Category: Stocks

Let Them Eat Yield!

Let Them Eat Yield!

Posted on by David Merkel

An article in Friday’s Wall Street Journal described the creation of new closed-end funds dedicated to the production of yield. I am simultaneously horrified at the concept, and yet wondering whether I couldn’t create one with multiple strategies to smooth out the difficulties of single strategy yield creation. I could buy:

  • unusual bonds with high yields.
  • certain fixed income closed end funds at a discount.
  • dividend paying stocks, and occasionally (ugh) preferred stocks.
  • non- or low dividend paying stocks that fit my eight rules, and sell out-of-the-money calls against them.
  • lever the fund by borrowing at LIBOR.
  • Use my mean reverting REIT, utility, LP strategy. Backtests have it generating a 20% return annually, and I haven’t tweaked it.

The thing is, though, yield is a conceit. People like to think that they are merely scraping the income off of the portfolio, when in many cases, they are truly consuming capital, but the accounting doesn’t make it look that way. Think of a high yield fund with a single-B average credit quality. During good times, the full yield, and maybe a tiny amount of capital gains comes into income. During bad times, the yield shrinks, and capital losses get passed through. Over a full cycle, the NAV of a high yield fund shrinks.

Logical people would not invest in income vehicles like that, but invest they do. Two parting bits of advice. One, there is no reason to ever invest in a closed-end fund IPO. Closed-end funds should trade at a discount equal to the annual fee times five (or so). Two, be conservative in yield investing. It is little known that lower yielding REITs tend to outperform higher yielding REITs. The only time to stretch for yield is when everyone is scared. Even then be careful; make sure the yield that you are getting is secure.

What I Have Been Doing Lately

What I Have Been Doing Lately

Posted on by David Merkel

Recently I have had rebalancing trades, selling a little Dorel Indsutries and Sappi. Also, I swapped Sonic Automotive for Group 1 Automotive early on Tuesday. I was able to enjoy two unexpected sell-side upgrades. It’s not supposed to work this well, but it is nice when it does.

On another note, from a piece by Lloyd Byrne of Morgan Stanley, in 2006 only 73% of oil production was replaced by new reserves for companies that they follow. This is just another reason why I am overweight energy. The replacement ratio has fallen for the last four years.

Finally, if you subscribe to RealMoney, be sure to read Jim Griffin’s post, Fed-Watchers Have Blinders On. I have been contending that the housing lending crisis is serious but will not derail the economy on is own. With the decline in the dollar, it is no surprise that our exporters are seeing some growth. Funny that few notice that. I guess we are used to being importers only….

Full disclosure: long GPI DIIB SPP

Your Money or Your Job! (Or Both!)

Your Money or Your Job! (Or Both!)

Posted on by David Merkel

I must admit to being unimpressed with Sam Zell’s bid for Tribune. I can’t remember the last time someone put up so little money for so great an asset, aside for when I was the juniormost member of the AIG team considering whether to take over The Equitable. (AXA walked away with it, and the untold story is how AIG botched the whole thing.)

The skinny is this: Tribune the company borrows money, and gives it to the ESOP [employee stock ownership plan] to buy up the shares of Tribune. Sam Zell provides a small amount of subordinated financing ($325 million) to Tribune to help make this happen, and receives a warrant to purchase 40% of the company for $500 million. If the true value of the company is $8 billion, this is one sweet deal for Zell. Imagine getting interests in a company worth $3.2 billion, and only having to put up $825 million for that right.

Now, Tribune in its soon to be levered state might not be worth that much, to Zell, or to the employees. This deal presumes a lot in terms of the future profitability of Tribune. Will they be able to carry the debt load?Those that have read me for a while (at RealMoney) know that I am a bear on the newspapers, and most non-internet media businesses. The internet is destroying the margins that support newspapers in three ways:

  • Classified ads are more effective over the web
  • Advertising on the web is more targeted
  • Why subscribe to a paper, when the data is freely available online?

Now in each area a newspaper is still useful, but enough erosion occurs to ruin the economics. I doubt you can turn around a newspaper; perhaps you can create ancillary businesses off of proprietary content, but try to get people to pay for it, or stream a ton of traffic to get ad revenue.

As for the use of the ESOP to finance the takeover, it puts a gun to the heads of employees, who can only vaguely affect firm performance. Any value that they had built up in the ESOP is now at greater risk. If they succeed, they could make quite a bit (while Sam Zell makes proportionately more. If Tribune fails, the ESOP will be worthless, for any who were relying on it. (I realize some older workers can diversify some, but that’s not enough.) Sam Zell would lose his investment, but he can afford that easily. The proportionate impact to workers whose largest asset might be the ESOP would be much worse.

If I were a Tribune worker, I would urge the ESOP to vote down the deal. The downside is more significant than the upside.

Update on Indicators, Part 2

Update on Indicators, Part 2

Posted on by David Merkel

I should mention that Assurant has been added to the S&P 500. Could not happen to a more deserving company; they are truly innovators in the insurance industry.

And now, more on indicators, bullish, bearish, and otherwise:

Bullish

  1. Low quality stocks outperformed in the first quarter, according to Merrill Lynch. That’s bullish in the short run, but not the intermediate term.
  2. LBO volume and private equity volume continue unabated.

Bearish

  1. Economy feels like stagflation-lite. Low positive growth, and rising inflation.
  2. Inflation is rising globally, particularly in India and China.
  3. Mortgage interest payments in the US are a record high (since 1989) compared to Disposable Personal Income.
  4. Corporate credit metrics are deteriorating for both junk and high grade corporate debt, but are not critical yet.
  5. Equity REITs seem to be rolling over.

That’s all for now. Tomorrow is another day.
Full Disclosure: long AIZ

Update on Indicators

Update on Indicators

Posted on by David Merkel

Usually I look at my indicators at the beginning of a month. If I look at them more frequently, the changes are too small, and I don’t get the signal. In no particular order, here are my thoughts, both Bullish and Bearish:

Bullish

  1. Contrary to what the bear in Barron’s said this weekend, the chart for the Merger Fund is bullish. They paid a dividend at year end, and the current chart shows that arbs are making money, which is bullish.
  2. ECRI’s indicators are forecasting growth up, and inflation down.
  3. Both emerging market stocks an bonds have bounced back well.
  4. Earnings yields are still high relative to Treasuries, though if profit margins mean-revert, this argument is hooey.
  5. ISI Group’s broadline retailer’s survey is showing some life.
  6. Securitization of subprime loans, and CDOs containing tranches of subprime deals rated less than AA, are not getting done. These assets are getting sold to financial intermediaries that have adequate balance sheets to fund them.

Bearish

  1. From Alan Abelson’s column in Barron’s this weekend, Henry Kauffman uses a concept akin to my “bicycle stability versus table stability” to discuss liquidity. The former is access to credit, while the latter is excess high quality assets that are readily salable.
  2. Imposing tariffs on China is a real dumbkopf move. Eventually that will bite into the capital flow that keeps our interest rates so low, in addition to decreasing the benefits from the global division of labor.
  3. M3 is falling, and significantly. The banks are pulling back from landing, and credit availability is shrinking. My M3 proxy is the total liabilities of the banking system. Works very well.
  4. Fed funds continues to miss on the high side, since the FOMC meeting. The monetary base has gone flat, and there has been only one permanent open market operation this year, on 2/26.
  5. Financial stocks are lagging the market.
  6. The yield curve is still flat.
  7. Equity REITs don’t yield enough relative to Treasuries.
  8. Housing prices are falling nationwide.
  9. Asset price changes are increasingly in two camps: safe and risky. Correlations within the two camps are high and positive. Correlations of the two camps are very negative.
  10. Inflation remains high over the Fed’s comfort zone.

Neutral, or You Call It

  1. Implied volatilities have bounced up, but are still low.
  2. Corporate bond spreads have bounced up, but are still low.
  3. Implied 5 year inflation, five years forward, has been in a channel between 2.2% and 2.8% for the last four years.
  4. TED spreads are higher, but still low.
  5. The swap curve gained slope after the recent mini-crisis.
  6. The FOMC tightened less this time relative to prior times, if the measure is inflation versus the Fed funds rate.

That’s all for now. The two biggest bits of news are the tariffs on Chinese goods, and the decline in my M3 proxy. Bearish items both.

A Good Quarter

A Good Quarter

Posted on by David Merkel

I’m still looking for a way to document my performance to readers, but let me simply say that the broad market portfolio beat the S&P by a few percent. What worked?

  • Fresh Del Monte
  • Grupo Casa Saba
  • Valero Energy
  • Helmerich & Payne
  • ABN Amro (sold too soon) 😉
  • Dorel Industries (wish they hadn’t delisted)
  • Lyondell Chemicals
  • Dow Chemicals, and
  • SPX Corp

You see any commonalities there? Energy, especially refining. Chemicals. Aside from that, I don’t see anything really correlated.

What didn’t work?

  • St. Joe
  • Barclays plc
  • Japan Smaller Capitalization Fund
  • Nam Tai Electronics
  • Cemex
  • Lithia Motors
  • Conoco Phillips
  • Magna International
  • Jones Apparel
  • Deerfield Triarc, and
  • Allstate (ouch)

Commonalities? Autos, maybe? Away from that, it seems eclectic to me.

In my balanced mandates, my foreign bonds and floating rate securities worked. High quality paid off as volatility rose. Really didn’t have any problems with my bonds.

Now I just have to do as well next quarter. 🙂

Full disclosure: long? FDP SAB VLO HP ABN DIIB LYO DOW SPW JOE BCS NTE CX LAD COP MGA JNY DFR ALL

Around the Web, and then Some

Around the Web, and then Some

Posted on by David Merkel
  1. There were two articles on reinsurers this morning suggesting that there should be a lot of consolidation via M&A. I’m not so sure. First, most players there want to acquire, not be acquired. Second, most of them don’t trust the underwriting and reserving of their competitors to the degree that they trust their own. To the extent that current players want to diversify, it is cheaper to do it organically than by acquisition. With the high degree of ease of entry into the market, the franchise value of a reinsurer is low. Now, maybe the property-centric reinsurers want to diversify (a smart idea, but they are stubborn), or the new reinsurers want to buy in a reverse merger one of the class of 2001 to eliminate the capital haircut from the ratings agencies (but they don’t have the cash for it). Those ideas make sense, but scale isn’t that much of a virtue here, and with P&C reinsurers the reserving is opaque as mud. I can see a deal or two getting done, but not a lot of them.
  2. With all the hand-wringing in the Wall Street Journal this morning on free trade, just watch, we impose some series of tariffs or restrictions that reduce the current account deficit, only to see the capital account surplus shrink also, leading to higher interest rates and a lower dollar, breaking the current cycle giving the US cheap imported goods in exchange for dollar denominated bonds.
  3. Throw a rock, hit a commentator who says that the Bank of China (or other major central bank with large dollar holdings) would never sell their positions because it would work against their interests, driving the value of the dollar down. That’s a half truth at best. Here’s why: the central bank will eventually focus on the future, realizing that sunk costs are sunk. Just because you have a big dollar position, does that mean you have to add to it to preserve its current value. Ignore the past, and let the dollar denominated securities mature. Use fresh cash and maturity proceeds to buy assets in the currencies that you like. It won’t cause a panic, but the dollar will still adjust down. Recognize from the start that the dollar assets are worth less than current exchange rates, and maximize value from there. (Large holders of any asset under pressure have to think this way to maximize value.)
  4. Buyer Beware. Or maybe, it should be borrower beware. People are generally less competent at making rational choices when they are borrowing rather than paying cash. So it is no surprise that when Beazer finances homes that they sold, buyers might have gotten less than an optimal deal. This is true with many financial transactions. In general, the more moving parts in a transaction, the worse off the average person is in evaluating a deal. Better to line up your financing separate from the decision to purchase an asset, or you could end up up with a bop on your beezer, figuratively speaking.
  5. So FASB might have a tighter leash on its neck from the SEC? Not sure whether that is good or bad. Neither organization gets high marks in my book. FASB desperately needs a more coherent overarching approach to accounting, rather than the piecemeal addjustments that they are doing. The SEC, if anything, is more beholden to political pressure, and the idiocy that that brings into accounting.
  6. Then there’s Texas, basically invalidating the GASB on reporting the liability for long term government employee benefits. You might remember my piece at RealMoney, Pensions: Things Can Always Be Worse. Well, this is an example of that, and it is not limited to Texas. Though the Texas argument may have merits, governments all over the country are finding that they have to finally recognize the present value of the pension promises that they have made, and disclose it to the citizenry. It will be a mess, because a large amount of these promises are totally unfunded, much like Social Security, Medicare, and most other programs of our Federal Government.
  7. It takes a week, but finally the market comes around to my view of the FOMC, though it takes Bernanke before Congress to correct the view of the markets. Inflation is not on hold, but the FOMC is, for now.
Bond Market Notes

Bond Market Notes

Posted on by David Merkel

What a week. The yield curve disinverted with ten-year Treasury yields moving above two year yields. 30-year bonds traded off 11 basis points, 10-years 7 bp, 5 years 5 bp. The short end of the curve was largely unchanged.

But now look at Treasury Inflation Protected Securities. TIPS 10 years and longer fell a mere 3 bp. TIPS 5 years and shorter were flat. Now, I have a large allocation of my balanced mandates in TIPS and short-term debt, so my downside was protected this week.

So why did the bond market move that way? The FOMC shifted its monetary policy language this week in a way that said that they no longer have a bias to tighten policy, but they do have have a bias to worry about inflation. The Fed’s announcement this week says that they are willing to tolerate a little more inflation. The bond market reacted accordingly, and required more yield on bonds with no inflation protection.

What else happened? The equity markets rallied, both before and after the FOMC announcement. Credit spreads largely tightened, and the dollar fell on the FOMC announcement, before rallying back to flat the rest of the week. In general, the carry trade currencies, the yen and the swiss franc, underperformed, and higher yielding currencies did better.

What can I say, then? The willingness to take risk is alive and well, and the carry trade is re-emerging. M&A isn’t suffering; note the possible deals on Tribune, ABN AMRO, Chrysler and Volkswagen. And, at least according to Bloomberg, there are a scad of CDO deals in the pipeline waiting to be done. So, let the party continue; let others ignore the rising inflation (at your peril), and enjoy the punch that the Fed is serving. As for me, I’ll just enjoy my mug of tea, slowly reduce risk, and watch the spectacle.

Beat, but not Beaten

Beat, but not Beaten

Posted on by David Merkel

Ugh. What a day. It’s 1:30AM as I begin to write this, and I have been going since 4AM after traveling to Manhattan to DC and back, with the usual difficulties. The two highlights of my day were meeting with the best operational management team in insurance, Assurant, and meeting up with my work colleagues for dinner to celebrate new members coming onto staff. The lowlight was not getting any time with my family.

Now, one of the nice things about my portfolio management style is that I can ignore the markets for short amounts of time, and 99% of the time, it doesn’t matter. I do 95-99% of all my trades through portfolio rebalancings and portfolio reshapings. Like Buffett, who I admire (though I don’t always agree with), I wouldn’t mind if the market were closed more frequently. So today my broad market portfolio was up 50 basis points in my absence. I am now ahead of where i was at 2/26, before the shock.? Maybe I should be absent more often. 🙂

While traveling, I put the finishing touches on six (yes) articles that will be published on RealMoney over the next month. One should be next week, and is a compilation of what I have written here on my recent portfolio reshaping, with a few bits taken out and another page of explanatory data added for greater clarity. The other five articles are a series that I have worked on for a while which I have informally entitled “The Excellent Analyst” series. It goes through the framework of questions that I ask when I have a management team all to myself. I don’t go for material nonpublic information; I also don’t go for earnings trivia, rather, I try to see how the management team thinks as businessmen. Another place where I agree with Buffett, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”

With insurance, that comes natively to me, having done pricing, reserving, reinsurance, and corporate work as an actuary, having managed a small division of a company, with underwriting, marketing, and investment risk control. And my time managing insurance assets, mortgage bonds and then corporates, together with the derivatives. Having done all that, understanding insurance managements is second nature to me. I can sense a bad management team, and I delight in a great management team.

This brings me full circle to Assurant. Why are they the top operational insurance management team to me? This is a non-exhaustive list:

  1. Few other companies in insurance have seriously thought about sustainable competitive advantage. Assurant does it well, being #1 or #2 in almost all of the businesses in which they choose to compete.
  2. They invest in IT and customer relationships to create barriers to entry that are difficult to reverse engineer.
  3. Few insurance companies figure out their core competencies so closely, and then look for adjacent markets to apply them to.
  4. Few insurance companies look for “blue ocean” markets, where there is an unmet need and no competitors.
  5. Excellent capital allocators.
  6. Excellent at M&A, doing small infill acquisitions and growing them organically.
  7. Understands the concepts in market segmentation, and applies it to pricing, reserving, customer service and risk control.
  8. Executes almost flawlessly. What a great culture.

And if that’s not enough, they earn an ROE that is solidly in the top quartile for insurers, and I have no doubt that they will do the same next year. Progressive and AFLAC, move over. There is a new growth insurance name in town, and their valuation metrics are inexpensive, compared to what we are likely to get.

 

Full Disclosure: Long AIZ

Final Step and My Portfolio Decisions

Final Step and My Portfolio Decisions

Posted on by David Merkel

Here?s the final list that I worked with in making my trades. Working up from the bottom of my list, I decide on what to sell. If I?m not selling something that rates low on my quantitative screen, I have to have an explanation as to why I am keeping it.

What I Am Not Selling

 

St. Joe ? This doesn?t score well. The idea here is the land is considerably more valuable than the share price would indicate.

SPX Corp, Sara Lee ? These are still in turnaround mode. Metrics don?t look good now, but should improve.

Sappi ? Value of underlying assets not reflected in the metrics. South Africa is also out of favor.

Dow Chemical ? it?s still cheap, and there are probably transactions that can unlock value.

DTE Energy ? My one US utility. Would benefit from a sell-off of their energy production arm. I might be close to selling, but am not there yet.

Premium Standard ? The merger with Smithfield will go through, and Smithfield will be able to take out costs. They might also gain a wee bit of pricing power. I think cost pressures have reached their maximum here, and profits will improve more than street estimates.

What I Am Selling

ABN AMRO ? Barclays may do the deal or not. ABN Amro is fully valued here, and then some.

Devon Energy and Apache ? I like them both, but their valuations have risen, and I have other places to deploy money.

What I am not Buying

After this, I look from the top down, and look for replacement candidates from the list. If I reject a highly rated name, I have to have a reason:

Group 1 Automotive ? I already have Lithia Motors and Sonic Automotive. It?s in less desirable areas of the country, so I will pass on it for now, but will revisit it at a later date.

Georgia Gulf ? It?s cheap, but I worry about the balance sheet, and I already own Dow and Lyondell.

Thornburg Mortgage ? Would give me conflicts of interest with my employer.

Optimal Group ? This is the most interesting of the ones that I did not buy. They have some interesting payments technologies, but the earnings estimate momentum was negative, and I could not really discern what competitive advantages they had.

Encore Wire ? A bit of a cult stock. I just don?t like the business that they are in.

Arkansas Best, P.A.M. Transportation ? I own YRC Worldwide, and these are not appreciably cheaper.

Foot Locker ? Too many earnings disappointments.

Spectrum Brands ? Lousy set of brands, and a poor earnings history.

Stolt Neilsen ? I own Tsakos, and I think it has better growth prospects.

National Coal ? Too small.

Home Solutions of America ? I don?t like their business, given my view of the housing market.

What I am Buying

Bronco Drilling ? Seems to be a cheap land driller, and replaces some of the exposure I lost selling Apache and Devon.

Komag, Nam Tai Electronics, Vishay Intertechnology ? Cheap technology stocks that are near the beginning of the technology food chain. The businesses are more stable than those who buy their products.

Full Disclosure: long VSH KOMG NTE BRNC BCS LAD SAH DOW LYO JOE SPP SPX SLE DTE PORK YRCW TNP

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