cultural problem @ $JPM $$ Mar 15, 2013
Bubble Exchange: Technology vs Financials http://t.co/BJKoaFfjdo Suggests that financials, not tech, will do better in the future $$ Mar 15, 2013
EU Said to Plan Concession on Tax Credits as Bank Capital http://t.co/Ss3J4KBGbv Deferred Tax Assets should not be allowed as capital $$ Mar 15, 2013
Deferred Tax Assets r only valuable if a company makes $$ in the future, which for a bank in distress is less likely; should not b capital Mar 15, 2013
Beware of a New Banking Bubble http://t.co/gr5c2S9NaI Three recent deals involved premiums of 32% to 83% above tangible book value $$ #fire Mar 14, 2013
Fisher and Rosenblum: How to Shrink the TBTF Banks http://t.co/pNfzML2A22 Could work, roll back safety net, keep pieces small, holdcos fail Mar 14, 2013
5 Big Questions for the Future of Retail Banking http://t.co/sCKi6QjfCu Branches buy/sell, online/mobile, layoffs, interest margins down $$ Mar 14, 2013

Companies & Industries

Lawmakers Examine Ethanol Credits’ Affect on Gas Prices http://t.co/5RHXnKcuFG Wasteful program doesn’t aid conservation adds 2 pollution $$ Mar 15, 2013
5 beloved tech products that were sentenced to death http://t.co/bg4S90UHlZ Impending death of Google Reader makes writer wax nostalgic $$ Mar 15, 2013
Google and Bing Say the Future of Search Is Conversational http://t.co/mx2gfh6oSr Software improves ability 2 understand contextual data $$ Mar 15, 2013
Herbalife short-seller sues banks, Icahn over alleged fraud http://t.co/NaL4X9aXW3 Losing investor throws good $$ after bad, will not win Mar 14, 2013
Evolv, Making Hourly Workers More Profitable, Lands $15 Million http://t.co/DDEyoCk7Ay Improves retention of the employees u want 2 keep $$ Mar 14, 2013
Lincoln?s Cooper Shuns Shoot-For-Moon Funds After Goldman http://t.co/7PdLGT5TGb This does not make me feel better about $LNC. Avoid. $$ Mar 14, 2013
How Benjamin Franklin Invented the Mail-Order Business http://t.co/TC6DmWsZck A look at the precursors to mail-order retail. Interesting $$ Mar 14, 2013
Lego Builds New Billionaires as Toymaker Topples Mattel http://t.co/jxkqNatzZk Family controls 75% of the operation through Kirkbi A/S $$ Mar 14, 2013
8 Megatrends Defining the Oil & Gas Industry http://t.co/Taz5Dsujwh Nationalization, Ending subsidies, Green, New frontiers, LNG, M&A $$ &c Mar 14, 2013
Blackstone Said to Get $2.1 Billion Loan for Home Purchases http://t.co/qDg7DrSBGk I’m skeptical, don’t think renting homes is scalable $$ Mar 14, 2013
Many hospitals, doctors offer cash discount for medical bills http://t.co/ckLOHxh1TH ht: @dpinsen | Sometimes ucan pay less w/o insurance $$ Mar 13, 2013
Gas Rigs Drop to Fewest Since 1999 as Drilling Declines http://t.co/b3YztqbTqs Almost like the old days when they would flare off natgas $$ Mar 13, 2013
Starr Proceeds With Fight Over $AIG Rescue http://t.co/WPNIOyib7B I don’t think he will win, but Greenberg will get his day in court $$ Mar 13, 2013
Beating The Downturn By Degrees http://t.co/9BT69ix6Fs Good summary article on the for-profit educators $$ Mar 13, 2013
Liberal-Arts Colleges Dangle Deals to Woo Students http://t.co/v3Qd07x8AD Pay for 4 years & never have 2 pay again; u *can* finish 4 free $$ Mar 13, 2013
InTrade Online Betting Site Shuts Down Abruptly http://t.co/Rb0Ppald2u A long shot from the start, current bettors may b stuck w/the loss $$ Mar 12, 2013
Green Cars Have a Dirty Little Secret http://t.co/wk5UfvYiYn Producing and charging electric cars means heavy carbon-dioxide emissions. $$ Mar 12, 2013
Uninsured Americans Get Hit With Biggest Hospital Bills http://t.co/6QeybZMIz8 First value of insurance is buying power lowering prices $$ Mar 12, 2013

Other

Jim Gaffigan Is the King of (Clean) Comedy http://t.co/RhUM30krSU Heartening 2c clean humor getting attention; certainly harder 2 do $$ Mar 15, 2013
The Bearded Man http://t.co/ub5n07UjFZ I’m no trendsetter. If you’re out of fashion long enough, eventually u accidentally get in fashion $$ Mar 15, 2013
Does money taint the sharing economy? http://t.co/yTjd3w8ThO If you want an organization to last, there must be a profit margin $$ Mar 15, 2013
Scientists find how deadly new virus infects human cells http://t.co/YLfoqPbvJ1 Disease is similar to SARS. Infected 15, killed 9 $$ Mar 14, 2013
Former Ravens May Outnumber Ravens http://t.co/SIxpATVmC6 Noticed in Baltimore; curse of the Joe Flacco contract; less $$ for rest of team Mar 14, 2013

Retweets & Replies

‘ @tradewins @moorehn The problems are concealing data from the regulators, & Dimon perhaps concealing what he truly knew at the time $$ Mar 16, 2013
@TWealthMgmt Yeah, they are good, & I mentioned them. Seems many bond blogs have folded; they had a finite maturity 😉 Mar 15, 2013
@nelson3748 Railroads r scarce; impossible to replicate; has a big moat w/pricing power; trucking has no moat; scale is needed Mar 14, 2013
I just left a comment in “5 ways Warren Buffett invests that you don?t – Jonathan Burton’s Life Savings – MarketWat?” http://t.co/2tjAaDwkV7 Mar 14, 2013
Yes, but the nice thing about Pi day is that it has been a round RT @EddyElfenbein: Celebrating Pi Day seems so irrational. Mar 14, 2013
@EliHoffmann Don’t get me wrong I *like* dividends & have for a long time. They r more frail than the new advocates assume Mar 14, 2013
@EliHoffmann There r other things he got wrong re insurance, but the faith in dividends is naive. They get cut in bad periods like the ’70s Mar 14, 2013
@EliHoffmann Annuities r guaranteed by state guarantee funds Mar 14, 2013
@DavidSchawel Thanks, but r u bullish on it or neutral? Mar 14, 2013
@DavidSchawel How successful? Mar 14, 2013
No RT @pdacosta: VZ president says Chavez, now close to Christ, had a hand in choice of South American pope http://t.co/WYR2izYIsk Mar 14, 2013
“Pretty cool. Billy Joel took a chance on the student, and it was beautiful. Kid had moxie.” ? David_Merkel http://t.co/YBUfXDNSGH $$ Mar 14, 2013
UCan say that again RT @ReformedBroker:Muppet Bait MT @researchpuzzler:Don’t miss your chance 2 play w/big boys of PE http://t.co/5fg2tLPXS3 Mar 14, 2013
Listening to broadcasters in Rome, it reminds me of the Super Bowl when the power went out; gotta say something, but not much to say… $$ Mar 13, 2013
. @scott_matagrano Also, $AIG’s domestic life companies were BK until rescued b/c of sec lending… long story: http://t.co/EmnSclWqVS $$ Mar 13, 2013
@scott_matagrano Not *quite* riskless. There were some bond trades I could not execute b/c we could not get the shares back. Mar 13, 2013
@merrillmatter I don’t but some of my clients do. Mar 13, 2013
@ReformedBroker Hey Josh, where is that indicator now? Mar 12, 2013
@weelifeworkplay Saw that, but property tends not to vary in value as much as currencies do. Owning land tends to preserve value, mostly $$ Mar 12, 2013
@prchovanec In a word, overvalued. P/E measurements of value fluctuate too much b/c earnings varies more than sales or book $$ Mar 12, 2013
@exMBB I avoid life companies that primarily write variable business; the accounting quality is poor. No opinion on $PNX $$ Mar 12, 2013
@SagittaCapital I’m afraid that one is a ‘No.” I don’t have a lot to say there. Mar 12, 2013
@60Minutes @sherylsandberg That’s dumb. It could just be rudeness, or ego, and the same applies to boys. Will to power <> leadership $$ Mar 11, 2013
@prchovanec P/E is more significant in the short-run. CAPE10 & Q-ratio more significant in the long run. $$ Mar 10, 2013

FWIW

My week on twitter: 48 retweets received, 11 new listings, 51 new followers, 55 mentions. Via: http://t.co/cPSEMLXpb8 Mar 14, 2013

On Insurance Investing, Part 5

Posted on 14 March 2013 by David Merkel

The Squishy Stuff

I think I have just one more post left after this one, and this series ends.? This post deals with qualitative factors, which are harder to ascertain than the quantitative factors, and require more experience in order to learn.? But maybe I can aid my readers with a few pointers so they can learn faster.

Before we go, this series published at The Street.com University is an excellent start for any analyst, and includes many insurance examples.? But now for the rest.

Some products cannot be underwritten.? Anytime the insured knows more than the company, that is not a policy to write.? As an example, I toss out Long-term care policies, where the insurance industry has lost and lost again.? The insureds know their likely claims far better than the insurers do.? I feel the same about credit and mortgage insurance, where losses are so correlated that in a real crisis the insurance company fails, and those relying on the insurance fail as well.

I feel the same way about variable annuity living benefits at present — a rising market sets up the losses for when the market falls.

Avoid investing in companies where the law of large numbers does not apply.? This is true of all financial coverages.? If there is one big macro factor that drives your business it is not a safe place to be.

On Management

Management teams should be reliable.? They should always give complete and consistent answers to all questions, and demonstrate that they are managing the business, with underwriting being profitable.? They also should be willing to let results fall short of analysts’ estimates when it is true.

Though the short-term stock performance will be bad, the honesty will support the stock nearer to book value.? Investors appreciate honest companies, even when they do badly.

Finally if management has any sustainable competitive advantages (rare in insurance) they will use the advantages, and describe them in general terms so hat other insurers don’t reverse engineer them.

Be sure and read my series listed above.? It offers far more than what I have written here.

Neglected Stocks Are Typically in Strong Hands

Posted on 13 March 2013 by David Merkel

Neglected stocks — I measure it by the ratio of market cap to average dollar volume.? 15% of my portfolio is allocated to such stocks, but I would be happy for it to be 50%, if not more. Many of my companies have a single large holder or group — Industrias Bachoco, National Western Life Insurance Company, CVR Energy, and?Berkshire Hathaway.? These companies have few analysts; there is no way for a brokerage to make money off of them.

Yes, there is a control discount for such companies, because they can’t be taken over, except by the dominant owner.? But if they are well-run, they can be great places to invest.? The dominant investor has his interests aligned with yours over the long haul.? This means that in good and bad times, a large amount of the stock is locked up, and is not available to be bought or sold.? Strong hands hold the stock, which is typically a good place to be.

I like holding cheap, illiquid companies, where there is no hint of financial stress, and they are earning decent money.? I don’t care if they are in dull industries.? If they are compounding their earnings at a decent clip, the stock will eventually catch up.

The point is to own good businesses at good prices.? That’s what I aim to do.

Full disclosure: long BRK/B, CVI, IBA & NWLI

Should Brokers Be Fiduciaries?

Posted on 13 March 2013 by David Merkel

From a reader:

As a reader of yours, I find your views always interesting and well thought-out, even when I disagree. Thank you for sharing your thoughts, wisdom, and experience, as I truly believe you raise up the areas of thought you touch.

I have a question that I hope you will address on your blog, though the urgency is low. As a CFA and CFP working in a small RIA, I have been paying close attention to the debate about imposing a uniform fiduciary standard onto RIAs and brokers. I would loved to hear your thoughts about this topic, maybe addressing the following:

Should brokers giving advice be held to the high fiduciary standard of advisers?

Could a two-tier fiduciary standard work (i.e. codification of the Merrill rule)?

The primary broker argument against the fiduciary standard, as I hear it, is that it would make services to retirement accounts unprofitable. Do you agree?

I hope to hear your thoughts on this published on your blog because I know that quite a few people with second or third degree connections (maybe first, but I don’t know) to the policy makers and lobbyists read your blog.

First, thanks — I know my reader base stretches into some lofty places, not that I deserve it.

There should be informed choice when choosing those that advise investors.? I don’t think that brokers should be held to a fiduciary standard, but I do think they should have to state to clients that they have a potential “conflict of interests.”? Clients don’t make money when trades occur, but brokers do.

The trouble is, retail investors are the dumb money.? There is a tension between allowing freedom and letting people get shorn by those that are more skilled.? Some financial products are sold not bought, and it is largely because people will not plan in advance for themselves.? We see that in life insurance all the time.

Here’s the other side of it: we can’t make retail investors smart.? In most transactions of life, the foolish get hosed.? We can’t protect people from being dumb.? If we did that consistently, our economy would probably fail.

The idea of “just prices” does not work.? It’s not flexible enough.? In the end, things work best when we let let markets work, but require extensive disclosure that most will understand, and some won’t.

Perfection is not possible in law or regulation.? If we get “pretty good” we have hit the top.? Enjoy pretty good where it exists, though I would encourage investors to use those that have to put your interests ahead of all else.

PS — there has to be a way to service retirement accounts — as with insurance contracts, some sort of AUM fee or trailer commission would do it, but not something based off of transactions…

On Annuities, Particularly Variable Annuities

Posted on 12 March 2013 by David Merkel

From a Reader:

I read your blog quite frequently and really enjoy the work you put into it.? It helps me to think about other opinions/concepts and always look at things in a different light.?? I’m a financial advisor in St. Louis for a small boutique firm and truly feel your blog helps me be a better financial advisor.
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Anyway, in trying to better myself and feel even more comfortable about recommendations I make for clients, I wanted to get your opinion on annuities.? In short, I used to avoid these things like the plague early in my career.? Now?? I find myself using them quite a bit for a portion of clients money and I find that in the planning process, they are a great tool in which to be able to tell clients exactly how much income they can expect in 5 or 10 years when they retire.? These riders and benefits are actually very useful in my opinion and have come a long way over the years.? I guess where I struggled in the past was during the 2008 crisis when my nice, neat 60/40 allocation for clients still lost them money…..sure, I was charging 1% and that’s cheap compared to the cost of an annuity but I can’t help but think how far ahead of the game clients would be if they had a portion in a product that guaranteed their income.? Of course, their account values might be down but their guaranteed income would still be intact.
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So, with all that in mind and because of your background in the insurance business, I figured you might be the perfect person to fire away a few questions.
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1) What’s your general opinion of guaranteed income riders?? Do you think they are worth it?? I know everything is relative to clients needs but from a pure practical standpoint, do you find that the benefit is still a good one?
2) What’s your opinion on contracts like with Jackson National or Metlife that offer a 5% guaranteed withdrawal AND a minimum death benefit combo of at least your initial contribution?? You have to leave $1 dollar left in the contract for the death benefit to pay but it seems to me to be an attractive option….guaranteed 5% w/d’s with assurance you can pass at least the initial premium on to your spouse or heirs
3) Lastly, what’s your take on this recent article?? Maybe for clients not wishing to pass money to heirs, this might be a good strategy?? Seems smart actually when they lay it out this way…..
http://www.advisorone.com/2013/02/22/milevskys-va-shocker-turn-on-your-living-benefit-n
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I’m sure you are extremely busy.? I appreciate any feedback.? Sorry to ramble, just wanted to get my thoughts across.

When a Variable Annuity is popular, it is because the secondary benefit is underpriced.? Many life insurance companies sell such policies; that is one reason why I don’t invest in them.? The other reason is that GAAP accounting for life insurers is too liberal, particularly with guarantees on variable products.

There are many attractive benefits that have been offered in the past with variable annuities.? If an insurance company offers to buy you out of an annuity with such benefits, refuse them, unless you know better than they do that you will die soon.

There are some attractive benefits out there, and insurers that have underpriced the benefits.? Where you find attractive benefits, have clients invest in them.

Finally, if the living benefit is attractive, exercise the option.? Think in your own interests.? What will give you the best payoff?? At a time like this, where equity values are high, converting asset value into income could be a great idea.

On Merger Arbitrage

Posted on 12 March 2013 by David Merkel

From a Reader:

I?ve mentioned this before but I?m an avid reader of the blog. I?m currently going through your old posts one by one and learning a lot. Yours is one of 2 or 3 other blogs that I am reading the archives? thanks for spending so much time sharing.

My question is about arbitrage (tenders and merger arb). I?ve been reading through Buffett?s old letters and in the late 1980?s he had quite an impressive run with his arbitrage investments (I think in 1987 he made around 80% on his arb investments).

Both he and Graham seem to have had long time success for decades using merger arb and other arbitrage techniques. I?m wondering if you ever employ any of these strategies in your portfolio? It seems like a specialized area, but also seems like an area that would add uncorrelated returns to the portfolio, and serve as a great substitute for cash when markets begin to become overvalued.

Would love to hear your thoughts on merger arb if you have time?

I did small deal merger arb for two years 1998-1999 and took some losses in the process.? On the whole I made money, but:

Merger arbitrage is a lot like credit analysis.? Analyze why the deal might not go through.? Your upside is capped, but your downside is unlimited.
Only work with binding commitments.? Do not speculate on “letters of intent.”
Do not speculate on mergers that the media cooks up.
Merger arbitrage is an “over-fished” area of the market.? The regular gains from it have been competed down to low yields.

When Buffett was doing merger arbitrage, few were doing it. That’s why he did so well then, though it was a small part of his strategy from an asset standpoint.

You are picking up nickels in front of a steamroller when you do this, so? don’t deceive yourself into thinking this is a low-risk venture.? This is a mature area of investing, with a lot of clever competitors.

One final note: this is not as uncorrelated as you think.? Merger arb is highly correlated to the credit cycle, because most mergers require credit to fund the purchase.? Also, many funds that do merger arbitrage consider fixed income investments as an alternative.

So be wary here… there is no free lunch.

On Floating Rate Funds

Posted on 12 March 2013 by David Merkel

From a Reader:

Floating Rate Funds — Do you have any thoughts on these investments. I don?t want to be involved in something that is going to blow up.

In general, I like bank loans because:

Default rates are low.
They are senior in the capital structure, so losses are small when they happen
They float with short-term rates, which are zero now, so they can only go up

Here’s the problem though.? Enough people know that such that ALL of the closed-end loan participation funds trade at a premium to net asset value.? I have never seen this before.

I would avoid the asset class, unless you buy into the non-traded funds, which price at book value.? Bank loans tend to have low default rates, and when they do default, losses are smaller than for bonds.

Comments on the Berkshire Hathaway Annual Letter

Posted on 2 March 2013 by David Merkel

I’ll let Buffett speak, and I will add a few comments.

When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $24.1 billion would be subpar, in terms of the comparison we present on the facing page.

But subpar it was. For the ninth time in 48 years, Berkshire?s percentage increase in book value was less than the S&P?s percentage gain (a calculation that includes dividends as well as price appreciation). In eight of those nine years, it should be noted, the S&P had a gain of 15% or more. We do better when the wind is in our face.

To date, we?ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. (The record is on page 103.) But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.

One thing of which you can be certain: Whatever Berkshire?s results, my partner Charlie Munger, the company?s Vice Chairman, and I will not change yardsticks. It?s our job to increase intrinsic business value ? for which we use book value as a significantly understated proxy ? at a faster rate than the market gains of the S&P. If we do so, Berkshire?s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.

I appreciate Buffett & Munger not changing their metric.? They could have said that the market return beat the S&P in 2012, but they didn’t.? Buffett is a compounder.? He figures that if he compounds net worth at an above average rate, he will beat the market returns of the S&P 500 over the intermediate term.? I agree; building intrinsic value will almost always lead to outperformance, unless the stock was significantly overvalued at the beginning.

On Searching for Acquisitions

Our luck, however, changed early this year. In February, we agreed to buy 50% of a holding company that will own all of H. J. Heinz. The other half will be owned by a small group of investors led by Jorge Paulo Lemann, a renowned Brazilian businessman and philanthropist.

We couldn?t be in better company. Jorge Paulo is a long-time friend of mine and an extraordinary manager. His group and Berkshire will each contribute about $4 billion for common equity in the holding company. Berkshire will also invest $8 billion in preferred shares that pay a 9% dividend. The preferred has two other features that materially increase its value: at some point it will be redeemed at a significant premium price and the preferred also comes with warrants permitting us to buy 5% of the holding company?s common stock for a nominal sum.

Once again, we don’t know all of the details, but it really looks like Buffett got the better part of the deal, and by a decent margin.? He continues:

Our total investment of about $12 billion soaks up much of what Berkshire earned last year. But we still have plenty of cash and are generating more at a good clip. So it?s back to work; Charlie and I have again donned our safari outfits and resumed our search for elephants.

As many expected, Buffett has more than enough cash to deploy if he sees the right deal.? With valuations being high, I don’t see how they fire the elephant gun, unless a company with protected boundaries wants to sell.

Though I failed to land a major acquisition in 2012, the managers of our subsidiaries did far better. We had a record year for ?bolt-on? purchases, spending about $2.3 billion for 26 companies that were melded into our existing businesses. These transactions were completed without Berkshire issuing any shares.

Charlie and I love these acquisitions: Usually they are low-risk, burden headquarters not at all, and expand the scope of our proven managers.

The tuck-in acquisitions of BRK are particularly valuable.? Done out of the spotlight, they get done at reasonable terms, and grow BRK organically.

The new investment managers, Combs and Weschler, did well in 2012, and Buffett is giving them more assets to manage.

As noted in the first section of this report, we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money.

Now interest rates are low, and underwriting standards are far tougher across the industry than if we were in a high interest rate environment.

Let me emphasize once again that cost-free float is not an outcome to be expected for the P/C industry as a whole: There is very little ?Berkshire-quality? float existing in the insurance world. In 37 of the 45 years ending in 2011, the industry?s premiums have been inadequate to cover claims plus expenses. Consequently, the industry?s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue.

What Buffett is saying is that his float is unique because:

His company underwrites carefully.
There is a decent amount of long-tailed business.
The short-tailed business (GEICO) is growing, which makes short-dated float feel long — in essence Buffett can borrow short and invest long, for now.

A further unpleasant reality adds to the industry?s dim prospects: Insurance earnings are now benefitting [sic] from ?legacy? bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years ? and perhaps for many years beyond that. Today?s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.

He is overstating the case here.? Most P&C insurers run short asset portfolios and have already adjusted to the low interest rate environment.

Now regarding the non-insurance operating businesses of BRK, they almost all had good years in 2012.? I’m not going to say more, though I will say that Buffett spent too much ink on newspapers; it is a teensy part of BRK.

Finally. Buffett talks about dividends.? There are two major ideas here:

Dividends are tax-disadvantaged versus buybacks.
If you can compound earnings at an above-average rate, there is no reason to ever pay a dividend.

What this might mean is that when a future CEO of BRK concludes that “there are no more worlds left to conquer” a la Alexander the Great, it would be reasonable to pay a dividend.? That said, he could also:

Centralize HR, legal and other functions.
Streamline subsidiaries, and make fewer managers manage more of BRK.
E.g., turn BRK into a real company.

There would be many ways to reshape BRK post-Buffett.? There are benefits and costs to doing that, but I think the benefits would be significant, unless the new CEO could keep the “hands off” way that Buffett does private equity.

Full Disclosure: Long BRK/B