Category: Stocks

Ten Things Not To Worry About

Ten Things Not To Worry About

Posted on by David Merkel

There are many that cover the markets that try to get you to worry about things that aren’t real problems.? Here’s a sampling for the evening:

1) Changes in accounting standards, or ineffective/opaque accounting standards.? Take Goldman Sachs and level 3 assets as an example.? The accounting standard is fine, so long as you understand it.? In general, the higher the level of level 3 assets, the more opaque the valuation of assets is, and a valuation haircut gets assigned to the stock.? This is proper, because it happens to all companies with high or cloudy accrual figures.? It makes it hard to estimate free cash flow.

Should we move from US GAAP to IFRS, it should not affect the valuations of stocks on average, though it will make it a little harder to do financial analysis.? What does not change is free cash flow, which is not subject to accounting rules.? The money that can be withdrawn from a business without harming its current prospects (free cash flow) is the key metric for understanding business value.

2) Counterparty risk.? In derivatives, for every loser, there is a winner.? So long as the appropriate margin levels are maintained at the main brokerages, and the main brokers don’t experience conditions that dramatically change their credit quality, counterparty risk is not a problem.? (Or maybe, I should say, worry about the brokers, not the other counterparties.)

3)? Investors moving to cash.? Money rarely leaves the market.? When funds raise cash (and here), others buy their shares at a discount.? Typically, they are stronger holders than those that sold.? I wouldn’t be too bullish over stories of investors moving to cash, but I certainly would not be bearish.

4)? Rating agency downgrades, unless they trigger a debt covenant.? For the most part, market spreads and yields are set independently of debt ratings.? Sophisticated investors dominate the market, not the rating agencies.? As an example, suppose the US were downgraded to Aa1/AA+/AA+.? After a week, I doubt yields would change much at all, because the fundamental view of the US would not be changed by a change in its rating.

5) High credit spreads.? Those are a reason to be optimistic, because it means pain has been taken already.? Spreads can’t get higher than a certain level, or companies start delevering, because it is profitable to do so.? So when you see spreads near record highs, that is a buying signal, at least for the debt.

6) Retailers in trouble.? Some retailers are always in trouble during hard economic times.? It’s a tough business model, so expect some defaults; it is normal and healthy for the economy as a whole.

7) Collapse of a large portion of the auction rate securities market. ? Most borrowers will refinance.? In the interim, speculators are driving down the rates that get paid.

8) Downgrades of the major financial guarantors.? The market has priced it in, and perhaps we just run off MBIA and Ambac.

9) Tranche warfare in CDOs.? Read your prospectus with care, but when the seniors grab hold of a deal after and event of default, that is a step toward normalizing the market, though the mezzanine holders may ineffectively object as they end up getting nothing.

10) The ABX indexes, etc.? I’ve written about this before, but the various synthetic indexes — ABX, CMBX, LCDX, etc., are very hard to arbitrage against the cash market bonds that they represent.? The indexes should not be used for pricing as a result.? Whenever the synthetic market gets too much bigger than the cash market, it becomes a bettors market, and becomes incapable of delivering pricing signals to the underlying cash markets.

There are enough real things to worry about.? Perhaps I will write about those tomorrow.

Second Quarter 2008 Portfolio Changes

Second Quarter 2008 Portfolio Changes

Posted on by David Merkel

For this quarter, I sold two my two placeholder assets, the Industrial and Technology SPDRs, and Arkansas Best, which had richened enough for me to trade out of it.

I had two rebalancing buys, Charlotte Russe and Avnet.? On Charlotte Russe, the rebalancing buy occurred because I tendered all my stock @ $18 in the Dutch Tender, and 45% of it got bought.? On Avnet, things aren’t as bad as the market thought on 4/15, in my opinion.? I had one rebalancing sell, Helmerich and Payne.? Just taking some off the table for risk reduction purposes.

Here is my final comparison file that was based off of data at the close of business on Monday.? To comply with the Bloomberg data license, all numeric fields remaining are ones that I calculated.? The columns of the file rank the 290 stocks on the following metrics (lower better unless noted):

  • 52-week RSI
  • Trailing P/E
  • P/Book (2)
  • P/Sales (2)
  • P/2008E
  • P/2009E
  • Dividend Yield (higher better)
  • Net Operating Accruals (2)
  • Implied Volatility
  • Neglect (higher better)

The grand rank sums up the ranks giving double weights to P/B, P/S, and NOA.? My current stocks are highlighted in yellow, except for the two middle ones, which are in orange.? Candidates for sale come from the lower half (high grand ranks), candidates to buy from the upper half.

Here were my purchases (P/2008E):

  • International Rectifier — 9.5x
  • Group 1 Automotive — 7.1x
  • OfficeMax — 9.3x
  • Universal American Financial — 5.8x

Cheap names all (and could get cheaper?).? If you asked me what my concerns might be over this group of names, I would say that credit quality is adequate but not stellar.? I would also confess a little doubt on Universal American.? It looks cheap, and lines of business they are in are stable lines.? They lost money on mezzanine subprime mortgage ABS.? I looked at the writedowns, and they seem adequate.? If you send the security vintages 2006-2007 to zero, this stock is still cheap, in my opinion.?? What I can’t evaluate is whether they could have operational problems in their senior health insurance business.? It’s a good business, if managed properly.

As for International Rectifier and Group 1, I have owned them before.? With IRF, I like industrial technology — stuff that is harder to obsolete.? On Group 1, I looked at all of the small cap auto retailers, and picked this one.? I liked its business mix, and what seemed to be a clean balance sheet, with few immediate needs for liquidity.? The group as a whole has been smashed, and is discounting very unfavorable conditions.? I don’t think things are that bad, and besides, a lot of the revenues come from repairs and sales of used cars.

With OfficeMax, I think prospects are less cyclical than the market seems to believe.? Office supplies get purchased during bad economic times as well, and the current price already discounts? a lot of pain.

Well, those are my purchases.? Let’s see how they fare over the coming years.

Full disclosure: long HP CHIC AVT GPI UAM OMX IRF

The Global View — Six Themes

The Global View — Six Themes

Posted on by David Merkel

Though I write mainly about US economic and investment issues, I try to be think globally as I consider macroeconomics. I think that many economists are hobbled because they think about the US economy in a closed framework, neglecting the effects that the rest of the world has on the US. Prior to the end of the cold war, that was a useful shortcut, but now many aspects of the US economy depend on global, and less on local factors. (Some articles cited here will be dated, but are still relevant in my mind.)

This article is meant to take you through six themes affecting the global economy. Here goes:

China

I’ve been writing about neomercantilism and China now for almost five years. The negative effects are now obvious. Inflation has been rising in China, because too much credit is chasing too few goods. That inflation is funneling into US goods prices as well. China exports too much, and imports too little, which forces them to import US credit. This is getting tired, and the Chinese and Middle Eastern savings gluts need a new place to invest, or better, new goods to buy. Absent these adjustments, in order to cool the economy, the PBOC keeps raising reserve requirements again and again. Better they should revalue the yuan up 20%, or they will continue to import inflation from the US.

China has its growing pains amid this. Pollution is rampant, and standards for product safety are low. Beyond that, China now competes with the US and Europe for economic alliances in Africa. Given past bad blood there, the Chinese may at many points be better received, that is, until they abuse their welcome.

Currencies

The main question here is the demise of “Bretton Woods II” where the rest of the world uses the US Dollar as the main reserve currency, while the US continues to debase the dollar through the issuance of more dollar claims. You can read about it in any of the following articles:

Now, Ken Fisher told us not to worry about the declining dollar, but the euro-yen exchange rate. It’s too early to say, but that exchange rate is flat, while the S&P 500 is off 7% or so. Perhaps the overall carry trade is weakening, but not with the euro as a currency to purchase, yet.

Finally, not only is the weak dollar good for exports, but for tourism as well. Now maybe they buy some of our slack houses as well…. please?

Inflation, Especially Food Prices

All the buzz is over rice, which has risen fivefold in six years. You can read about it here:

Now, that inflation is feeding back to the US, but slowly.? You would think that this would be a great time to eliminate US farm subsidies, but no, they are too effective at buying votes insuring economic stability in the Midwest.

Now, in the face of these inflationary pressures, the ECB is not mimicking the Fed.? They see the inflationary pressures, and aren’t loosening, at least not much.? Australia is even tightening.

Recession Fears in the Developed World

Now there are similar stresses in housing in some places of Europe, as compared to the US.? Consider Spain (and here), and the UK.? Low-ish interest rates can lead to overbuilding anywhere, if the regulators look the other way.? Japan may not have housing worries, but their growth is slowing, and they worry about the next recessionary leg of a what is proving to be a long recessionary era (since 1990).

Energy

It doesn’t matter how you slice it, Chavez has mismanaged the Venezuelan economy, and particularly the oil industry.? Now he is trying to do the same thing to cement.? Venezuelans are experiencing shortages and high inflation, as Chavez directs resources that he has stolen nationalized to his cronies and his foreign interests that he funds in order to make life difficult for US foreign policy in Latin America (not that I am a great fan of US policy there — I only recognize the conflict).

The Middle East has lots of new oil fields to tap at the right price, yes?? Well, I’m not so sure.? It is interesting to see the UAE develop a nuclear program.? Perhaps they are looking to a day when oil will not be so plentiful?? Then again, maybe we will have a big energy find in Greenland (an island that may once again be green, now that temperatures are rising to levels last seen in the middle ages).

Emerging Markets

Coming back to the beginning of the article, emerging markets (like China), are going through an adjustment period.? Since these two articles were written, emerging market equities have fallen significantly.? They may fall further; many of those nations are geared to global growth, and when it slows, it slows even more for them.? Many of them are absorbing US inflation as well, and need to raise their exchange rates.? That will hurt exports in the short run, but will aid in bringing economic stability.

Industry Ranks April 2008

Industry Ranks April 2008

Posted on by David Merkel

Okay, here are my industry ranks for April 2008. Please remember that my model can be used in value mode (the green zone) or in momentum mode (the red zone). I usually just stick to the green zone, but this time I included a few red zone ideas. So, this time I added in technology companies, insurance, industrial and healthcare companies. Yeah, I know that’s a lot, and my results reflected that — usually I have just 20 or so companies from the screen, but this time it is 80+.

Oh, my screen, aside from industry, has only two factors: market cap greater than $100 million, and Price-to-book times Price-to-forward earnings must be less than 10. Ben Graham had a similar criterion, except that he used trailing P/E, and his cutoff was 22.5. Here are the tickers:

ABG ACGL ACMR ACW ADPI AEL AFFM AGYS AHL AIG AMSF ARM AWH AXS BBW BC BRLC BRNC CBR CHUX CLS CMOS CNA CVGI DK EDS ENH ENSG FFG FL FLEX FMR FRPT GPI HMX HOTT HTRN IKN INDM IPCR IRF KEM KG LAD LNY LTR MENT MIG MRH MRT MWA MXGL NCS NNBR NSIT NSTC NYM OCR ODP PCCC PDFS PKOH PLAB PMACA PNX PRE PSS PTP RE RMIX RNR ROCK RTEC SAF SAH SANM SEAB SMP SNX TECUA THG TRS TRW TRX UAM UNM XL XRIT

Lots of insurers — what can I say, the group is cheap… cheaper than the lack of pricing power should make them. Add in two more tickers that crossed my desk today: MRO and AWI, and I think I am ready to put my spreadsheet together and start analyzing promising cheap companies. One nice thing about my methods is that it can accommodate a large number of tickers. When you add up the tickers from yesterday and today, and add in the 32 existing tickers, that’s almost 300 tickers altogether.

Fortunately, my ranking system helps my winnow down the list pretty quickly, as it scores cheapness on a wide number of variables at once, and throws in many of the anomalies that are mispriced in the markets. Then it is up to me to use business judgment to decide what makes sense, because most cheap stocks are cheap for a reason, while the gems are merely overlooked.

Feel free to pitch in more stock ideas. I should come to decisions within a week or so.

PS — Have you checked out Newsflashr.com yet? It looks like a promising way of aggregating financial news, as well as other news.

The Financings of Last Resort

The Financings of Last Resort

Posted on by David Merkel

After seeing the amazing “refinancings” done by entities like MBIA, Thornburg, WaMu, and Rescap, I felt it was right to comment on last-ditch financing methods, so that you can recognize desperation (if it’s not obvious already).? Here are some methods:

  • Borrow money using a healthy subsidiary while limiting capital flows up to the less than healthy holding company (e.g., MBIA) .
  • Do a rights offering at a significant discount, diluting existing shareholders if they don’t participate.
  • Offer common stock at a significant discount to a private buyer (perhaps with warrants), diluting existing shareholders, but perhaps allowing the company a chance to play again another day. (e.g. WaMu, Thornburg).
  • Offer a convertible bond/preferred to monetize the volatility of the stock price, contingently diluting existing shareholders. (e.g. Lehman, Citigroup, Merrill)

With the exception of the first one, all of these dilute existing shareholders, usually driving the stock price down in the short run, unless the removal of fear of bankruptcy is the dominant factor.? With the first one, it is an example of structurally subordinating lenders to the holding company, who now lose “first dibs” on the value of the healthy subsidiary.

I try to avoid companies that do financings like these, or are likely to do them.? They have a high default rate.? And what goes for the stock here, goes triple for the corporate bonds, where you have all of the downside of the stock, and little of the upside, if the company should manage to survive.

Beginning of the Second Quarter Portfolio Reshaping

Beginning of the Second Quarter Portfolio Reshaping

Posted on by David Merkel

Well, it’s that time again. Time to make a few portfolio swaps. At present I have two placeholder securities, the industrial Spider, and the technology Spider. Those will go, and I may sell one more security, but that’s it. I will use the proceeds to buy 2-4 positions, so that I will end with 34-35 positions.

When I run across an idea between quarters, I write it down on a sheet and wait for the next reshaping. Well, here is the list of tickers I came across over the last 3 months:

AAUK ACE ADI ADPT ADSK ALB ALL ALV AMAT AMGN AMH AN ANDS APD ARG ASH AW AZN BA BDK BGC BNI BRCD BTU CAG CB CC CCI CHRS CIU CLNE CNQ CONN CPB CRC CRI CSCO CSE CSX CTHR CVG CVI DEO DITC DKS DNR DRI EMC EQ ETFC ETP FMX FRX FSII FTD GDI GIII GT GTI GTS HAR HBOOY HCC HD HOC HTCH HTH HUM IBM INFS ISLN ITRN JBL JCI JCP JRT JTX KFS KMP KMX KOP KR KSS LAMR LDIS LM LOW LXK MAS MCHP MMP MNKD MSN MTA MTW MYE NII NSC NTGR NTT NUHC OMX ORCL OVTI OXY PARL PAYX PBR PCZ PERY PHH PMRY POM PTEN PVX PX QTM RAI RDC RDS RELL RES RHD RJF ROST RSC S SCSS SCX SHW SIRF SNDK SNY SPIL STX STZ SU SUN SUR SVU T TBAC TDW TGT TM TOT TRV TSN TSO TXN TXT TZOO UNP UPRT URBN VMW VOXX VZ WAG WC WDC WHR WIN WLP WNR WPC WTM XRX YUM ZURNY

One of the fun parts of this exercise is that I invite readers to submit their own ideas as well. Feel free to leave them in the comments below.

From here, I will update my industry model, run some screens, and post additional tickers. After that, I will compare the replacement candidates against my existing portfolio, using my multifactor appoach. I will keep you apprised of my thoughts as I move toward making the portfolio changes.

Full disclosure: long XLI XLK

Uptight on Uptick

Uptight on Uptick

Posted on by David Merkel

There have been many writing about the impact of the lack of an uptick rule in the present market.? In the past, before a player could sell short, the stock had to trade up from the last trade — an uptick.? This made it hard to short a stock too heavily, forcing the price down.

Well, maybe.? I still think shorting is a pretty tough business.? First, the long community is much larger than the short community.? Second, the longs can always move their positions to the cash account if they don’t like other players borrowing their shares.? (Move to the cash account, squeeze the shorts.? Wait.? You don’t want to lose the securities lending income?? Shame on you; you should put client interests first.)

The thing is the uptick rule is not the real problem.? The real problem is that shorts don’t have to get a positive locate at the time of the shorting; a mere indication from the broker enables the short for a few weeks, while search for loanable shares goes on. This is a computerized era.? There is no reason why there can’t be real-time data on loanable shares.

There is a second problem, and less so with stocks, than with other financial instruments that are borrowed.? There needs to be stricter rules/penalties on what happens when a party fails to deliver a security.? As it is, when the cost of failing to deliver is miniscule, it can really bollix up the markets.

The longs have adequate tools to fight the uptick rule; they don’t have adequate tools to help against naked shorting and failures to deliver.

Seven Notes on Equity Investing

Seven Notes on Equity Investing

Posted on by David Merkel

1) A lament for Bill Miller.? Owning Bear Stearns on top of it all is adding insult to injury.? Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.? I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.? During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.? When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.? What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.? The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)? Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.? Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.? What a concept amid falling housing and equity prices.? Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.? My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.? I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.? When there are problems, major economic actors are not passive; they look for solutions.? That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.? It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.? Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.? These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.? They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.? They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.? When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.? But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.? Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.? Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.? But without fully invested conventional wisdom, contrarianism has little to fight.

The Lost Decade

The Lost Decade

Posted on by David Merkel

I’ve written about “the lost decade” before at RealMoney.? A lost decade is where? the stock market goes nowhere, or loses money for ten years.? My purpose in doing so was to point out:

  • That it is normal for lost decades to occur.? Stock returns are weakly autocorrelated.? Good years tend to be followed by good years, and bad years by bad years.
  • Once a generation, you have to get a severe boom and a severe bust.? It is partly driven by monetary policy/financial regulation laxity, followed by tightness.? It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
  • This has a chilling effect on retirement planning.? Recall my recent article on longevity risk.? In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.

I’ll amplify the last point, because the WSJ doesn’t do much with it.? Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment).? Same for an individual financial plan.? If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%.? The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.

As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track.? Oops, wait.? This is America.? We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs.? Only our corporations save on net.

So, what to do?

  • Save more.
  • ?Don’t materially increase or decrease allocations to stocks.? Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
  • Avoid investing in companies with large pension funding deficits.
  • Avoid investments with high embedded leverage, whether individual companies, or ETFs.
  • Be wary of investing in esoteric asset classes this late in the performance cycle.? They may do well for a while longer, but their time is running out.? (It could be one year or another decade.)
  • Be ready for increasing inflation.? Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
  • To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.

Of course, you could be a good stock picker, but that’s not a common gift.? The choices are hard when we have a “lost decade.”? There’s no silver bullet; only ways to mitigate the pain.

“Should I be worried about the economy?”

“Should I be worried about the economy?”

Posted on by David Merkel

Most of my friends don’t follow the economy or the markets that closely, so it has been interesting for a number of them to ask me recently, “Should I be worried about the economy?”? The answer isn’t a simple one.

Part of the answer depends on your line of work.? Stuff that’s economically necessary (utilities, staples, government, common services) will probably do okay, though there will be some slackening of demand at the edges.? For example, I visited? a hair salon recently, and asked how business was.? The answer was that customer numbers were unchanged, but that the average purchase level had dropped.? Even government positions, stable as they are will experience some pressure, because budgets have to balance, and tax revenues are starting to sag a bit.

Now if you work in an export-oriented sector, with the dollar down, you will probably do okay.? Demand for food, energy, raw materials, industrial goods, and some technologies will continue relatively strong.

But institutions that rely on credit risk, whether borrowing or lending, will have it tough.? During the boom phase, more and more bodies get added to service the cash flow.? At his point, bodies are coming out of banking, investment banking, real estate, homebuilding, etc.

You can also ask how well capitalized and profitable your current firm is.? This is not a time that rewards high degrees of leverage and short-term financing (unless you are very well capitalized). Volatility rewards firms that have excess capital; it is worth more when times are panicky.

Another part of the answer is how dependent you are on the need for continued external financing.? Can you meet all of your obligations, with some room for error over the next two years?? Do you have excess assets to aid you if you have a sudden crisis?

Finally, if you have investments, look them over.? Examine what investments are sensitive to worsening credit problems, and remove weakly financed companies from your portfolio.? You should have some investments that are inflation-sensitive, like stock in industries that have pricing power (precious few 🙁 ), cash, TIPS, and foreign-currency demoninated bonds.? Now, carefully selected muni, mortgage and corporate bonds have value here, though don’t put on a full position at present.

In summary, it depends on your personal financial position, the firm and industry that you serve, and how much you have prepared to weather bad times in investing.? It’s not a pretty time as the leverage unwinds, but if you planned in advance for the possibility of trouble, then you should do adequately.

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