Category: Stocks

Going Through the Research Stack

Going Through the Research Stack

Posted on by David Merkel

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:

Inflation

  1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
  2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
  3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
  4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
  5. The increase in Owners Equivalent Rent seems to have topped out.

International

  1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
  2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
  3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
  4. Europe has many of the problems that the US does, but its debts are self-funded.
  5. The Japanese recovery is still problematic, and the carry trade continues.
  6. Few central banks are loosening at present. Most are tightening or holding.
  7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

  1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
  2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
  3. Autos and housing are providing no help at present.

Speculation, Etc.

  1. When are we going to get some big IPOs to sop up some of this liquidity?
  2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
  3. Because of the LBOs and buybacks, we remain in a value market for now.
  4. Volatility remains low ? haven?t had a 2% gain in the DJIA in two years.
  5. Hedge funds are running at high gross and net exposures at present.
  6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
  7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
  8. There are many ?securities? in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

Comments to this? Ask below, and I’ll see if I can’t flesh out answers.

The Premature Return of Equity REITs?

The Premature Return of Equity REITs?

Posted on by David Merkel

Ugh. After the purchase of EOP, I felt that equity REITs had reached valuation levels that not only discounted the lifetime of my children, but eternity as well. With the purchases of Archstone Smith and the Pennsylvania REIT, we are at valuation levels near those at the EOP purchase. My metric is equity REIT dividend yields versus the 10-year treasury yield. When one has to give up 1.2% in yield to move from safe Treasuries to risky REIT equity, there is something amiss. The valuation levels embed significant assumptions for growth in rents, which is particularly dangerous when the bull cycle in commercial real estate is so extended.


As a side note, before the purchases were announced, REITs looked the worst from a technical standpoint in the financial space. Now they are the best. So much for the utility of technical analysis.

When Will the Goat Reach the End of the Snake?

When Will the Goat Reach the End of the Snake?

Posted on by David Merkel

Speculation.? Rampant speculation.? This run in the market has to end soon, right?? Right?!

Look, I’m not so sure.? I have a lot to write on this topic, but not so much time.? Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect.? Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).

  1. The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap.? US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital.? We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
  2. Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds.??? Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
  3. New supply comes to the equity market, overwhelming cash available.? This could come from private equity seeking to liquefy marginal asses at favorable prices.? Alternatively, this could come from private equity investments that are unable to pay their debt coupons.? It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
  4. Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.

Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.).? Until then, the party can go on.? I have an article being developed on this topic, but I fear it is a “next week” item.

Bottom Left Hand Drawer Issues

Bottom Left Hand Drawer Issues

Posted on by David Merkel

Back in the saddle.? I have a lot to write about, but not so much time.? The insights developed over vacation will be spread out over the next week or so.

Just a quick one to get started.? In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets.? (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well?? E-mail me, and we can talk.)

I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock.? I think that it is a mistake.? Why?

  1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them.? The same should be done with assets.? Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions.? It gives up what should be a profit center for the enterprise as a whole.
  2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues.? I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable.? Third-party relationships lack the freedom for customization that in-house management allows for.? Often because accounting systems don’t get it quite right, human intervention is needed.? Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right.? In a third party solution, those issues can get lost; I have personally seen it fail.
  3. Penny wise, pound foolish.? The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure.? Though I can’t prove it, the soft costs are large.

If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop.? The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.

Insurance Earnings So Far 1Q07 — XII (Final)

Insurance Earnings So Far 1Q07 — XII (Final)

Posted on by David Merkel

Only three more companies to mention since my last post, here goes:

Primary Commercial

Employers Holdings beats estimates, but on falling premium volume. North Pointe misses earnings on falling premium volume, a higher loss ratio, and expansion expenses that can’t be deferred. Their acquisition looks interesting though; should be accretive to earnings.

Personal Lines

Affirmative Holdings misses estimates badly. More premiums, but higher loss and expense ratios.

Quarter End Summary

Here are the themes of the quarter. I would expect them to persist into the next quarter, which is what normally happens, but when themes don’t persist, the adjustment to prices can be severe.

  1. Though the sell side has gotten into greater agreement with the idea that the top line doesn’t matter much (an idea that I support), the buy side did not agree this quarter. In general, companies that grew their premiums were rewarded, and vice-versa for those who shrank or stood still.
  2. What worked: Primary Commercial, The Bermudans, Financial Guarantors and Life Companies. With Life companies, in general, the larger companies, and the ones with greater exposure to asset management did better. With Primary Commercial insurers and the Bermudans, in general the less conservative did better.
  3. What sort of worked: Personal lines and Conglomerates.
  4. Indeterminate: Title Insurers.
  5. What didn’t work: Brokers, Mortgage Insurers and Specialty Credit players. Credit trends were poor in the first quarter, and brokers faced shrinking revenue from shrinking premium rates.

That was the quarter as I saw it. Did you find this series valuable? If so, e-mail me at the address listed at the Aleph Blog. I have a few ideas on how to make it better, but perhaps this is too superficial to be of use. If so, tell me, and I’ll focus on other things.

Full Disclosure: long NPTE

Back From Bermuda

Back From Bermuda

Posted on by David Merkel

My blog isn’t meant to be mostly about insurance, but I’ve been writing about it a lot lately.? After this, I should have one more wrap-up post about first quarter earnings, and that should be it.

My Bermuda trip went well.? Here’s what I learned:

  1. On net, pricing is actually improving at present.? Property rates have been improving, with 6/1 and 7/1 renewals at the same level as last year.? Casualty rates continue to deteriorate across almost all lines with aviation and D&O possibly having the most overcapacity.? Florida rates have been improving, because insurers are buying coverage above the Florida Hurricane Catastrophe Fund, and second event coverage as well.? Demand is high.? (And Florida is not charging anywhere near enough for reinsurance in their fund… a disaster waiting to happen.)
  2. Everyone wants to expand their specialty businesses, whether through tuck-in acquisitions, or lift-outs of underwriting teams.? At the same time, more of the business is being written standard by admitted writers.
  3. Because capacity with the highly rated carriers is adequate, the class of 2005 is having a hard time gaining enough business.? This is exacerbated by the insureds generally taking higher deductibles, and insurers retaining more and ceding less.? Also, sidecars are less needed in such an environment; many are maturing, and disappearing.
  4. “Revenge of the Nerds” could have been the theme of the meetings.? Only?two of the 10 companies is growing their business.? Most are doing?buybacks, and rest, minus Axis, are considering it.? All of them are following roughly the same investment models (excluding Max Capital), and all of them are following roughly the same risk control strategy, though a few are limiting their writings at absolute limits, rather than probability based limits, which have been known to overexpose companies when rare bad events hit.
  5. Conservatism is generally a good, but over-conservatism is a bad.? Platinum Underwriters is too conservative, and is losing vitality by not writing business unless they are almost certain they will make a 10% ROE.? They are shrinking now.
  6. Finally, reserves are the biggest area of disagreement.? Everyone says their own reserves are conservative, but few are willing to prove it, like PartnerRe and ACE.? XL may be going that way as well, disclosing reserve triangles.? In general it seems that if there are problems, it should be located in the portfolios of the heavier Casualty writers, like ACGL.

I came away relatively happy with our positions.? I like Allied World, Endurance, and PartnerRe roughly equally well.? I was impressed with Flagstone, and think that it could be a good buy during a wind crisis.? Arch and Max Capital presented well; there are reserving questions with Arch though.? XL did well, but I still wonder if they have control over their lines the way PartnerRe does.? Platinum is too conservative, and Axis smacked of braggadocio, somewhat touchy and defensive.? Answers were among the least clear given.

Final note, on people: The Arch meeting was a hoot.? They spoke their minds and dished on everyone, though not by name (clever analysts know, though).? XL’s CEO expressed contempt for MR Greenberg (“glad he’s gone”), and AWH’s CEO talked about his friendship with Greenberg, and how it is bringing AWH business.? Going with Harry Fong was a plus — his 30 years of experience is unmatched, and he has a quirky way of teasing the answers out.

Full disclosure: long AWH ENH

Still Another Boon from RealMoney.com

Still Another Boon from RealMoney.com

Posted on by David Merkel

There are a number of articles that I wrote for RealMoney that fell into the “labor of love” category. So it was with my “If you get to Talk to Management” series. RM has republished the series at their TheStreet.com University. Enjoy it if you haven’t read it already.

Much as would like to post more, while I am in Bermuda it is unlikely that I will post much; look for me to be back on Wednesday.

One Dozen More Compelling Articles Around the Web

One Dozen More Compelling Articles Around the Web

Posted on by David Merkel

1)? Picking up where I left off last night, I have a trio of items from Random Roger.? Is M&A Bullish or Bearish?? Great question.? Here’s my answer: at the beginning of an M&A wave, M&A is unambiguously bullish as investors seize on cheap valuations that have gone unnoticed.? Typically they pay cash, because the investors are very certain about the value obtained.

From the middle to the end of the M&A wave, the action is bullish in the short run, and bearish in the intermediate term.? The cash component of deals declines; investors want to do the deals, but increasingly don’t want to part with cash, because they don’t want to be so leveraged.

My advice: watch two things. One, the cash component of deals, and two, the reaction of the market as deals are announced.? Here’s a quick test: good deals increase the overall market cap of the acquirer and target as a whole.? Bad deals decrease that sum.? Generally, deal quality by that measure declines over the course of an M&A wave.

2) Ah, the virtues of moderation, given that market timing is so difficult. This is why I developed my eight rules, because they force risk control upon me, making me buy low and sell high, no matter how painful it seems.? It forces me to buy when things are down, and sell when things are running up.? Buy burned out industries.? Reshape to eliminate names tht are now overvalued.? These rules cut against the grain of investors, because we like to buy when comapnies are successful, and sell when the are failures.? There is more money to be made the other way, most of the time.

3) From Roger’s catch-all post, I would only want to note one lesser noticed aspect of exchange traded notes.? They carry the credit risk of the issuing institution.? As an example, my balanced mandates hold a note that pays off of the weighted average performance of four Asian currencies.? In the unlikely event that Citigroup goes under, my balanced mandates will stand in line with the other unsecured debtholders of Citigroup to receive payment.

4) Bespoke Investment Group notices a negative correlation between good economic reports and stock price performance.? This should not be a surprise.? Good economic news pushes up both earnings and bond yields, with the percentage effect usually greater on bond yields, making new commitments to bonds relatively more attractive, compared to stocks.

5) From a Dash of Insight, I want to offer my own take on Avoiding the Time Frame Mistake.? When I take on a position, I have to place the idea in one of three buckets: momentum (speculation), valuation, or secular theme.? What I am writing here is more general than my eight rules.? When I was a bond manager, I was more flexible with trading, but any position I brought on had to conform to one of the three buckets.? I would buy bonds of the brokers when I had excess cash, and I felt the speculative fervor was shifting bullish.? If it worked, I would ride them in the short run; if not, I would kick them out for a loss.

Then there were bonds that I owned because they were undervalued.? I would buy more if they went down, until I got to a maximum position.? If I still wanted more, I would do swaps to increase spread duration.? But when the valuations reached their targets, I would sell.

With bonds, secular themes don’t apply so well, unless you’re in the mid-80s, and you think that rates are going down over the next decade or two.? If so, you buy the longest noncallable bonds, add keep buying every dip, until rates reach your expected nadir.? Secular themes work better with equities, where the upside is not as limited.? My current favorite theme is buying the stock of companies that benefit from the development of the developing world.? That said, most of those names are too pricey for me now, so I wait for a pullback that may never come.

6) I’ve offered my own ideas of what Buffett might buy, but I think this article gets it wrong.? We should be thinking not of large public businesses, but large private businesses, like Cargill and Koch Industries.? Even if a public business were willing to sell itself cheap enough to Buffett, Buffett doesn’t want the bidding war that will erupt from others that want to buy it more dearly.? Private businesses can avoid that fracas.

7) And now, a trio on accounting.? First, complaints have arisen over the discussion draft that would allow companies to use IFRS in place of GAAP.? Good.? Let’s be men here; one standard or the other, but don’t allow choice.? We have enough work to do analyzing companies without having to work with two accounting standards.

8) SFAS 159?? You heard it at this blog first, but now others are noticing how much creative flexibility it offers managements in manipulating asset values to achieve their accounting goals.? My opinion, this financial accounting standard will be scrapped or severely modified before long.

9) Ah, SFAS 133. When I was an investment actuary, I marveled that hedges had to be virtually perfect to get hedge treatment.? Perfect?? Perfect hedges rarely exist, and if they do, they are more expensive than imperfect ones.? Well, no telling where this one will go, but FASB is reviewing the intensely complex SFAS 133 with an eye to simplifying it.? This could make SFAS 133 more useful to all involved… on the other hand, given their recent track record, they could allow more discretion a la SFAS 159, which would be worse for accounting statement users, unless disclosure was extensive. Even then, it might be a lot more work.

10) ECRI indicates better growth and lower inflation coming soon.? I’ll go for the first; I’m not so sure about the second, with inflation rising globally.

11) What nation has more per capita housing debt then the US?? Britain. (And its almost all floating rate…)? With economics, it is hard to amaze me, but this Wall Street Journal article managed to do so.? Though lending institutions bear some blame for sloppy underwriting, it amazes me that marginal borrowers that are less than responsible can think that they can own a home, or that people who have been less than provident in saving, think that they can rescue their retirement position by borrowing a lot of money to buy a number of properties in order to rent them out.? In desperate times, desperate people do desperate things, but most fail; few succeed.? We have more of that to see on this side of the Atlantic.

12) I am not a fan of what I view as naive comparisons to other markets and time periods.? There has to be some significant similarity in the underlying economics to make me buy the analogy.? Thus, I’m not crazy about this comparison of the current US market to the Nikkei in the late 80s.? Japan was a much more closed economy, and monetary policy was far more loose than ours is today.? I can even argue that the US is presently relatively conservative in its monetary policy versus the rest of the developed world.? So it goes.

Insurance Earnings So Far 1Q07 — XI

Insurance Earnings So Far 1Q07 — XI

Posted on by David Merkel

We’re going to end this one at a dozen, cousin.? Leaving aside a few new and oddball names, by Tuesday of next week virtually everyone will have reported.? So, after I get back from Bermuda, I will finish this series up.

Bermuda?? Business only.? Going to hit about a dozen companies in two days with one of my favorite P&C analysts, Harry Fong of Calyon.? I hope there are a decent number of insurance only buy-side analysts along for the ride.? They make grilling the management teams so much fun.

As an aside, the last time I was in Bermuda was after Wilma.? I was traveling with Bill Wilt of Morgan Stanley (another good analyst).? Because of a glitch, only seven buy-side analysts analysts were on the trip, but four were “insurance only.”? Between us and Bill, we got a lot done.? The meetings were free-form, with a lot of good give and take.

But the night before the meetings started, I had just gotten to my hotel, and I was hungry.? The hotel bar was the only thing open, so I went down with my computer to get a burger or something.? While sitting there, waiting for my food to come, I work on a RealMoney article.? A fellow that I have never met walks up to me and says, “You’re David Merkel; what are you doing here?”? I am floored; I ask him how he knew me, and he said that I wrote for RealMoney.? Amazing what that little picture will do.

He explains to me that he is there for the Bermuda tour.? I tell him that I am glad he is there for the Morgan Stanley tour.? He looks at me puzzled and says he is there for the Lehman tour.? The Lehman tour is well planned… too well planned.? 24 analysts in all.? Whereas we got the give and take, they got the canned presentations.? Oh well.

Wait, this was supposed to be about earnings.? We have only two companies.? AIG beat by a healthy amount on both the top and bottom lines.? Whether out of hedge fund mischief, MR Greenberg selling out of spite, or that the buy-side had gotten ahead of the sell side because of prior good earnings this quarter, AIG stock traded down in the after hours.? Hallmark Financial Services, primarily a personal lines insurer, met estimates.? Nothing amazing one way or another.

Insurance Earnings So Far 1Q07 — X

Insurance Earnings So Far 1Q07 — X

Posted on by David Merkel

With a few exceptions (young company, etc.) late reporters tend not to do as well versus expectations as earlier reporters do.? Well, in issue 10 of this this series, it feels like the cat dragged in many of these reports.

Life

Alas, but a company that has given me a hard time many times over.? Scottish Re missed earnings badly.? Oh, they’re solvent now, just ask Cerberus or Mass Mutual, or the banks that are extending finance to them.? Will they be able to write significant new business at present?? Not likely for a while.? Will they make money in 2007?? That is anyone’s guess.

Primary Casualty

ProAssurance beat (the only one today) and AmComp missed.? In general, medmal did well this quarter, so good for PRA, which had flat premiums.? AmComp, if anything wrote less business, which might be conservative, but hurt current earnings.? That hasn’t been a recipe for stock price outperformance.

Financial

American Capital Access and Primus Guaranty both missed.? In general, I feel there is little franchise value to these companies that deal in credit default swaps and suchlike.? Much of the reason for the miss is rising credit spreads through the quarter.? That very well may revert over the next quarter.

Personal Lines

Bristol West misses badly, with the loss ratio up.? Since Zurich sees enough value to buy this company out, I only wish them well.? They will need all the good wishes that they can get.? National Atlantic, a company that my employer has a large investment in, met estimates today, but had better revenues than expected.? More of the business mix moves to homeowners and small business commercial, and away from auto.? How many insurance companies do you know that have growing revenues, trade at a single digit forward earnings multiple, and trade below book (and book is conservative)?? Don’t think too hard here, there aren’t many.

Earnings season is drawing to a close.? There are a few more companies to go, and I will bring them to you over the next few days.

Full Disclosure: very long NAHC

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