Quantitative Methods – Page 31

Alternative Investments, Illiquidity, and Endowment Management

Posted on 17 September 200920 June 2017 by David Merkel

I am a risk manager first, and a profit maker second.? I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?? Knowledge travels.

So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.? A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.? A skeptic, because many endowments were taking on too much illiquidity.

Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.? I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.? In insurance liabilities, nothing is longer than a portfolio of structured settlements.

Buy long-dated debt?? Illiquid debt?? If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.? WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.

Pushing it Past the Illiquidity Limit

I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:

There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.

The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.? There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.

Here is my example: Harvard.? At the end of fiscal 2008, those that managed Harvard Management Company were heroes.? The largest university endowment, stupendous returns, etc.? Who could ask for more?

The risk manager could ask for more.? With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.? Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.? Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.?? If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.? Even after their great investment successes, Harvard did not have enough liquidity.

Then Came Fiscal 2009 — We’re out of liquid assets!

My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.? Thus they moved to sell illiquid investments, and take a haircut on them.? They reduced their forward commitments by $3 billion.? They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.

This is clear evidence of a panic, and an indication that the portfolio was too illiquid.? What else might indicate that?? Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.

The idea of an endowment is that you can run your institution without fear of the future.? But that also implies that those endowed will not make abnormal demands on the endowment.? That applies to the amount disbursed and the liquidity of the underlying investments.

Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.? Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.? (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)? Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.? Even if cash doesn’t return anything, it is still valuable.? You can’t pay professors with shares of a venture capital partnership.

The Horizon Isn’t Infinite

This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.? The horizon for an endowment is infinite only under conditions of permanent prosperity.? Well, anyone can invest forever under conditions of permanent prosperity.? The forever-growing investments can be borrowed against.

The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.? There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.? That will give the institution more than adequate time to adjust to the new economic conditions.

Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.? But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).? That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.

Alternative Investments are not Alternative Anymore

There is another reason, though, to be cautious about illiquid investments.? With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!? Trouble is, knowledge travels, and success breeds imitators.? The imitators typically bring deals that will have lower returns or higher risks than the original deals.? But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.? Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.

Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.? That? gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.? In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.

Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.? The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.? Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.

Summary

Liquidity is valuable, and should not be surrendered without proper compensation.
Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
After failure, they tend to be more correlated with other risk assets.
Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.

Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.? Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.? Better safe than sorry.

Articles on the Harvard Endowment

6:46 PM Update — So I write this, and Morningstar comes out with a good piece like this one.? So it goes.

Ten Notes on Risk in the Markets

Posted on 12 September 200913 September 2009 by David Merkel

1) Credit cycles tend to persist for more than just one year.? That is one reason why I am skeptical of the run in the high yield corporate bond market at present.? Sharp short moves are very unusual.? To use 2001-2003 as an example, we got faked out twice before the final rally commenced.? So, as I look at record high defaults after a significant rally, I am left uneasy.? Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion.? S&P is still bearish on default rates.? I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.

2) Of course, there are bank loans in the same predicament.? Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs.? Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.

3) Where should your asset allocation be?? Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000.? Good timing, that.

David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields.? For that bet to work out, deflation must persist.

One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks.? Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.

4) Maybe demographics are another way to consider the market.? When there are more savers/investors vs. spenders, equity markets do better.? I’ve seen this analysis done in other forms.? So we buy Japan?? I’m not ready for that yet.

5) Illiquid assets require a premium return.? After the infallibility of the Harvard/Yale model, that rule is on display.? As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets.? Harvard and Yale may indeed have gotten a premium return versus equities.? It’s hard to say, the track record is so short.? One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need.? As such, investors in alternative investments are looking for more liquidity and transparency.

6)? There are limits to arbitrage.? As an example, consider long swap rates.? 30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.

7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks.? When managements are confident, we see that; managements are not yet confident.

8 ) I would be wary of buying into a distressed debt fund.? Yields have come down considerable on distressed debt, and I think there will bew better opportunities later.

9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies.? I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.

10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.

Book Review: Finding Alpha

Posted on 3 September 2009 by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Book Review: The Flaw of Averages

Posted on 27 August 2009 by David Merkel

“Just give me the number, willya?”? Ugh.? I’ve had the question asked many times in my life working in or alongside financial reporting in a company.? They need a number for the budget, even though that number will certainly be wrong, leading to numerous explanations for why we are mistracking the budget.

The truth is though there will be one result for the question you ask prospectively, hypothetical answers will often systematically mis-estimate the result when average inputs are fed into models.

As I have experienced in the insurance industry many times, good companies accept feedback from claim experience? into new product pricing, and consider the potential downside risks.? Bad companies rely on industry tables (averages), and assume that downside deviations are just random.

Would we manage companies better if we shared data on how uncertain our estimates are?? Certainly, but the whole company would have to be geared toward understanding how to deal with risk and uncertainty.

Often there is option-like behavior in companies, where if sales are low, expenses will be cut back to a baseline level, but if they are high, expenses will run.? Average expense numbers rarely express the likely result.

Most people/companies assume that things will be stable.? If we look at projections of investment results, stability is the norm.? But our world is unstable.? There are booms and busts; there are wars.? Plans lose their validity when the real world appears.

“The Flaw of Averages” is a popular book on statistics.? It points out many ways in which statistics are abused.? This book will make you a skeptical and reasoned consumer of statistics.

Quibble:? My main difficultly with the book, is that much as the author tries to simplify the concept of complex simulations, is that in the ninth part of the book, he seems to overly encourage use of his own software.

Aside from that, the average reader will learn many ways that statistics such as averages can deceive.? As Benjamin Disraeli, once said, “There are three kinds of lies: lies, damned lies, and statistics.”? This book will help you avoid the last sort of lie.? I recommend this book.

If you want to buy it, you can buy it here: The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

Full disclosure: All purchases from Amazon entering through my site give me a small commission.? Your price at Amazon does not change as a result of the commission.

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

Posted on 21 August 200920 June 2017 by David Merkel

This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.? The two world are stable value funds and commodity ETFs.

Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.? Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.? Unlike government promises, they are uniquely suitable for being money.? (Sorry, had to say that.)

Other commodities require futures markets or off-exchange markets where swaps get traded.? The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.? I’ve written about that before, along with criticisms of exchange-traded notes.

One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.? “Buy the front month futures contract, and roll to the second month contract before the front month expires.”? Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.

So, what do the other investors do?? They take the opposite side of the trade early, in order to make it more expensive to do the roll.? Buy the second month contract, and short the first.? As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.? What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.

Compounding Money Slowly

If you want to keep your money safe, and earn a little bit, what should you do?? Invest in a money market fund.? “Wait a minute,” some intrepid investor would say, “I can do better than that.? I don’t need all of my money for immediate liquidity.? I can ladder my funds out over a longer period.? I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.? I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”

Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.? Commonly, it averages around 2.0 years.

The funds could invest everything short and give up yield.? That would give them certainty, but lose yield.? That is what the commodity funds are doing.

What could go wrong?? There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.? So far that has not happened with stable value funds.

The Fusion Solution

Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.? In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.? Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.? Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.

Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.

This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.? Please pass this on to those who might benefit from it.

A Closing Aside:

Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.? I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.

Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.? I will help you.

Return of the “Carry Trade”

Posted on 20 August 2009 by David Merkel

The idea of a carry trade is simple.? Borrow inexpensively, and invest at a higher yield.? Make money.

Too easy you say?? Right.? Usually something has to be compromised for a carry trade to work, usually betting on lower rated credits performing, or currencies not moving against those borrowing in a low interest rate currency, and investing in a high interest rate currency.? Or, borrow short and lend long when the yield curve is steep, hoping the situation will correct with the long yield coming down, rather than a 1994 scenario, where short rates outrace long rates higher.

Carry trades blow up during times of high volatility, which typically have high yield bonds or countries seeming to be more risky than usual. Carry trades return when times are quiet, allowing placidity to clip yield.? As the WSJ has commented, that time is now, and the carry trade has returned.

I’m going to use the Japanese Yen as my example here.? Because of the chronically low interest rates there, it is a favorite currency for borrowing, and using the money to invest in higher yielding currencies.

That’s the yen over the last five years.? Wish I could have gotten option implied volatility over the same period, but I got nearly the last two years here, by using the CurrencyShares Yen ETF:

You can see how option implied volatility peaked in late October of 2008.? At that time, with the strength of the yen, which would not crest until mid-December, there was a rush to buy protection against the rising yen, because those with carry trades on were losing money, and wanted to get out.? Momentum carried the yen for another six weeks.

After significant fury, the implied volatility settled out at a baseline level, and the carry trade returns because conditions are more placid.? Implied volatility and the currency have stabilized for now.

As another example. consider this:

The Powershares DB G10 Currency Harvest Fund [DBV] borrows in the three lowest yielding currencies of the ten countries that it tracks, and invests in the three highest yielding.? This is the perpetual carry trade fund.

Note the plunge into October/November 2008.? High yield currencies were getting killed, and low yield currencies were rallying.? Since then, the performance of DBV has improved.? Why?? The currencies are more placid, so clipping excess yield makes sense to some in the short-run.

And so it will be until the next big implied volatility explosion occurs.? Carry trades don’t offer significant profits across a full cycle, but can profit those who time it right, few as those people are, and matched by those who lose.

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PS — Sorry for not writing about commercial mortgages, as I said I would.? I will get to it soon, but I have been hindered by personal issues.

Twenty Notes on Current Risks in the Markets

Posted on 14 August 2009 by David Merkel

1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)

2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.

4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.

6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)? So things are looking better with junk bond defaults.? Perhaps it was an overestimate, or that it would not all come in 2009.? We will see.

13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.

16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.

17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)? As a nation, I like Japan, and would like to visit it someday.? What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)? Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.? There is more pain to come.? The time to de-risk is now.

Earnings, Analyst Estimates, and Estimating Future Prospects

Posted on 8 August 20099 August 2009 by David Merkel

This has been an interesting earnings season.? Many companies have been beating earnings estimates once certain one-time items are excluded.? This has led to criticism by market commentators alleging that earnings estimates and/or adjusted earnings are not a reliable guide for individual stocks or the market as a whole.? There’s some truth there, but let me try to give a more nuanced view.

What are we really trying to estimate?

Earnings estimates do not primarily exist for the purpose of estimating the next few quarters’ or years’ earnings.? They exist for estimating the future path of free cash flows.? Wait, what is free cash flow?? Free cash flow is the amount of money that you can take away from a business at the end of an accounting period and leave the company as well off as it was at the beginning of the accounting period.? How does that compare to earnings?? Typically, non-cash charges like depreciation and amortization get added back to earnings, and maintenance capital expenditures get deducted — what remains is free cash flow, which can be used for dividends, buybacks, and investments to build the business.? Free cash flow is similar to what I will call “run rate” earnings, though there are some differences.

In that sense, analysts are trying to estimate “run rate” earnings when they adjust for “one time” events.? Absent these abnormal occurrences which won’t happen next quarter, what would the earnings have been?? Surprises above and below the consensus estimates of the analysts provide information to investors.? Positive surprises indicate that the future run rate for earnings might be higher, and vice-versa for negative surprises.

I say “might be,” rather than “will be,” because of randomness in profitability, or, an inability to truly figure out all of the abnormalities and timing differences in a given quarter.? Typically, several positive earnings surprises must take place before estimates of the run rate begin to rise.? One is normal randomness, two is happenstance, three is a pattern, four is a change in trend.

Guiding up, guiding down

Of course, corporate management can make life easier by giving earnings guidance to analysts, and then guiding the estimates up or down as they see best.? They can also break out their estimates of operating or adjusted earnings in order that analysts can decide for themselves which adjustments are “one time,” and which aren’t.? (In my opinion, Allstate does a particularly good job with this, as does Assurant.)

But changing guidance is powerful, particularly for companies with a reputation for UPOD (underpromise, overdeliver), as opposed to companies with a reputation for OPUD (overpromise, underdeliver).? When analyzing guidance changes, one must adjust for prior earnings surprises to figure out whether th raise in guidance reflects only past successes, or forecasts greater successes in the future.

That’s a lot of “one time” events!? Why do so many of them raise operating earnings?? Shouldn’t the difference net to zero over a long enough timespan?

Alas, once we start adjusting earnings to create operating earnings, we enter a new world with a new accounting basis that superficially resembles “run rate earnings” but with a fault.? Almost every quarter has its parade of “one time” events.? On average, the adjustments raise operating earnings over ordinary GAAP earnings.? Managements are more incented to find the positive adjustments to earnings in the short run.? Obvious negative adjustments get accounted for, but non-obvious ones don’t get searched for.

But clever investors eventually adjust for this.? Here’s a way to do it.? Analyze a long period of time, say five years, or the CEO tenure, whichever is shorter.? Look at the growth in book value, and add back dividends.? Compare that to cumulative diluted earnings over the same time period.? If cumulative diluted earnings are higher, then earnings are inflated.? Here’s another way: if you have a long enough data series, add up operating and diluted earnings over a long period of time, say five years, or the CEO tenure, whichever is shorter.? If operating earnings are significantly larger, there is a company that is using operating earnings to make itself look more profitable than it actually is.

If nothing else, over a long enough period of time, this is a means of measuring the honesty of management teams where it comes to financial reporting.? In my book, honest/conservative management teams deserve higher multiples than less scrupulous management teams.? These measures document the games that management teams play in order to make their results look better than they should appear.

How are we doing versus the expectations of the market?

The investment game is one where profitability performance versus expectations determines price performance.? Prices don’t ordinarily react to backward-looking data, unless there is a big one-time charge that adds a lot to book value, or takes a lot away, perhaps impairing the future prospects of the firm.? Prices do react to the signals given through earnings relative to expectations, as it leads investors to update their views of potential future run rate earnings, or, free cash flow.

Can we make a lot of money off of this effect?

Not so much any more.? There are many investors following earnings momentum, earnings surprises, analyst estimate revisions, and price momentum, that the average investor can’t make a lot of money off of this effect.? But ordinarily it does help an investor understand what is going on when stock prices move after earnings are released.? Expectations of the future change, and that drives current stock prices.

Full disclosure: long ALL AIZ

Seven Notes on the Current Market Mess

Posted on 27 July 2009 by David Merkel

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

Most bloggers are not anonymous, like me.
Many of us are experts in our? specialty areas.
Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

Industry Ranks

Posted on 18 July 2009 by David Merkel

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

Now, as a bonus to Aleph Blog readers, I’ll share with you my second industry rotation model, which I put out weekly to clients.? This model looks at the S&P 1500 Supercomposite, and using price momentum, among other factors, encourages the purchase of equities that have done well over the past? year.? Comparing it to the first model, this report always works in the red zone, because price momentum tends to persist in the short run.? This is a short term model.

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I’m not saying to change if things are working well.? I’m saying don’t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

Anyway, consider this, and if you have more good ideas on industries, share them with the group.? I can always learn more.