Stocks – Page 129 – The Aleph Blog

Failing Well

Posted on 1 May 200822 June 2017 by David Merkel

Just a quick note on how my equity investing is doing — in April I was slightly ahead of the S&P 500, and year-to-date, things are quite good. This is not to say that I haven’t had my share of failures… Deerfield Capital, YRC Worldwide, Jones Apparel, National Atlantic, and Vishay Intertechnology have hurt. But in a portfolio of 35 stocks, even large percentage whacks get evened out if the stock picking on the remainder has been good enough. And, for me it has, though the successes are not as notable as the failures.

As an investor, I am a singles hitter, but my average is high, and strikeouts low. I have my failures, but the eight rules, which are my risk controllers and return generators, protect me. At least it seems that way for the last 7.7 years, but I know enough that even if the principles are right, they are no guarantee for the next day, year, or decade. “The markets always find a new way to make a fool out of you,” and so I encourage caution in investing. Risk control wins the game in the long run, not bold moves.

So, I keep plugging on, adapting to what I think the market will reward in the future, and ignoring the past for the most part.

Full disclosure: long VSH YRCW NAHC JNY

Book Review: The Fundamental Index

Posted on 1 May 200820 May 2008 by David Merkel

The books keep rolling in; I keep reviewing. Given that I am a generalist, perhaps this is a good task for me. Before I start for the evening, though, because I know the material relatively well, I skimmed the book, and read the parts that I thought were the most critical.

The Religious War Over Indexing

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

The market is efficient!
Keep expenses low!
Don’t trade fund positions!
Fundholders buy and hold!
Tax efficiency!
Weight by market cap or float!

For fundamental indexers:

The market is inefficient (in specific gameable ways).
Keep expenses relatively low.
Adjust internal fund positions as valuations change!
Fundholders buy and hold!
Relative tax efficiency!
Weight by fundamental value!

Some of the arguments in Journals like the Financial Analysts Jounrnal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I’m going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: “How can I get the average return out of a class of publicly buyable assets?” The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: “What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let’s set up a portfolio that weights the positions by the estimated future values.” Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value — dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That’s worth the fuss. Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin’s Q — it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can’t do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

Asset Allocation — best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn’t work.. but everyone doesn’t do it. Ask Jeremy Grantham…)
The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors… in general, the more volatile, the more fund investors lose from bad market timing.)
A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal…)
And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That’s not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint… but I could be wrong.)

Who should buy this book? Academics interested in the debate, and buyers of indexed equity products should buy the book. It is well-written, and ably sets forth the case for fundamental indexing.

Full disclosure: If you buy anything from Amazon after entering Amazon through any link on my leftbar, I get a small commission. It is my version of the tip jar, and it does not increase your costs at all.

Financial Literacy for Children

Posted on 30 April 2008 by David Merkel

As we were driving down the highway Monday evening, back from our oldest daughter’s symphony concert at U-MD, my wife and I began talking about teaching children about money.? We homeschool, so we have to consider a lot in training our children for the real world.

Some of my children have an interest in the market, some don’t. Personalities differ, but you want to give them some core knowledge that everyone can use. There have been people in our home school get-togethers who when they find out I am an investor, they ask “Do you know of any good books on the stock market for kids?” Lamely, I suggest the out-of-print book by Ken Fisher’s son, Clayton, which is pretty good, but I didn’t think it was definitive.? One has complained to me about the Stock Market Game, which seems to teach speculation, not investment.

That’s true of most stock market contests — the only exception I can think of was the Value Line contest back in 1984 . I managed to place in the top 1%, but not high enough to win. That contest forced you to pick 10 stocks from ten different groups for six months. The stocks were sorted by price volatility deciles, so you had to pick some volatile stocks and tame stocks. The stocks were equal weighted, and there was no trading. Great contest — I would love to run something like that. I have suggested it to The Street.com, but no dice. Hey, maybe Seeking Alpha would like to try it! Nominal prize money, but there would be bragging rights!? (Abnormal Returns, this could work for you as well…)

My wife tells me to think about it. Well, today, as I’m going through my personal e-mail, I run across a note from the Home School Legal Defense Association promoting the National Financial Literacy Challenge. Timely, I think. They are having a competition based off of the national standards published in 2007 by the Jump$tart Coalition for Personal Finance.

So I look at the standards, and I think, “These are pretty detailed… how can you turn this into a usable curriculum?”? I print them out and read a little bit of them to my wife Ruth, who says, “Typical for those that set standards, and aren’t teachers; you can’t work with that stuff.”? My wife was a high school teacher, and despite that hindrance, she still homeschools well.? But she knows the troubles that come to public school teachers as mandates come down from on high.

She asked me, “What would you recommend, then?”? I thought about it and said that the personal finance book that I reviewed recently, Easy Money, would be a good book for high school seniors to read.? It’s not a complex book at all.? Afterward I would discuss it with them.? She asked me why I hadn’t done that for our older two children and I said, “It was published after they went to college.? I’ll ask them to read it this summer.”

For investing, I still think that Buffett’s Annual Reports are understandable to most teens.? Marty Whitman is easy to read as well.? But I always liked Ben Graham, and I think The Intelligent Investor is accessible to the average teenager.? Good investing is not complex… but often we make it so.

Full disclosure: if you enter Amazon from my links and buy anything, I get a small commission.? It is my substitute for the tip jar, and it doesn’t increase your costs at all.

One Dozen Notes on Our Manic Capital Markets

Posted on 26 April 200822 June 2017 by David Merkel

1) I think Ambac is dreaming if they think they will maintain their AAA ratings. Aside from the real deterioration in their capital position, they now face stronger competition. Buffett got the AAA without the usual five-year delay because he has one of the few remaining natural AAAs behind him at Berky. (Political pressure doesn’t hurt either… many municipalities want credit enhancement that they believe is worth something.)

2) I read through the documents from the Senate hearings on the rating agencies, and my quick conclusion is that there won’t be a lot of change, particularly on such a technical topic in an election year. And, in my opinion, it would be difficult to change the system from its current configuration, and still have securitization go on. Now, maybe securitization should be banned; after all, it offers an illusion of liquidity liquidity in good times, but not in bad times, for underlying assets that are fungible, but not liquid.

3) I am not a fan of Fair Value Accounting. But if we’re going to do it, let’s do it right, as I suggested to an IASB commissioner several years ago. Have two balance sheets and two income statements. One set would be fair value, and the other amortized cost. It would not be any more work than we are doing now.

4) Now, some bankers are up in arms over fair value, and I’m afraid I can’t sympathize. If you’re going to invest in or borrow using complex instruments that amortized cost accounting can’t deal with, you should expect the accounting regulations to change.

5) Just because you can classify assets or liabilities as level 3 doesn’t mean the market will give full credibility to your model. Accounting uncertainty always receives lower valuations. It as if the market says, :These assets will have to prove themselves through their cash flows, we can’t capitalize earnings here. The same applies to the temporary gains from revaluing corporate liabilities down because of credit stress. If the creditworthiness recovers, though gains will be reversed, and good analysts should lower their future earnings estimates when bond spreads widen, to the degree that present gains are taken.

6) The student loan market is interesting, with so many lenders dropping out. This is one area where the auction-rate securities market initially hurt matters when it blew up, but there was a feature that said that the auction rate bonds could not receive more than the student lenders were receiving. So, after rates blew out for a little while, now some the auction rate bonds are receiving zero (for a while).

7) After yesterday’s post, I mused about how much the high yield market has come back, and with few defaults, aside from those that should have been dead anyway. With liquidiity low at some firms, there will be more to come. Personally, I expect spreads to eclipse their recent wides as things get worse, but enjoy the bear market rally for now.

8) Many munis are still cheap, but the “stupid cheap” money has been made. Lighten up a little if you went to maximum overweight.

9) What’s the Big Money smoking? They certainly are optimistic in this Barron’s piece. One thing that I can find to support them is insider buying, which is high relative to selling at present. And, even ahead of the recent run, hedge funds (and many mutual funds) had been getting more conservative. Guess they had to buy the rally. On the other side, there is a sort of leakage from DB plans, as many of them allocate more to hedge funds and private equity.

10) Does large private equity fund size lead to bad decision making? I would think so. Larger deals are more scarce, and so added urgency comes when they are available. Negotiating for such deals is more intense, and the winner often suffers the winner’s curse of having overbid.

11) I am not a believer in the shorts being able to manipulate the markets as much as some would say. It’s easier to manipulate on the long side. Here is a good post at Ultimi Barbarorum on the topic.

12) Financials are the largest sector in the S&P 500.? Perhaps not for long… they may shrink below the size of the Tech sector at current rates, or, Energy could grow to be the largest.? Nothing would make me more skittish about my energy longs.? The largest sector always seems to get hit the hardest, whether Financials today, or Tech in 2000, or Energy in the mid-90s.

Book Review: Beating the Market, 3 Months at a Time

Posted on 26 April 200826 April 2008 by David Merkel

A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.

Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…

I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.

If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.

Enough about my review process; on with the review:

When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.

The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.

Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.

I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.

Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?

Commend

Momentum effects do tend to persist across equity styles.
Momentum effects do tend to persist across international regional equity returns.
Momentum effects do tend to persist on high yield returns in the short run.
The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
Keeps investment expenses low.
Gives you some more advanced strategies as well as simple ones.
The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)

Discredit

The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.

The Verdict

I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:

There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
Interest rates are low today, and equity valuations are not low.

Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.

Full disclosure: If you buy anything from Amazon after entering through one of my links, I get a small commission.

I Don’t Get It

Posted on 23 April 2008 by David Merkel

1) Liberty Mutual buys Safeco?? Pays 1.75x book, and 11x estimated earnings?? Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal.? They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead?? This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions.? There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present.? There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer.? Off of Safeco, he likes Chubb.? Okay, I like Chubb too.? Great company, and cheap.?? I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative.? Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds.? With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold.? With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings.? With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool.? I wouldn’t go there.

3) I don’t get Bill Miller.? I’m a value investor.? I like companies that trade at modest multiples of book and earnings.? I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies.? Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis.? At this rate next year, he might be behind the S&P over ten years.? Quite a flameout for one who was so lionized.? Could he be fired?? Yes, but not by Chip Mason.? They are too close.? If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade.? Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility.? I’m a professional, and I think humility is a key virtue in handling money.? As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net.? Hey, I’ve paid market tuition, and it is painful.? But boy, I learned a lot, and I don’t repeat mistakes often.? (Repeating mistakes sometimes is bad enough… 😉 )

Full disclosure: long SAFT (not SAF)

National Atlantic Notes, Part II

Posted on 22 April 200822 April 2008 by David Merkel

National Atlantic has filed its Preliminary Proxy Statement. I’m only going to tackle one part of it here tonight — the section starting on page 24, “Opinion of the Financial Advisor.” Those who have read me for a long time know that I am neither biased for or against any “fairness opinion.” For those who want to go back to my early days on RealMoney, you can view what I wrote on the MONY acquisition by AXA. The fairness opinion was correct, and the contesting value investors were dead wrong. Part of the problem was not understanding the insurance accounting.

With National Atlantic, I think the fairness opinion does not truly represent the value of the company. Let me go through a few critical bits of the fairness opinion:

(Page 26)

     Selected Publicly Traded Companies Analysis. Banc of America Securities
reviewed publicly available financial and stock market information for National
Atlantic and the following seven publicly traded personal lines property and
casualty insurance companies with a market capitalization below $2.5 billion:

        o   Mercury General Corporation
        o   State Auto Financial Corporation
        o   Horace Mann Educators Corporation
        o   Infinity Property & Casualty Corporation
        o   Safety Insurance Group, Inc.
        o   Donegal Group, Inc.
        o   Affirmative Insurance Holdings, Inc.

Banc of America Securities reviewed, among other things, per share equity
values, based on closing stock prices on March 7, 2008, of the selected publicly
traded companies as a multiple of calendar years 2008 and 2009 estimated
earnings per share, commonly referred to as EPS, and as a multiple of book value
per share as of December 31, 2007 (in the case of Safety Insurance Group and
Affirmative Insurance Holdings, as of September 30, 2007).

Affirmative and Infinity do not belong in this group, because they are both nonstandard auto writers, which get lower valuations than standard writers. Donegal is mainly a commercial writer when last I looked… the rest are fine. I might have included Gainsco, Commerce Group, or Universal Insurance Holdings. In any case, it biases the calculation of the estimated price low.

     Implied Per Share Equity Value Reference Ranges for National Atlantic         Consideration
     ---------------------------------------------------------------------         -------------

          2008E EPS                                    2007 Book Value
       ---------------                               -------------------

        $3.27 - $4.20                                   $5.24 - $7.85                   $6.25

It also would have been better to do a scatterplot of Price-to-book versus expected ROE on compared companies. I will have to perform that analysis eventually.

(Page 27)

Selected Precedent Transactions Analysis. Banc of America Securities
reviewed, to the extent publicly available, financial information relating to
the following twenty selected transactions involving property and casualty
insurance companies with a transaction value below $500 million:

Announcement
Date Acquiror Target
- --------------- -------------------------------------------------- -----------------------------------------

2/20/08 o Meadowbrook Insurance Group, Inc. o ProCentury Corp.
1/3/08 o QBE Insurance Group Ltd. o North Pointe Holdings Corp.
4/4/07 o Fortress Investment Group LLC o Alea Group Holdings Ltd.
3/14/07 o Argonaut Group, Inc. o PXRE Group Ltd.
12/4/06 o Elara Holdings Inc. o Direct General Corp.
11/22/06 o Clal Insurance Enterprises Holdings Ltd. o GUARD Financial Group Inc.
11/13/06 o Tower Group Inc. o Preserver Group Inc.
10/31/06 o American European Group, Inc. o Merchant's Group Inc.
10/6/06 o Affordable Residential Communities Inc. o NLASCO, Inc.
10/3/06 o Affirmative Insurance Holdings, Inc. o USAgencies, L.L.C.
9/28/06 o Arrowpoint Capital Corp. o Royal & Sun Alliance Insurance
8/16/06 o QBE Insurance Group Ltd. o One Beacon Insurance Group, Ltd.
8/4/06 o Delek Group, Ltd. o Republic Companies Group, Inc.
7/19/06 o Inverness Management L.L.C. o Omni Insurance Group Inc.
11/4/05 o General Motors Acceptance Corp. o MEEMIC Insurance Company
5/22/03 o Liberty Mutual Holding Company Inc. o Prudential Financial Inc.
5/22/03 o The Palisades Group o Prudential Financial Inc.
3/26/03 o Nationwide Mutual Insurance Co. o Prudential Financial Inc.
11/1/00 o American National Insurance Company o Farm Family Holdings, Inc.
10/25/00 o State Automobile Mutual Insurance Company o Meridian Insurance Group, Inc.

The only deal here that would truly be a “comparable” might be Republic Companies. It was a company that was mainly a personal lines company, unlike many of the rest of these deals which are for commercial insurers and reinsurers (I am not familiar with all of them). Republic was sold significantly over its book value. And, where is Commerce Group? I know it is too big to meet the cutoff, but there is a sale of a single state insurer. I would think that valuation would be relevant.

                 Implied Per Share Equity Value
              Reference Ranges for National Atlantic            Consideration
            ------------------------------------------        ------------------
               2008E EPS             2007 Book Value
            ----------------       -------------------

             $5.36 - $6.30             $8.51 - $9.82                $6.25

So, I think these values are low as well. There is far more certainty to the valuation of the reserves of a short-tailed insurer, which usually deserves a higher valuation.

(Page 28)

     Discounted Cash Flow Analysis. Banc of America Securities performed a
discounted cash flow analysis of National Atlantic to calculate the estimated
present value of the standalone unlevered, after-tax free cash flows that
National Atlantic could generate during National Atlantic's fiscal years 2008
through 2012 based on the National Atlantic management forecasts. Banc of
America Securities calculated terminal values for National Atlantic by applying
terminal forward multiples of 7.0x to 9.0x to National Atlantic's fiscal year
2013 estimated GAAP earnings and of 0.40x to 0.70x to National Atlantic's
estimated 2012 year-end book value. The cash flows and terminal values were then
discounted to present value as of March 7, 2008 using discount rates ranging
from 15% to 17%. This analysis indicated the following implied per share equity
value reference ranges for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                       $5.42 - $7.42                            $6.25

I’d like to see them spill the guts of the calculation, and the other calculations above as well. Using “0.40x to 0.70x to National Atlantic’s estimated 2012 year-end book value” and “discount rates ranging from 15% to 17%” is too severe. This is a company with no debt. It’s marginal cost of capital, using the “pecking order” theory is low. Also, short-tail P&C companies under competent management teams don’t retain valuations below 0.8x book.

     Run-off Analysis. Banc of America Securities also performed a run-off
analysis of National Atlantic to calculate the net present value of dividends
that would be paid to shareholders over the remaining life of the company
assuming that it serviced its existing policies without writing any additional
policies or renewing any existing policies. Based on the assessment of National
Atlantic management that the company would not be permitted to pay annual
dividends by the New Jersey regulators, this analysis calculated the net present
value of the final dividend available for distribution to shareholders after all
payouts on loss reserves and losses on unearned premium reserves, estimated to
be approximately $88.0 million payable in 2016. Banc of America Securities
applied a sensitivity analysis to assess a range of values if the loss reserves
were inadequate by up to 10% or were overstated, showing a redundancy of up to
10%. The range of final dividend distributions were then discounted to present
value as of March 7, 2008 using discount rates ranging from 13% to 17%. This
analysis indicated the following implied per share equity value reference ranges
for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                      $1.36 - $3.60                             $6.25

Again, the discount rate is too high. Beyond that, they make the fatal assumption that the company can’t close its books until 2016. If National Atlantic stopped writing policies today, then, one year from today, it would receive its last premium. The company would operate with a skeleton staff for one more year, after which, the remaining book could easily be sold to a company specializing in run-offs. You wouldn’t get your money in 2016. It would be more like 2010. Six years of interest discount at 13-17% makes a huge difference in the price.

=-=-=-=-=-=-=-=-=–=-==-=–=-==-=-=–=-==–=

I have more work to do here, but my fundamental view is not changed. I will be voting against the deal, and encouraging others to do the same. Should the deal succeed, I will likely file for appraisal rights. As I have noted before, I believe that I have meritorious arguments for a better price.

Full disclosure: long NAHC SAFT

The Financings of Last Resort, Part II

Posted on 22 April 2008 by David Merkel

When I wrote my last piece, “The Financings of Last Resort,” I did meant to add that this will be a common phenomenon for a year or so. Pretend you are part of a senior management team of a credit-sensitive financial institution, and your worst nightmare is slowly unfolding in front of you. You’re looking looking at delinquency and loss statistics stratified by year of issuance (“vintage”) and time since issuance. Every vintage since 2003 looks worse than the prior year, and the loss seasoning curves are all pointed upward — in the early vintages, mildly, and in the 2006-2007 vintages, wildly.

You are seeing current losses come through, and they are erasing much of current profits, or, creating crushing losses if you try to get ahead of the loss curve and put in sufficient reserves to handle likely future losses. Any loan loss estimate toward the beginning of a “bust” phase is a wild guess, and management teams are often behind the curve as they hope that the most recent data point was a statistical fluke.

But management teams often think along two tracks. The first is the “best current estimate,” which they give to the market through GAAP accounting. The second is “What if things get bad, and we run short of capital? Better to get financing now, while our stock price is relatively high, and bond and preferred spreads low.”

That reasoning drives two types of capital raising — financings of last resort, and protective financing. That second class of financing was what I commented on at Felix Salmon’s blog regarding JP Morgan.? Borrow when you can, not when you have to.? Get in front of the loss curve, not behind it.

But, for those that are behind the curve, the financings of last resort are protective, at least for a little while, of management teams and bondholders.? Consider the actions at:

But who loses? Current stockholders get diluted.? I can imagine the management consoling their consciences with the thought, “Yes, the stockholders lose, but what would they get in bankruptcy if things got worse, and we didn’t raise capital?”

So, even if credit-sensitive financial companies avoid going broke, they may not be good equity investments because of the dilution.? I said that early on with the financial guarantors.? The big guys are still alive, but their stock prices are down significantly.? (Oh, and note that the regulators like this approach.? No public funds get used.? No embarrassing front page insolvency news.? “What was the regulator doing?”)

How long will this continue?? Financings of last resort can go on until the stockholders rebel and throw out management (hard to do), or the estimated net present value of the profit stream of the company is negative; no one will finance that.? (Think of ACA Capital Holdings, maybe.)? The nature of a financing of last resort is that the financier hands over cash in exchange for cheap equity that can be recycled into the market.? It’s a coercive way of doing an equity or debt offering, and requires a significant discount to current financing valuations.

So, how long will the bailouts go on?? I think for quite some time, which I why I am avoiding that area of the market.? Avoid the equity “fire sales” if you can.? Remember, management teams usually know more than the average analyst when it comes to knowing the true value of cash that can be generated from illiquid assets.? So when you see financial firms pursuing liquidity during a time of debt deflation, don’t be a hero — avoid those companies.

It’s That Season, Again

Posted on 18 April 2008 by David Merkel

I don’t celebrate Easter or Passover, though it is intriguing how far apart the two days are this year.? The season that I am talking about is annual reports and proxies.? This is just a friendly reminder to say that voting your proxies is something that helps keep capitalism legitimate.? Granted, I think that board elections should always be contested, and that access to the proxy should be available to anyone with more than 1% of outstanding shares, but my view is that both amateur and professional investors should take the time to evaluate proxies, vote accordingly for their interests, and not blindly side with management.

I vote down:

All directors at firms that have lost money for me.? (And the auditor!)
Most options and supplemental pay plans.? Pay people cash, not contingent stock that dilutes me.? And, most of the officers earn enough already.? If you don’t do your job because you love it, you’re not the right person for the job.
Shareholder proposals limiting executive pay, environmental issues, and other liberal folderol.

I vote up:

Proposals for greater shareholder democracy.
Plans to de-classify boards, and eliminate poison pills.
Proposals to split the Chairman and CEO positions.

If we’re going to be capitalists, let’s exercise our responsibilities, and have our companies act fairly and ethically.?? When we do that, it helps give capitalism a good name, and maximizesw the benefits in the long run to shareholders.

Not Concerned About Reinsurance Group of America

Posted on 18 April 200818 April 2008 by David Merkel

So Reinsurance Group of America missed estimates. Big deal; they’ve had good-to-excellent earnings for the last ten quarters; they have a bad quarter now and then when the “law of small numbers” catches up with them. Look at 2Q05 and 4Q01 for examples. The law of small numbers means that every now and then, you get a random gaggle of deaths with high face amounts, and the quarter is bad. This is often a good buying opportunity, because Wall Street, which only understands that the earnings missed, without understanding the underlying model, assumes that the miss will persist into the future. That has not been true of RGA.

I have met the CEO and CFO of RGA, and I think they know what they are doing, more than all of the other companies that do life reinsurance. They are the quality name in the space, including their more complex European competitors.

The stock price is currently way above my lower rebalance point, but I would be a buyer on weakness if I did not have a position. This is one of those stocks that you tuck away for 5-7 years, and you find that it doubles. The current oligopolistic nature of life reinsurance may shorten that timespan.

Full disclosure: long RGA