Quantitative Methods – Page 18

Grow Embedded Value

Posted on 7 July 20128 July 2012 by David Merkel

One of my rules of thumb in equity investing is that if I buy companies trading below tangible book value,? with earnings yields over 10%, it is difficult to lose value, and the odds favor gaining value.

But there are some caveats:

Analyze the balance sheet, highly indebted companies are not to be trusted, but that varies by industry.
Longer dated assets, like property, plant & equipment should be discounted.
Banks and REITs must be scrutinized carefully, because of their weak liability structures.
Foreign companies need extra scrutiny, because the disclosures are often not as good.? This goes triple for Chinese companies.
Make sure you are not investing in a “buggy whip” industry, particularly in the era of the internet.? How can your company be disrupted?

The idea is a simple one.? Buy companies below their tangible book value when they have good earnings, and good earnings prospects. Over a long enough period of time, the growth in tangible book value will help drive growth in the stock price.

For companies with over $100 million in market capitalization, here are the companies that fit this description:

company	ticker	img_desc	country	exchg_desc	P / TB	P / E	Expected P/E	Mkt cap	LT Debt/ Equity
AerCap Holdings N.V.	AER	0939 – Rental & Leasing	Netherlands	N – New York	0.66	7.6	5.2	1524.4	263.6
Aircastle Limited	AYR	0939 – Rental & Leasing	United States	N – New York	0.64	8.4	8.1	931.2	202.1
American International Group,	AIG	0715 – Insurance (Property & Casualty)	United States	N – New York	0.55	2.9	9.8	56637	73.6
Anworth Mortgage Asset Corpora	ANH	0933 – Real Estate Operations	United States	N – New York	0.94	7.8	7.9	917.8	3.8
Assurant, Inc.	AIZ	0709 – Insurance (Life)	United States	N – New York	0.74	5.7	6	2992.7	19.6
AXA (ADR)	AXAHY	0709 – Insurance (Life)	France	O – Over the counter	0.88	7.6	5.8	29204.3	21.5
Axis Capital Holdings Limited	AXS	0715 – Insurance (Property & Casualty)	Bermuda	N – New York	0.86	8.3	8.8	4325.9	19.3
AXT, Inc.	AXTI	1033 – Semiconductors	United States	M – Nasdaq	0.94	7.5	9.9	129	2.8
Banco Bilbao Vizcaya Argentari	BBVA	0724 – Money Center Banks	Spain	N – New York	0.9	8.7	6	34554.8	250.4
Barclays PLC (ADR)	BCS	0727 – Regional Banks	United Kingdom	N – New York	0.42	6.9	3.6	31291.9	44.7
Callon Petroleum Company	CPE	0609 – Oil & Gas Operations	United States	N – New York	0.86	1.7	5.8	171.6	62.6
Chimera Investment Corporation	CIM	0703 – Consumer Financial Services	United States	N – New York	0.73	4.6	5.3	2434.6	59.2
China Gerui Adv Mtals Grp Ltd	CHOP	0121 – Iron & Steel	China	M – Nasdaq	0.55	2.3	1.7	157.4	0
China Zenix Auto International	ZX	0415 – Auto & Truck Parts	China	N – New York	0.49	1.8	1.4	127.3	0
Citigroup Inc.	C	0724 – Money Center Banks	United States	N – New York	0.53	7.4	5.8	77291.7	165.3
Corning Incorporated	GLW	1024 – Electronic Instruments & Controls	United States	N – New York	0.95	8	8.4	19410	14.7
Crexus Investment Corp	CXS	0933 – Real Estate Operations	United States	N – New York	0.85	6.6	9.4	779.2	0
Deutsche Bank AG (USA)	DB	0727 – Regional Banks	Germany	N – New York	0.65	7.6	4.7	31543.1	318.7
GeoEye Inc.	GEOY	0909 – Business Services	United States	M – Nasdaq	0.8	7.3	8.7	358.5	97.6
Hardinge Inc.	HDNG	0218 – Misc. Capital Goods	United States	M – Nasdaq	0.74	8	7.4	105.1	4.3
Homex Development Corp. (ADR)	HXM	0215 – Construction Services	Mexico	N – New York	0.91	8.6	5.5	846.4	85.4
Ingles Markets, Incorporated	IMKTA	0957 – Retail (Grocery)	United States	M – Nasdaq	0.91	9.9	8.2	400	183.1
Ingram Micro Inc.	IM	1006 – Computer Hardware	United States	N – New York	0.77	9.6	7.6	2591.2	8.7
Jinpan International Limited	JST	1024 – Electronic Instruments & Controls	China	M – Nasdaq	0.85	5.3	4.7	132	0.8
Kelly Services, Inc.	KELYA	0909 – Business Services	United States	M – Nasdaq	0.77	6.4	7.4	462.9	0
KeyCorp	KEY	0727 – Regional Banks	United States	N – New York	0.83	8.4	9.5	7339.2	90.7
KKR Financial Holdings LLC	KFN	0718 – Investment Services	United States	N – New York	0.89	5.1	4.7	1557.4	0
Knightsbridge Tankers Limited	VLCCF	1118 – Water Transportation	Bermuda	M – Nasdaq	0.61	6.9	9.4	215.2	42
KT Corporation (ADR)	KT	0915 – Communications Services	South Korea	N – New York	0.89	9	7	7041.3	72.6
Le Gaga Holdings Ltd ADR	GAGA	0509 – Crops	Hong Kong	M – Nasdaq	0.89	8.1	4.1	200.3	5.3
Lihua International Inc	LIWA	0127 – Misc. Fabricated Products	China	M – Nasdaq	0.7	3.1	2.1	161.3	0
LUKOIL (ADR)	LUKOY	0606 – Oil & Gas – Integrated	Russia	O – Over the counter	0.68	4.2	4	47753.8	10.4
Mechel OAO (ADR)	MTL	0124 – Metal Mining	Russia	N – New York	0.8	4.6	3.5	3322.6	139.6
Metlife Inc	MET	0709 – Insurance (Life)	United States	N – New York	0.69	5.7	5.4	32402.5	45.3
Mizuho Financial Group Inc. (A	MFG	0727 – Regional Banks	Japan	N – New York	0.9	3.5	8.5	40165.5	236.3
Navios Maritime Holdings Inc.	NM	1118 – Water Transportation	Greece	N – New York	0.53	4.6	7.6	350.3	131.3
Newfield Exploration Co.	NFX	0609 – Oil & Gas Operations	United States	N – New York	0.98	5.9	8.8	3943.1	72.2
Olympic Steel, Inc.	ZEUS	0127 – Misc. Fabricated Products	United States	M – Nasdaq	0.86	8.8	6.4	181.8	95.4
Orbotech Ltd.	ORBK	1033 – Semiconductors	Israel	M – Nasdaq	0.78	6.3	9.7	329.7	13.1
Patterson-UTI Energy, Inc.	PTEN	0612 – Oil Well Services & Equipment	United States	M – Nasdaq	0.93	6.6	8.3	2276.5	18.7
Petroleo Brasileiro SA (ADR)	PBR	0606 – Oil & Gas – Integrated	Brazil	N – New York	0.9	6.8	6.3	126006.1	43.5
Phoenix Companies, Inc., The	PNX	0709 – Insurance (Life)	United States	N – New York	0.21	3.6	3.7	203.5	45
Popular, Inc.	BPOP	0727 – Regional Banks	Puerto Rico	M – Nasdaq	0.52	8.9	6.1	1664	47.1
Protective Life Corp.	PL	0709 – Insurance (Life)	United States	N – New York	0.7	7.2	8	2557	53
Reinsurance Group of America I	RGA	0706 – Insurance (Accident & Health)	United States	N – New York	0.68	7.8	7.2	4059.3	34.9
Republic Bancorp, Inc. KY	RBCAA	0727 – Regional Banks	United States	M – Nasdaq	0.94	4.7	8.7	489.6	7.7
REX American Resources Corp	REX	0103 – Chemical Manufacturing	United States	N – New York	0.65	7.8	6.8	163.9	41
Royal Caribbean Cruises Ltd.	RCL	1118 – Water Transportation	United States	N – New York	0.71	9.7	9.5	5542.1	91.9
Societe Generale SA (ADR)	SCGLY	0724 – Money Center Banks	France	O – Over the counter	0.29	5.8	3.8	16945.2	20.7
StanCorp Financial Group, Inc.	SFG	0706 – Insurance (Accident & Health)	United States	N – New York	0.84	2.5	8.7	1676.1	14.8
StealthGas Inc.	GASS	1118 – Water Transportation	Greece	M – Nasdaq	0.38	8.5	5	122.1	98.5
Symetra Financial Corporation	SYA	0709 – Insurance (Life)	United States	N – New York	0.47	7.8	8.5	1494.6	0
Tech Data Corp	TECD	1006 – Computer Hardware	United States	M – Nasdaq	0.96	9.8	8	1918.9	2.9
Ternium S.A. (ADR)	TX	0121 – Iron & Steel	Luxembourg	N – New York	0.81	8.3	5.8	3993.4	26.2
Thompson Creek Metals Company,	TC	0124 – Metal Mining	United States	N – New York	0.33	3.5	5.7	563.9	20.8
Transportadora de Gas del Sur	TGS	0609 – Oil & Gas Operations	Argentina	N – New York	0.43	5.6	7.5	191.7	80.6
TravelCenters of America LLC	TA	0963 – Retail (Specialty Non-Apparel)	United States	A – American	0.51	4	3.7	145	31.9
Triple-S Management Corp.	GTS	0806 – Healthcare Facilities	Puerto Rico	N – New York	0.76	9.4	8.6	510.6	18.2
Unit Corporation	UNT	0612 – Oil Well Services & Equipment	United States	N – New York	0.94	8.7	9	1819.7	15.8
Valero Energy Corporation	VLO	0609 – Oil & Gas Operations	United States	N – New York	0.86	9.1	5.6	13578.5	40.5
Vishay Intertechnology	VSH	1033 – Semiconductors	United States	N – New York	0.97	7.7	7.1	1433.8	23.4
Woori Finance Holdings Co., Lt	WF	0727 – Regional Banks	South Korea	N – New York	0.57	4.5	4.8	8482.1	0
Xinyuan Real Estate Co., Ltd.	XIN	0215 – Construction Services	China	N – New York	0.33	2	2.1	215.1	8.8
Yongye International Inc	YONG	0103 – Chemical Manufacturing	China	M – Nasdaq	0.55	1.9	1.3	163.7	2.8
ZHONGPIN INC.	HOGS	0515 – Food Processing	China	M – Nasdaq	0.89	6.6	5.5	371.9	18.1
Zuoan Fashion Ltd (ADR)	ZA	0403 – Apparel/Accessories	China	N – New York	0.6	2.4	1.8	102.1	0

Full disclosure: long AIZ, PBR, RGA, SFG, VLO

PS — be wary of Chinese companies, I mean it…? Also, use the Ctrl-Minus key to view this in entire.

An Analysis of Three-Month LIBOR 2005-2008

Posted on 6 July 20126 July 2012 by David Merkel

I downloaded the data for LIBOR over the period 2005-2008, and decided to run regressions of the 3-month rates submitted from each bank versus 3-month LIBOR, since I think it is the most commonly used.? Here are the results:

Note the inverse relationship between the willingness to be above the consensus, and the willingness to move with the consensus.

Those that were above the LIBOR rate were in general less willing to adjust to changes in LIBOR whereas those below were more willing to adjust.? This could all be an artifact of being in a declining interest rate environment.

Also note that JP Morgan was below the LIBOR consensus by more than Barclays was above it.? Why is JP Morgan escaping criticism if Barclays is getting it?

Let’s look at the residuals from the regressions over the whole period:

As you can see, we had the great moderation in effect from 2005 through mid-2007. Everything was placid; central banking could not err, even as it erred by providing too much liquidity.? Financial companies could not err either.

There are three periods here: the great moderation, the SIV/correlation crisis in the third quarter of 2007, and the bank solvency crisis in the second half of 2008.? Let’s look at them closer up.

SIV/Correlation crisis, residual bank yields in percent:

Now, in the above graph which covers July 2007 vs 2008, same graph as above, just expanded for better viewing, you can see at the left the orderliness of the past.? Deviations from normal LIBOR behavior are 1-2 basis points; the banks in the middle generally agree about where LIBOR should be on any given day, and those that are in the tails are excluded from the calculation.

But the deviations are small, relatively speaking from what the banks commonly did — +/- 0.05% usually, and almost never higher than +/- 0.10%.? You can note that in 2008 JPM and Barclays get closer together.? JPM is ~5 basis points higher than its normal practice, and Barclays is ~5 lower, but given that on average Barclays was 7 basis points over LIBOR, and JPM 12 bp under LIBOR, that cuts the gap in half in that era.

But now lets take a walk on the wild side:

Banking Solvency crisis, residual bank yields in percent:

In mid-September, as the failures cascade, the submissions for LIBOR lose regularity.? Some go high, like Barclays, HBOS, Credit Suisse, and BTMU.? Others go low, like WestLB, Rabobank, JP Morgan, HSBC, Lloyds and Citi.? Most of these don’t make it into the LIBOR calculation, because they are outliers.? Sizes of the deviations are ~10x the size of what they were during the SIV/Correlation crisis.

By mid-November, semi-normalcy turns, though JP Morgan is lower than their normal practice, and Barclays starts higher, and ends the year lower than their normal practice.

The Correlation Matrix

So, if I were hunting for a conspiracy to fix LIBOR, I would look for clusters of high positive correlations, which are dark green in the correlation matrix above.? Starting with Barclays, I get BTMU, Credit Suisse, HBOS, Norinchuckin, and RBS, maybe Deutsche.? With BTMU, I get Barclays, Credit Suisse, HBOS, Norinchuckin, and RBS, maybe Deutsche.? With HBOS, I get Barclays, BTMU, Credit Suisse, but none of the rest.? By the time I am done, I have an informal group that seems to act together: Barclays, BTMU, Credit Suisse, HBOS, Norinchuckin, and RBS.

Maybe there is another cluster.? Starting with Citi, I have HSBC, JP Morgan, Lloyds, and Rabobank.? Yes, upon further inspection, that’s the second and only other cluster, which means we can ignore for now Bank of America, Deutsche, RBC, UBS, and WestLB.

Here’s my punchline: go back to my table at the top.? The first group, Barclays, BTMU, Credit Suisse, HBOS, Norinchuckin, and RBS are high LIBOR submitters (along with Deutsche, who is close to being a part of the group).? The second group, Citi, HSBC, JP Morgan, Lloyds, and Rabobank are low LIBOR submitters.? (Weaker ties may exist with Bank of America and RBC.)

My initial diagnosis is this: whether formally or informally, you have two groups of banks submitting rates for LIBOR.? One group is trying to pull LIBOR up, the other is trying to pull LIBOR down.? Statistically, if I add up their intercept terms from the first table, they both sum to 0.23%, one positive, the other negative.? Even if LIBOR were a simple average, which it is not, this is a colossal game of tug of war, with two equal teams.

As it is, LIBOR excludes the outliers, and calculates an average off of those that remain.? It’s a difficult measure to manipulate.? There may have been attempts to manipulate LIBOR, and even two groups of banks trying to pull LIBOR their own way, but successful systemic manipulation of LIBOR is unlikely in my opinion.

But if you disagree, here are the two clusters of banks, pursue their collusions:

Coalition to pull LIBOR up

Barclays
BTMU
Credit Suisse
HBOS
Norinchuckin
RBS

Coalition to pull LIBOR down

Citi
HSBC
JP Morgan
Lloyds
Rabobank

Start with Barclays and JP Morgan, they are the outliers, and if there is collusion, they are the likely leaders.

Do Insurance Stocks Do Better than Average Over the Long-Run?

Posted on 27 June 201227 June 2012 by David Merkel

Why should insurance companies be such a good place to invest?? That’s a great question, and I will try to outline an answer.? Before I do, let me draw a few distinctions:

I’m not talking about life companies, they are far more capital encumbered then P&C companies.
I am also not talking about title, mortgage, or finance insurers.? They are too risky, and that was my opinion in the early 2000s.
Health insurers have a different model, much more subject to regulation.
Many insurance companies that don’t survive 10 years as a public company do poorly.? They did not underwrite well.
Small companies tend to fail disproportionately.
We aren’t talking about specialty companies.

What I am talking about are non-microcap companies with stable P&C liability structures and conservative reserving.? Boring, maybe.? Simple, somewhat, but you try setting up a competitor to them.? It takes some doing.? That is the competitive advantage; it is the barrier to entry.? Few companies have diversified liabilities; fewer reserve conservatively.

Thus I highlight P&C companies with ten year track records.? Here are the good ones: ACE, Chubb, Cincinnati Financial, Donegal Group, HCC Insurance, Markel, ProAssurance, RLI, Selective Insurance, Travelers, United Fire Group, W.R. Berkley, Arch Capital, Alterra Capital Holdings, PartnerRe, Everest Re, Renaissance Re, White Mountains, Progressive, State Auto Financial, and Erie Indemnity.

And here are the trailing ones: American Financial Group, Baldwin & Lyons, EMC Insurance, Navigators Group, XL Group, Allegheny Corporation, American National, Allstate, and Horace Mann.

And two really lousy ones: CNA Insurance and Meadowbrook Insurance Group.

On the whole, the outperformers more than absorb the underperformers, though I can’t prove that, for these reasons:

Hasn’t happened much in a while, but P&C insurance companies do occasionally die & disappear.? Think of Reliance Insurance Company.
Sometimes P&C companies make very bad underwriting decisions, lose a dramatic amount of money, and their stock prices fall enough that they get taken over, e.g., PXRe would be an example.
I may be guilty of selection and survivor bias by sticking with diversified bigger firms that are at least 10 years old.? I know of a lot of smaller firms that flame out because they take too much underwriting risk due to hubris and/or inexperience.

To do a complete study, we would have to use the CRSP database, which has all of the data for stocks not currently living.? We would see the losses from insolvencies, and the losses/gains fhereof.? It would take place at the halfway point for US efforts, which would be 4 seconds ahead of the Greeks as they hurried to compete/complete at constant speeds.

That’s what would happen.? Now before I go, I want to leave charts behind for the stocks mentioned:

Above

Below

Well Below

So though I know many value investors think a lot of P&C insurers, my answer on whether they are a generally good industry to invest in is “possibly,” but not “certainly.”? There are advantages for sophisticated investors that can understand complex accounting and its limitations, as well as those that can sense whether a management team is conservative or not.? That may be part of the reason for how I limited the selection of companies above; I was trying to mimic what sort of companies tended to last a long time; they tend to be conservative.

That’s all for now; criticism is welcome.

Full disclosure: Long HCC , TRV

PS — I will be gone the next three days, and posting will be irregular, as it has been recently.

Modified Glass-Steagall

Posted on 16 June 201217 June 2012 by David Merkel

If you’ve read me for more than two months, you probably know that I am an actuary, though not a practicing actuary at present.? I grew up in the life insurance industry.? It’s an unusual place for an investor to start, but there are some advantages:

You learn some of the most complex accounting rules in business.
You learn the value of having a strong balance sheet, because when it slips, it is hard to get back.
You learn the value of simplicity, because many companies that wander from that die.
You get to know a lot of people with different bits of specialized knowledge, which you the actuary have to tie together.? And, respecting the older people in dead-end jobs which they do well goes a long way toward getting significant cooperation.
If you are a corporate actuary, as I sometimes was, potentially you become a good risk manager.
If are an investment actuary, you learn that risk control is far more difficult than it seems, and so you learn not to take obscure risks, and test a variety of modeling assumptions, because models can go wrong.
You build in margins for error if you are a pricing actuary, as I often was, and review actual results when setting assumptions.
You get to see regulation up close and personal, because you have to interact with 51 different regulators if you do valuation, cash flow testing, pricing, etc., with your home state regulators leading the way.

There’s more, but my topic this evening is financial regulation generally.? I’ve been thinking about it, and I have had a moderate shift in my views: I think it would be wise to reinstitute a modified version of Glass-Steagall, but modeled after the way that insurance regulation is done today.? For solvency regulation, insurers are much better regulated than banks.? The banking industry should imitate the insurance industry in a number of ways.

Here’s the main idea: Allow financial holding companies to own all manner of financial subsidiaries, but disallow:

Stacking of subsidiaries.? No A owns B, B owns C.? This allows capital to be stretched thin.
Cross-ownership and cross-lending: subsidiaries may not interlace their capital.
There may be no reinsurance or derivative agreements across subsidiaries.

This would bar complex ownership charts.? There would be a big box at the top, with lines to little boxes below, but only one level of depth, and no lines between subsidiaries.

Also:

Each subsidiary must be subject to its own regulator.? There must not be an overall regulator for “financial supermarkets.”? Keep it simple and focused.? Remember, the Fed has never been a good regulator.
Since financial holding companies die if they don’t get dividends, make the payment of dividends from any subsidiary to the parent company subject to the discretion of the regulators.? Regulators should not care about the holding companies, but only about the solvency of subsidiaries.
If a company is presently in two businesses with different regulators, the company must divide the business into two subsidiaries which each regulator can separately regulate.
Subsidiaries do not get to choose their regulators.? If there are potentially duplicate regulators, merge them and create one regulator if that makes sense.? Otherwise, make rules so that there is no ambiguity on who regulates what.

The view of the government toward financial holding companies should be this: we don’t care if you fail.? We do care if your subsidiaries fail, so if the solvency of any of them is getting marginal, dividends to the holding company will be cut off.

Now, I would prefer the rest of the financial industry mimic the insurance industry, in that State regulation is better than Federal regulation.? If you want to end too big to fail, split up banks into state subsidiaries.? Each state regulator would separately determine solvency issues, and would limit dividends back to the holding company.

Remember, we don’t care if holding companies go broke.? If a holding company goes broke, and all of the subsidiaries are solvent, the subsidiaries will easily be sold to other holding companies.? The creditors of the bankrupt financial holding company will divide the spoils after a year or so.? Cost to the taxpayers: zero.

And maybe, mimic the guarantee funds of the insurance industry, and let the financial subsidiaries self-fund the losses of their fallen competitors.? Cost to the taxpayers: zero.

Under this sort of arrangement, you can have “financial supermarkets,” but they would be very different, because the solvency of each part would be separately regulated.? You don’t want macro-regulators, they are far easier to fool; specialization in financial regulation is a plus; don’t give any credit to those who use a diversification argument.? We are focusing on risks, not risk.? Failure does not happen from risk in abstract, but from particular risks that were underrated.

Finally you need risk managers inside all regulated financial institutions that are either FSAs [Fellows in the Society of Actuaries] or CFAs [Chartered Financial Analysts].? I am both, though my FSA status is inactive, because I don’t pay the dues.? Why is this valuable?

You need organizations with ethics codes to teach and monitor the behavior of those within.? There are failures amid FSAs and CFAs, but society and legal punishment tends to decrease the occurrence.

If we did this, financial companies would be much more stable, and we would reduce the need for the FDIC.? There would be personal ethics standards among risk managers inside financial companies, and less reason for regulators to compromise from political pressure.

This is my modified version of Glass-Steagall, which gives financial industries most of what they want, but offers solvency protections far beyond what we have today.? Is this a good compromise, or what?

The Best of the Aleph Blog, Part 16

Posted on 9 June 201210 June 2012 by David Merkel

I try to do “The Best of the? Aleph Blog” pieces between 1-2 years after original publication.? Why?? It gives time for reflection, time for series to complete, time for me to be proven wrong/right, etc.? I would have preferred that readers do this job for me, so that I could be neutral, but I realized that I am the one that has the most concentrated interest in doing this, so that is why I do this.? The main benefit for me in doing this is when I submit free content to “Wall Street All Stars,” I know what I think is good stuff, and I utter a few words to explain how my wisdom has proven right, or fell on its face.

This episode covers the era of November 2010 through January 2011.

On Investment Modeling, Part 1

On Investment Modeling, Part 2

On Investment Modeling, Part 3

On Investment Modeling, Part 4

Investment modeling is tough, you omit some bits of reality, and deny other bits of reality.? In this four-part series, I try to explain how difficult good modeling is, and how to make it better.

Flavors of Insurance, Part I

Flavors of Insurance, Part II (Life)

Flavors of Insurance, Part III (Personal Lines)

Flavors of Insurance, Part IV (Commercial)

Flavors of Insurance, Part V (Reinsurance)

Flavors of Insurance, Part VI (Brokers)

Flavors of Insurance, Part VII (Health)

Flavors of Insurance, Part VIII (Financial)

Flavors of Insurance, Part IX (Title)

Flavors of Insurance, Part X (Conglomerates)

Flavors of Insurance, Part XI (Banks and the Insurance Business)

Flavors of Insurance, Part XII (Summary ? The End)

This was a unique series where I tried to bring my expertise to bear on a complex industry.? I wrote the original piece in 2003, and it never got published.? I used OCR to scan it and one of my brighter children to edit it, so you have my original text, plus my commentary in 2010, pointing out where I was right and wrong.

Time to Grow Up

I am an advocate for a brainy libertarianism that reflects the intelligence embedded in the Bible, coming form the Creator Himself.? I do not back what the t-party has to say, whose positions reflect personal selfishness.

Nonidentical Twins: Solvency and Liquidity (III)

Now, when a government is overleveraged, but interest rates are low, the situation is potentially unstable.? A rise in rates could tip the scales.? Market actors would conclude that they can?t survive at rates high than a certain threshold, so sell the debt now, in case rates would get so high.? That action forces rates higher, leading to a self-reinforcing panic.

Sometimes this happens in advance of a debt refinancing, leading some politicians and bureaucrats to say the forever bogus phrase, ?This is not a solvency crisis, this is a liquidity crisis.?? Sorry, if you play near the cliff, don?t complain if you happen to fall off.

Liquidity crises do not happen to governments with low debt levels.? Liquidity crises are solvency crises during the panic phase, before they are revealed to be solvency crises alone.

The Value of Fair Accounting

Why fair value accounting has value to investors.? This should be a “duh” moment, because everyone should understand this.

2010 Financial Report of the US Government

My annual post on the topic, describing the deterioration of the situation.

A Portrait of Maryland?s Public Companies

I explain why Maryland, my adopted homestate, has the mix of publicly traded companies that it does.

Why We Don?t Need the Fed

We would do better with a commodity standard, and even a gold standard.? The Fed hoodwinks us with its pretended efforts to maintain value.? I genuinely mean that we could do better without the Fed.? Put James Grant and Steven Hanke in charge of our monetary policy, and we will do well

On Human Fertility

A controversial topic, but fertility rates are falling more rapidly than the demographers expect. Why? It is politically correct to say that the planet is running out of resources, a bogus idea, but often stated.? As it is, because of changes in the way that women and men view their roles, fewer children will be born.

And as for a guy who has sired three children, and adopted five (far more difficult), I would simply say that we are better off with more children in homes that care about the results of how children turn out.

Book Review: The Kelly Capital Growth Investment Criterion

Posted on 4 June 2012 by David Merkel

I have not read this book.? I read almost all books that I review, so I disclose when I have merely scanned a book such as this.

Why scan?? First, I didn’t ask for the book.? Second, it is 800+ pages long.? Third, it is a series of academic articles defending and attacking the Kelly Criterion — it will have a very specific audience that cares about the academic side of the debate.? The popular side is covered by the book, “Fortune’s Formula,” which I have favorably reviewed here.

The simple way to phrase the argument for the Kelly Criterion is this: you have an advantage versus the markets for whatever reason.? You have an edge on average, and the odds are tilted in your favor.? You size your bets as a ratio of edge over odds.? If your edge is durable, and the odds are calculated right, the optimal decision leads to the best compound growth of capital on average.

Samuelson sits in his ivory tower, where only efficient markets exist.? Those of us that are practitioners know that the markets are hard, but not efficient.

To me, the Kelly Criterion is intuitive, whereas the ideas of Modern Portfolio Theory are a stretch.? They don’t fit the way the market operates.

Who would benefit from this book:?? If you are really interested in the Kelly Criterion debate , and are willing to pay up to get a good summary of the debate, it is available here.? Note: you have to like math.? If you want to, you can buy the book here: The Kelly Capital Growth Investment Criterion: Theory and Practice (World Scientific Handbook in Financial Economic) (World Scientific Handbook in Financial Economic Series).

Full disclosure: This book came out of the blue; did not ask for it.

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

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

Book Review: The Alpha Masters

Posted on 21 May 201221 May 2012 by David Merkel

This book has just been released.? I got an early copy.? The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?? This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.?? Have you been through anything similar to that?? If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.? Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.? They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.? What are they like?

Among their many attributes, they are:

Driven/competitive — though I have known my share of failures in investing that have that attribute.
Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
Patient — if opportunities are not promising, don’t do much.? It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.? Study what could go wrong, and see if there is a way to take advantage of the situation.
Team-builders — They develop talented teams/cultures and motivate them to excellence.
Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

Ray Dalio — Bridgewater
Pierre LaGrange & Tim Wong — MAN Group / AHL
John Paulson — Paulson & Co.
Marc Lasry and Sonia Gardner — Avenue Capital Group
David Tepper — Appaloosa Management
William A. Ackman — Pershing Square Capital Management
Daniel Loeb — Third Point
James Chanos — Kynikos Associates LP
Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.? That’s how she gained the contacts in order to write the book.? Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”? That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).? The former is an accomplished investor, but is not an expert on hedge funds.? Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.? If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

Simple Stock Valuation

Posted on 12 May 201213 May 2012 by David Merkel

I appreciate Eddy Elfenbein.? He comes up with ideas that make me say, “Huh. Interesting.? Let’s test that.”? His recent article, World?s Simplest Stock Valuation Measure, put forth the idea that:

Growth Rate/2 + 8 = PE Ratio

Cool, reminds me of my 1993 formula for value investing:

Price per share < Tangible Book per share + 5 * EPS

Eddy’s idea is that you can buy a company that isn’t growing or shrinking earnings at a PE of 8, or alternatively, a E/P (earnings yield) of 12.5%.? In a weird environment like this, it means an earnings yield that is more than 9% over the long bond is a good purchase.? I like that idea, it offers a good reward for taking risk.

But as the growth rate rises, you can expand the PE multiple by half of the anticipated growth rate.? So, a company anticipated to grow at a 10% rate would warrant a PE multiple of 13, a 20% rate 18, etc.? I like his formula, because it is conservative.? It seeks growth at a reasonable price.? It will not overpay for high growth rates.

But now let’s test this statistically to see what validity it presently has.? I ran a regression on Current year expected PEs versus expected 3-5 year growth rates.? I excluded all companies with fewer than two analysts putting forth growth estimates.? Here were the results:

SUMMARY ?OUTPUT

Regression Statistics
Multiple R	0.15
R Square	0.0224
Adjusted R Square	0.0218
Standard Error	39.70
Observations	1,589

ANOVA
?	Df	SS	MS	F	Significance F
Regression	1	57,333	57,332.91	36.38	0.000000002
Residual	1,587	2,500,838	1,575.83
Total	1,588	2,558,170

?		Standard Error	t Stat	P-value	Lower 95%	Upper 95%	Eddy	T-test
Intercept	11.87	1.88	6.33	0.0000000003	8.19	15.55	8.00	2.06
eps_eg5	0.69	0.11	6.03	0.0000000020	0.47	0.91	0.50	1.66

Significant results statistically, but what a low R-squared.? Just shows us all how complex the market really is.? Look at this graph to see it as it is:

There really doesn?t seem to be much of a relationship.? But Eddy?s formula is conservative versus the estimates.? His formula invests in no-growth? companies ?at an earnings yield of 12.5%, the market does so at an earnings yield of 8.4%.? His formula increases the PE multiple at a 50% rate as earnings increases, but the market does so at a 69% rate.

Good for Eddy, and any that follow him.? His method builds in a margin of safety, which is a key to all good investing.

Before I close I would like to offer the 20 most mispriced companies, both positively and negatively.? Just be aware that the markets are complex, and this valuation method is simple, and most likely wrong? but it can provide a jumping-off point for due diligence.

Potential Buys

company	ticker	eps_eg5	PE
Seagate Technology PLC	STX	37.94	4.3
US Airways Group, Inc.	LCC	38.5	4.9
China Xiniya Fashion Ltd (ADR)	XNY	12	2.6
Exide Technologies	XIDE	15	3.4
HollyFrontier Corp	HFC	31.19	5.3
First Solar, Inc.	FSLR	20	4.2
Xerium Technologies, Inc.	XRM	20	4.3
YPF SA? (ADR)	YPF	13.69	3.9
Newmont Mining Corporation	NEM	54.68	9.6
Western Digital Corp.	WDC	20.84	5.1
Gulfport Energy Corporation	GPOR	48	9.1
Delta Air Lines, Inc.	DAL	17.25	4.9
KKR & Co. L.P.	KKR	22.43	5.7
Dana Holding Corporation	DAN	31.56	7.1
Perfect World Co., Ltd. (ADR)	PWRD	9.78	4
Marathon Petroleum Corp	MPC	25.16	6.3
Stoneridge, Inc.	SRI	35.2	7.8
GT Advanced Technologies Inc	GTAT	11	4.2
Telecom Argentina S.A. (ADR)	TEO	11.3	4.3
SUPERVALU INC.	SVU	11.1	4.3

Potential Sells

Company	Ticker	eps_eg5	PE
Rubicon Technology, Inc.	RBCN	15	125.6
NetSuite Inc.	N	34.79	204.1
Amazon.com, Inc.	AMZN	30.02	190.6
Clear Channel Outdoor Holdings	CCO	24.04	175.5
Servicesource International In	SREV	27	192.1
Wright Medical Group, Inc.	WMGI	9.43	117.1
Lamar Advertising Co	LAMR	4	96.8
Cogent Communications Group, I	CCOI	17	170.5
Shutterfly, Inc.	SFLY	18.75	182.6
Lattice Semiconductor	LSCC	11.5	165.3
Conceptus, Inc.	CPTS	17.5	201.6
Cepheid	CPHD	20	225
Black Diamond Inc	BDE	2.33	146.9
Quidel Corporation	QDEL	17.5	421.5
WebMD Health Corp.	WBMD	15	485.1
SL Green Realty Corp	SLG	-3.09	230.2
Diana Shipping Inc.	DSX	-16.62	11.4
Netflix, Inc.	NFLX	16.96	803.8
Citi Trends, Inc.	CTRN	10.67	942.7
Weatherford International Ltd	WFT	-30.72	11.4

That’s all for now.

The Best of the Aleph Blog, Part 15

Posted on 10 May 201220 June 2017 by David Merkel

This stretches from August 2010 to October 2010:

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.? I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.? Also, how to make money in the bond market when you reach the risk limits. 😉

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.? Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.?? Also, the end of my time as a bond manager, and the parties that came as a result.?? Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.? Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Portfolio Rule Eight

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

The Portfolio Rules Work Together

How the portfolio rules work together to create a “margin of safety.”

The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

The Rules, Part XIX

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

?The Rules, Part XX

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

?Managing Illiquid Assets

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don?t trade often.

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

-==-=-=-=-=–=-=

That’s all for now.? Never thought I would do so many long series when I started blogging.

We Eat Dollar Weighted Returns ? IV

Posted on 5 May 20125 May 2012 by David Merkel

I think one of the largest areas for practical investigation in finance is reviewing dollar-weighted versus time weighted returns, especially for vehicles that are traded heavily.? I am going to try to analyze one major ETF per month to see what the level of slippage is due to trading.

But if my hypothesis is wrong, I’ll post on it anyway.? The last post I did on this was on SPY, the S&P 500 Spider.? The slippage was 7%+/year.

Now I have done the calculation for the QQQ, the PowerShares QQQ Trust, which mimics the Nasdaq 100.? The Nasdaq 100 is more volatile than the S&P 500, so I expected the gap to be worse, but it wasn’t: from the inception in March 1999 to the end of the fiscal year in September of 2011, the dollar weighted return was 0.38%/year versus a time-weighted return that a buy-and-hold investor would get of 0.77%/year.? 0.4% of difference isn’t much to talk about.? It still indicates a little bad trading.

That said, the net amount of unit creation and liquidation tended to be small.? Maybe that is the difference.? I have to think more about this, but my advice to anyone using exchange traded products remains the same — read your prospectus carefully, and understand the weaknesses of the vehicle.? If creation units don’t have to be something exact, ask what that might imply for your returns.

Anyway, here were the figures from my dollar-weighted return calculation:

I used annual data, and assumed midperiod dates for the cashflows.

The next ETF I plan to analyze is XLF, the Financial Sector Spider.? I suspect that will look bad, but who knows?
Full disclosure: short SPY in some hedged accounts.