Value Investing – Page 10

Learning from the Past, Part 5c [Institutional Stock Version]

Posted on 2 May 2015 by David Merkel

This will be the last of my institutional error pieces. It is not that I have not made any other errors, but these were the big ones.

National Atlantic Holdings [NAHC]

I was wrong yesterday. ?I actually do have a lot available that I have written on this failure, since I wrote about it here at Aleph Blog. ?More than you can shake a stick at.

Let me start at the beginning. ?NAHC was an insurer with a niche presence in New Jersey. ?They competed only in personal lines, which usually is easy to analyze. ?New Jersey was a tough but not impossible state to operate in, and NAHC was a medium-sized fish for the size of the pond that they were in.

Chubb was not in NewJersey at that point in time, and so they wanted to insure autos, homes, and personal property, particularly that of wealthy people.

I thought it was an interesting company, trading slightly below tangible book, with a single-digit multiple on earnings, good protective boundaries, and a motivated management team. ?The CEO owned over 10% of the firm, which seemed to be enough to motivate, but not enough to ignore shareholders.

In 2005, we bought a 5%+ stake in the company, which in 2006 became 10%+, and eventually topped out at 17%. ?We might have bought more with the approval of the NewJersey Department of Insurance, which was easy at lower levels, and harder at higher levels, which was an interesting anti-takeover defense.

The company showed promise in many ways, but always seemed to have performance issues — little to medium surprises every few quarters. ?The stock price didn’t do that much bad or good. ?When I left Hovde at the end of July 2007, the position was at a modest gain. ?Hovde had a hard time finding long names in that era, so the performance up to that point wasn’t that bad.

If you want to see my original logic for buying the stock after I left Hovde, you can read it here.

Here was the stock price graph from May 2007 to May 2008:

My old employer Hovde owned 17%. ?I eventually owned 0.15%, at the prices you see there, at an average cost of $6.67 for me. ?I eventually sold out at an average price of around $6.10. ?(In the above graph, “Exit” was not a sale, but where I cut off the calculation.) ?This wasn’t my worst loss by any means, but it cost my former employer badly, and it was my fault, not theirs.

What Went Wrong?

Their competitive position deteriorated as companies that previously avoided New Jersey entered the state.
They announced that they had reserving errors, and reported moderate?losses as a result.
They announced a sale to Palisades Insurance, a private New Jersey insurer for $6.25/sh, valuing the company at less than 60% of tangible book value. ?The fairness opinion was a bad joke. ?The company would have been worth more in run-off.
Really, the management team was weak.

The first problem would be a tough one to solve. ?On the second problem, I never got a good answer to how the loss reserves got so cockeyed, and somehow no one was to blame for it. ?This is personal lines insurance — the reserves validate themselves every year.

But the third problem made me think the management was somewhat?dishonest. ?A larger company could have paid a higher price for NAHC, but that probably would have meant that management would lose their jobs. ?They gave shareholders the short end of the stick for the good of management, and perhaps employees.

My biggest error was giving too much credit, and too much patience to the management team. ?I met far better management teams in my time as a buy-side analyst, and they were on the low end of the competence scale. ?I let cheapness and a strong balance sheet blind me to the eroding competitiveness, and weak ability to deal with the problem.

Ultimately, Hovde found itself in a weak position because it could not file for appraisal rights, a fraud case would have been weak, and the NJ Department of Insurance would not let them acquire enough to block the deal. ?Besides, once arbs got a hold of over 40% of the shares, the deal was almost impossible to block.

As I often say, risk control is best done on the front end. ?On the back end, solutions are expensive, if they are available at all.

The front end for you can be learning from my errors. ?Wise men learn from the mistakes of others. ?Average men learn from their own mistakes. ?Dumb men never learn.

In closing, be conservative in investing, and be wise. ?I thought I was being both, so seek the counsel of others to check your logic.

Learning from the Past, Part 5b [Institutional Stock Version]

Posted on 1 May 2015 by David Merkel

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

This is one of the many times that I wish RealMoney.com had not changed its file structure, losing virtually all content prior to 2008. ?(It is also a reason that I am glad I started blogging. ?It’s more difficult to lose this content.) ?When I was a stock analyst at Hovde Capital Advisors, I made 2 humongous blunders. ?I wrote about them fairly extensively at RealMoney as the?situation unfolded, so if I had those posts, it would make the following article better. ?As it is, I am going to have to go from memory, because both companies are no longer in business. ?Here we go:

Scottish Re

Sustainable competitive advantage is difficult to find in insurance. ?Proprietary methods are as good as the employees creating and using them, and they can leave when they would like to. ?This applies to underwriting,?investing, and expense management. ?What else is there in an insurance company? ?There are back end processes of valuation?and?cash flow management, but those financial reporting processes serve to inform the front end of how an insurer operates.

One area that had and continues to have sustainable competitive advantage is life reinsurance. ?An global oligopoly of companies grew organically and through acquisitions to become dominant in life reinsurance. ?Their knowledge and mortality databases make them far more knowledgeable the life insurers that seek to pass some of the risk of the death of their policyholders to them. ?They can be very profitable and stable. ?I already owned shares of RGA for Hovde, and in 2005 wanted to expand the position by buying some of the cheaper and more junior company Scottish Re.

Scottish Re had only been in business since 1998, versus?RGA since 1973. ?These were the only pure play life reinsurers in the world. ?Scottish Re had grown organically and through acquisition to become the #5 member of the oligopoly. ?The top 5 life reinsurers controlled 80% of the global market. ?I made the case to the team at Hovde, and we took a medium-sized position.

The first thing I should have noticed was the high level of complexity of the holding company structure. ?Unlike RGA, they operated to a high degree?in a wide number of offshore tax and insurance haven domiciles — notably Bermuda, Ireland, Cayman Islands, and others. ?Second, their ownership diagrams rivaled AIG for complexity, and their market capitalization was less than 2% of AIG’s at the time. ?[Note: balance sheet complexity did not bode well for AIG either — down 98% since then, but it beats Scottish Re going out at zero.]

The second thing I should have noticed was the high degree of underwriting leverage. ?Relative to RGA, it reinsured much more life risk relative to the size of its balance sheet.

The third thing I should have noticed was the cleverness of some of the financing methods of Scottish Re — securitization was uncommon in life reinsurance, and they were doing it successfully.

The final thing that I should have noticed was that earnings quality was poor. ?They usually made their earnings, but often because their tax rate was so low… and the deferred tax assets were a large part of book value. ?(Note: deferred tax assets only have value if you are going to have pretax income in the future. ?That was soon not to be.)

In 2005, Scottish Re won the auction for buying up another member of the oligopoly, ING Life Re. ?I asked the CFO of RGA why they didn’t buy it, and his comment was that he didn’t think anyone would pay more than they bid. ?That should have led me to sell, but I didn’t. ?The price of Scottish Re drifted down, until August 3, 2006, when they announced second quarter earnings, reporting a huge loss, writing off a large portion of their deferred tax assets, and the stock price dropped 75% in one day. ?I eventually wrote about that at RealMoney, noting it was the single worst day in the hedge funds history, and it was due to my errors. ?You can also read my questions/comments from the conference call here?(pages 50-53).

If you look at the RealMoney article, you might note that we tripled our position at around $6.90?after the disaster. ?That took a lot of guts, and we didn’t know it then, but it was the wrong thing to do. ?The stock rallied all the way up to $10 or so. ?If it hit $11, we were going to sell out. ? That was not to be.

I spent hours and hours going through obscure insurance filings. ?I analyzed every document that I could get my hands on including?the rating agency analyses, because they had access to inside data in aggregate that no one else had outside of the company. ?The one consistent thing that I learned was that insolvency was unlikely — which would later prove wrong.

The stock price fell and fell all the way down to $3, with rumors of insolvency swirling, when Mass Mutual and Cerberus rode to the rescue on November 27, 2006, buying 69% of the company for a paltry $600 million in convertible preferred stock. ?At that point, I finally got it right. ?All of my prior research had some value, because when I read through the documents that day and saw the liquidity raised relative to the amount of ownership handed over. ?Given the data that they now handed out, I concluded that Scottish Re was worth $1/share, and possibly zero.

But there was a relief rally that day, and we sold into it. ?We ended up selling about 4% of the total market cap of Scottish Re that day at a price of $6.25.

The bright side of the whole matter was that we could have lost a lot more. ?Scottish Re was eventually worth zero, and?Mass Mutual and Cerberus took significant losses, as did the remaining shareholders.

As it was, the fault was all mine — my colleagues at Hovde deserved none of the blame.

The Lesson Learned

One year later, I wrote a note to the late Greg Newton who wrote the notable blog, Naked Shorts, when he was critical of Cerberus (they had a lot of failures in that era). ?This was the summary that I gave him on Scottish Re:

Cerberus got into SCT @ $3; it’s now around $2.? For me, on the bright side, when their deal with SCT was announced, I quickly went through the data, and recommended selling.? We got out @ $6.25.? That limited our losses, but it was still my biggest failure when I was at Hovde.? The mixture of leverage, alien domiciled subsidiaries, reinsurance underwriting leverage, plus complex and novel securitization structures was pure poison.? I was?mesmerized?by the?seemingly cheap valuation and actuarial studies that indicated that mortality experience was a little better than expected. ?I?violated my leverage and simplicity rules on that one.

He gave me a very kind response, better than I deserved. ?As it was Scottish Re went dark, delisting in May 2008, and trading for about a nickel per share at the last 10K?in July of 2008. ?It eventually went to zero.

The biggest lesson is to do the research better on illiquid and opaque financial companies, or, avoid them entirely. ?Complexity and leverage there are typically not rewarded. ?I’d like to say that I fully learned my lesson there, but I got whacked again by the same lesson on a personal investment later in 2008. ?That’s a subject for a later article.

I have one more bad equity investment from my hedge fund days, and I will write about that sometime soon, to end this part of the series.

Full disclosure: still long RGA for my clients and me

We Don’t Need To Be Able To Short Private Companies

Posted on 29 April 2015 by David Merkel

Photo Credit: Matthias Ripp?|| Some bad ideas should be locked away…

Dan Primack of Fortune wrote in his daily email:

Saving unicorns from themselves? There was an interesting piece last week from Martin Peers in The Information?(sub req), arguing that the private markets need some sort of shorting mechanism so that there is a check on unreasonable valuation inflation. It would make the market more efficient, Peers argues, even though implementation would require several structural changes (particularly to stock transfer rules). He writes:

“Private companies will probably resist the development of a short-selling market, given it would hurt valuations, which in turn can undermine the value of employee option programs, and give them less control over their shareholder group. But those risks are likely to be outweighed by the long term benefits of bringing more buyers into the market and ensuring the company’s valuation can be sustained outside of the constraints of the private market.”

Leaving out the technical difficulties — including?the lack of ongoing price discovery — one big counter could be that shorts didn’t so much to stop the earlier dotcom bubble (which largely took place in the public markets).

Adam D’Augelli of True Ventures pointed me to a 2002 academic paper (Princeton/London Biz School) that found “hedge funds during the time of the technology bubble on the Nasdaq… were heavily tilted towards overpriced technology stocks.” They add that “arbitrageurs are concerned about attacking the bubble too early without support from their peers,” and that they’re more likely to ride the bubble until just a few months before the end.

That would seem to be?too late to impose price discipline in private markets, but I’m curious in your thoughts. Does some sort of private shorting system make sense? And, if so, how would it be structured?

I’m going to take a stab at answering the final questions. ?There is often a reason why the financial world is set up the way it is, and why truly helpful financial innovations are rare. ?The answer is “no, we should not have any way of shorting private companies, and it is not a flaw in the system that we don’t have any easy way to do it.”

Two notes before I start: 1) I haven’t read the paper at The Information, because it is behind a paywall, but I don’t think I need to do so. ?I think the answer is obvious. ?2) I ran into this question answered at Quora. ?The answers are pretty good in aggregate, but what exists here are my own thoughts to present the answer in what I hope is a simple manner.

What is required to have an effective means of shorting assets

An asset must be capable of being easily transferred from one entity to another.
Entities willing to lend the asset in exchange for some compensation over a given lending term.
Entities willing to borrow the asset, put up collateral adequate to secure the asset, and then sell the asset to another entity.
An entity or entities to oversee the transaction, provide custody of the collateral, transmit payments, assure return of the asset at the end of the lending term, and gauge the adequacy of collateral relative to the value of the asset.

Here’s the best diagram I saw on the internet to help describe it (credit to this Latvian website):

I’m leaving aside the concept of naked shorting, because there are a lot of bad implications to allowing a third party to create ownership interests in a firm, a power which is reserved for?the firm itself.

The Troubles Associated with Shorting Private Assets

I can think of four?troubles. ?Here they are:

The ability to sell, lend, or buy shares in a private company are limited by the private company.
Lending over long terms with no continuous?price mechanism to aid in the gradual adjustment of collateral could lead to losses for the lender if the borrower can’t put up additional capital.
The asset lender can decide only to lend over lending?terms that will likely be disadvantageous to the borrower. ?Getting the asset returned at the end of the lending term could be problematic.
It is difficult enough shorting relatively illiquid publicly traded assets. ?Liquidity is required for any regular?shorting to happen.

The first one is the killer. ?There are no advantages to a private company to allow for the?mechanisms needed to allow for shorting. That is one of the advantages of being private. ?Information is not shared openly, and you can use the secrecy to aid your competitive edge. ?Skeptical short-sellers would not be welcome.

The second problem is tough, because sometimes?successive capital rounds are at considerably higher prices. ?The borrower will likely not have enough slack assets to increase his collateral, and he will be forced to buy shares in the round to cover his short because of that. ?The lender could find that the borrower cannot make good on the loan, and so the lender loses a portion of the value his ownership stake.

But imagining the first two problems away, problem three would still be significant. ?If the term for lending were not all the way to the IPO, next capital round or dissolution/sale, at the end of the term, the borrower would have to look for someone to sell shares to him. ?It is quite possible that no one would sell them at any reasonable price. ?They know they have a forced buyer on their hands, and there could be informal collusion on the price of a sale.

Perhaps another way to put it is don’t play in a game where the other team has significant control over the rules of the game. ?One of the reasons I say this is from my days of a bond manager. ?There were a lot of games played in securities lending, and bonds?are?not the most liquid place to short assets. ?I remember it being very difficult to get a bond back from an entity that borrowed it, and the custodian and trustee did not help much. ?I also remember how we used to gauge the liquidity of bonds we lent out, and if one was particularly illiquid, we would always recall the bond before selling it, which would often make the price of the bond rise. ?Games, games, games…

What Might Be Better

Perhaps using collateralized options or another type of derivative could allow bets to be taken, if the term extended all the way to the IPO, the next capital round, or dissolution/sale of the company. ?The options would have to be limited to the posted collateral being the most the seller of the option could lose. ?Some of the above four issues would still be in play at various points, but aside from issue one, this would minimize the troubles.

What Might Be Better Still

The value of the shorts is that they share information with the rest of the market that there is a bearish opinion on an asset. ?Short-sellers are nice to have around, but not necessary for the asset pricing function. ?It is not unreasonable to live with the problem that some assets will be overvalued in the intermediate-term, rather than set up a complex method to try to enable shorting. ?As Ben Graham said:

?In the short run, the market is a voting machine but in the long run, it is a weighing machine.?

The weighing machine will do its job soon enough, showing that the overvalued asset will never produce free cash adequate to justify its current high price. ?Is it a trouble?to wait for that to happen? ?If you don’t own it, you shouldn’t care much.

If you want to short it, I’m not sure that will hasten the price adjustment process that much, unless you can convince the existing owners of the asset that it isn’t worth even the current price. ?Given that buyers have convinced themselves to own the asset, because they think it will be worth more in the future, intellectually, convincing them that it is worth less?is a tough sell.

In the end, only asset and liability cash flows count, regardless of what secondary buyers and sellers do. ?Secondary trading does not affect the value of assets, though it may affect the perception of value in the short run. ?Thus, you don’t need short sellers to aid in setting secondary market prices, but they are an aid there. ?In the primary markets, where whole companies are bought and sold, the perceived cash return is all that matters.

Conclusion

Ergo, live with short run overvaluation in private markets. ?It is a high quality problem. ?Sell overvalued assets?if you own them. ?Watch if you don’t own them. ?Shorting, even if possible, is not worth the bother.

Learning from the Past, Part 4

Posted on 28 April 2015 by David Merkel

Welcome back to this irregular series where I go through the large blunders that I have committed in my investments. ?Let’s start with an unusual one: a telecommunications partnership.

In the late ’80s the US government allocated some telecom spectrum via a lottery process. ?I had some friends that participated in the first lottery, and received a decent amount of valuable spectrum. ?The only thing they had to do was have the engineering documents drawn up, which a third party consultant did. ?I said to myself that if it ever came around again, I would try to participate.

In the early ’90s, lo and behold, a second lottery with the same rules. ?I invested enough to gain a 30% interest in a partnership that would be going after the center of the US, ignoring the east and west coasts. ?I had seven partners with 10% interests, and they elected me to be the lead partner. ?So far, so good, right?

Well, seemingly. ?The thing is, why should the government allocate spectrum by lottery? ?Shouldn’t they sell it off to the highest bidder? ?After all, that’s what most people did with the spectrum they received in the first lottery. ?(I was planning on trying to create an operating company.) ?Shouldn’t the US government cut out the middlemen, and receive more for a valuable and somewhat limited asset?

Prompted by the telecommunication firms, who preferred having fewer and larger?auctions rather than buying from a bunch of disparate individuals, the US government acted in its own interests, and cancelled, even after all of the lottery participants plans had been approved.

In the end, we got back our fees from the government, but lost the money that we spent on engineering documents. ?After writing off the losses, it was a loss of 50%. ?That said, I also lost any profits from investing the money in stocks over the eight?years that the money was tied up. ?(The promoter that did the engineering documents went into hiding, having lost their shirts in the process, with a lot of annoyed people that bought their services.)

Small Cap Value Forever!

So what was I doing in equity investing in that era? ?Small cap value — little companies trading at bargain prices. ?Of all the managers that I interviewed when creating the multiple manager funds for my employer, I found the small cap value guys to be the most business-minded and interesting. ?A few of us at my firm would research out lesser known companies and?share the ideas. ?We had some fun with it. ?We would occasionally say to each other, “Small Cap Value Forever!”

Now, when the dot-com bubble came around, I was not tempted to play in that area of the market, but I fell into a lesser version of the same trap here. ?I started doing this just as small cap value’s period of outperformance was ending, and growth was taking over.

So how did I do? ?Not that bad… Small cap value lagged the S&P 500 by about 5%/year over the time I was focused on it, and I was able to beat the S&P 500 by a little bit. ?Not the greatest, but not the worst, either. ?In the process, I ran into a number of bizarre situations that taught me a lot, particularly with the smallest companies that I invested in.

In one case, I made the mistake of entering a market order to initiate a position. ?(Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was. ?The price promptly fell back to where it was prior to my purchase. ?Adding insult to injury, management ruined the place, and the price fell by over 80%. ?I looked at the situation, thought the assets were worth far more, and submitted a bid to an institutional investor to buy out his entire stake (and I would become a 5%+ holder of the company — I had to ask my compliance area if I could do that, and they were bemused at the odd request, and assented.) ?The investor did not take my bid, but held on, and the?management announced a buyout for the company at a level that would have given me a significant gain had I been able to buy the block of stock, but instead left me with a 80%+ loss on a small position, which wasn’t large enough to consider filing for appraisal rights.

Then there was one that went very well, but taught me the wrong lesson. ?A few weeks after I bought a stake in a small electronic parts company, Corcom, another company bought it for cash. ?At first I was happy with the quick and sizable win, but then I realized that I might have done better over time if the company hadn’t sold out.

That said, I noticed how wide the arbitrage spread was on the deal, and the annualized rate was 40%/year. ?I bought more and more of it, and eventually even used leverage to goose returns (this doesn’t sound like the older me, right? ?Right.) ?I made a lot of money in the process when the deal completed.

Here’s the wrong conclusion I drew: small deal arbitrage was lucrative and easy. ?I started doing that exclusively for two years during 1998-2000. ?During that time I learned:

It’s not easy. ?Small deal arbitrage investing is like investing in high yield bonds where the management teams have disproportionate opportunity to act against the interests of owners.
It’s not as lucrative as it looks, either. ?One deal gone wrong will eat the profits of ten that go right.
It takes a lot of time to find, analyze and compare new deals. ?I spent much more time on that than when I was doing value investing. ?I felt my time with my family was suffering.

More deals went bad than should have. ?My credit analysis on the deals was subpar. ?I particularly remember one where the buyer used an obscure clause to get out of the deal, and the company, Advanced Technical Products, took the acquirer to court and lost.

After the loss in court, I sold for a 70%+ loss, and then insult added to injury happened again… after 9/11, the products that they made for structural purposes came into high demand, and the stock shot up more than fifteen times. ?Had I held on, I would have quadrupled my original investment. ?(I smile and laugh a little as I write this.)

What did I learn?

This was the worst two years of all my investing, so I learned quite a bit:

Often your worst errors come trying to repeat a single abnormally large?success.
Stick to what you know best, which for me was value investing.
Don’t chase fads.
Analyze management teams of small companies very carefully. ?They can potentially get away with a lot more if there are no significant controlling investors.
Analyze your own investing to figure out what you are best at. ?I did such an analysis afterward, and saw value investing and industry analysis as key strengths.
Focus on risk control. ?Focus on risk control. ?Focus on risk control……
Do more analysis of unusual ways of investing before committing money.

On the bright side, this period set me for my best period of investing, which would be 2000-2010. ?The lessons and discipline learned would prove invaluable to me, and the companies that I served.

2000 More Points To Go; Look Elsewhere!

Posted on 24 April 2015 by David Merkel

15 years is a long time to wait for a 1%/yr return

The big news of the day is that the NASDAQ Composite hit a new high for the first time in 15 years. ?Nice, except as you note from the above graph, that if you adjusted for inflation, you still haven’t made a new high. ?By the time the NASDAQ Composite hits a new high, it will have to rack up at least another 2000 points, which is 40% or so away. ?Now if you add dividends back in since March 10th, 2000, you get to roughly a 1% return.

That’s a lot of pain for not much gain. ?That said, few if any rode out this storm in a fund like the NASDAQ composite. The pain would have been so great that most would have given up in 2002, and those that survived would have given up in 2008-9. ?We aren’t designed to take that much pain and hold on. ?I have a stronger financial pain tolerance than most, and I can’t think of a stock I hung on to past a 75% decline that ever came back in full. ?50%? ?Yes. ?75%? ?No.

I haven’t run the dollar-weighted return calculation for the QQQ, but I’ll try to run that calculation in a future blog post, and who knows, maybe I will run the calculation for John Hussman’s main fund at some future point also.

Look Elsewhere

Looking at the NASDAQ Composite is more a glimpse at the past rather than the future. ?But let me take two more glimpses at the past before I give you a guess at the future.

I remember March 10th, 2000, and the months around it. ?As the dot-com bubble expanded, what industry did the worst, and bounced back the hardest? ?Property/Casualty Insurance. ?I tell my story in detail in this post that I find amusing. ?To shorten this article, I can tell you that if you invested in undervalued industries in 2000-2001, you didn’t get hurt badly at all; you may even have made money like me. ?2002 was another matter — everything got smashed.

But many famous value investors never got to participate in that rally, because they got fired, or retired amid the furor of the dot-com bubble. ?This is yet another reason why it is so hard as an asset manager to hold onto promising assets that are out of favor… if your clients leave you because they?can’t take any more pain, you will be forced to liquidate because of them. ?If you are a big enough holder of those assets, the process may drive the price down further, adding insult to injury.

In my own case, I got derided by peers in early 2000 by owning a lot of property/casualty insurers, particularly my own company, The St. Paul (now part of the Travelers).

Here’s another glimpse: Sometime in 2005, I got introduced to a company called Industrias Bachoco [IBA]. ?It was a medium-sized chicken producer based in Celaya, Mexico. ?Today,?I believe?it is second to Tyson Foods in North America as far as chicken production goes.

It looked interesting and underfollowed, in an industry that I thought had good prospects, because in a world with a growing middle class, meat would be a?premium food product in demand. ?So I bought some, and mostly held on.

If you had bought IBA on March 10th, 2000, and held until today, you would have gotten a little more than a 17%/year return. ?4% of that came from dividends. ?Not quite a Peter Lynch 10-bagger from that point, but getting closer by the day.

Because I got there later, my returns haven’t been as good as that, but still well worth owning over the last ten years. ?I highlight IBA because I know it well, and it serves as a good example of a?winning?stock that few would have been likely to choose. ?Agriculture is not a sexy industry, whereas technology gets lots of admirers. ?But with an intelligent management team and conservative finances, IBA has done very well. ?Now, what will do well in the future?

This is why I tell you to look elsewhere for ideas, away from the crowds. ?Not that everything will do as well as IBA did, but where are the good assets that few are looking at?

Tough question. ?I’ll give you a few ideas, but then you have to work on it yourself.

1) Look at higher quality names in out-of-favor industries. ?The advantage of this approach is that your downside is likely to be limited, while the upside could be significant. ?I’ve seen it work many times. ?Note: avoid “buggy whip” industries where the decline is final; the internet is eating a lot of industries.

2) Look at companies outside the US that act in the best interests of outside, passive, minority investors like you and me. ?There is less competition there from analysts and clever US-focused investors. ?Note: spend extra time analyzing how they have used free cash flow in the past. ?Is management rational at allocating capital, or even clever?

3) Look at firms that can’t be taken over, where a control investor seems savvy, and acts in?the best interests of outside, passive, minority investors. ?Many won’t invest in those firms because they are less liquid, and a takeover is very unlikely.

4) Look at smaller firms pursuing a growing niche in an otherwise dull industry. ?Or smaller firms that have good finances, but have some taint that keeps investors from re-examining it.

5) Look through 13F filings for new names that look promising, before too many people learn about the company. ?Or, IPOs and spin-offs in industries that are dull.

6) Analyze stocks that are in the lowest quartile of performance over the last 3-5 years.

7) Or, go to Value Line, and look at the stocks with the highest appreciation potential, with an adequate safety rank.

Regardless, look forward from here, and look at assets that are cheap relative to future prospects that few others are looking at. ?There is little value in searching where everyone else does, such as the main stocks in the NASDAQ Composite.

Full Disclosure: long IBA and TRV for clients and me

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 2

Posted on 23 April 201523 April 2015 by David Merkel

You can catch part 1 here, where the first six reasons were:

Arrive at the wrong time
Leave at the wrong time
Chase the hot sector/industry
Ignore Valuations
Not think like a businessman, or treat it like a business
Not diversify enough

On to the last six reasons:

7)?Play around with pseudo-stocks

ETFs are simple. ?Perhaps they are too simple, allowing people to implement their investment views very rapidly, when have not done sufficient due diligence on the target of their investing.

As a quick example, consider the CurrencyShares series of ETFs. ?You know that if you use these, you are making an unsecured loan to JP Morgan, right? ?Well, you might be bright, but most people think these funds are collateralized.

ETFs are complex, particularly if you use any that are short or levered. ?They attempt to mirror the price move of a day, and typically underperform if held over longer periods. ?Again, you might know this, but most people don’t. ?Personally, I would ban them on public policy grounds.

Commodity ETFs and Bond ETFs have their own issues, as do ETNs with their credit risk, etc., etc. ?How many people actually look through the prospectus, or at least the information sheet provided by the fund? ?Precious few, I think.

If you use ETFs, stick to the good ones. (Article one, Article two)

8) Gamble

This one should be obvious. ?Most good investing focuses on avoiding losses, and compounding gains in a predictable manner. ?Taking chances, like speculating on the short-term direction of markets through puts and calls is a way to lose money predictably. ?(I leave out covered calls and married puts.) ?It is hard enough to get a good idea of where a stock is going in the long run. ?Getting it in the short run is much harder.

9) Ignore Balance Sheets and Cash Flow

Those who follow the fundamentals of most companies pay attention to the most manipulated of the three main financial statements — the income statement. ?Companies often try to make their earnings numbers, and compromise their accounting in the process.

Accrual entries depend on assumptions and can be tweaked to favor management’s view of profitability. ?Cash for the most part is a lot harder to fake, and most companies wouldn’t consider faking it, because few look there.

Looking at the change in net worth per share with dividends added back is often a better measure of financial progress than earnings per share. ?Beyond that, investing is not just about earnings, but about the margin of safety in the company. ?Many things look very cheap that have a significant risk of failure. ?Analyzing the balance sheet can keep you from many situations that will result in losses.

10) Try a little of this and a little of that ? No strategy / No edge

It takes a while to become good at a method of investing. ?Read about different methods and settle on one that fits the whole of your life. ?I gave up on certain methods because they took up too much time, and I had a family to tend to.

I rarely short assets, because to do it right would require large changes to the way I do risk control. ?(The same applies to options.) ?Good risk control is easy when the choice is between long assets and cash only. ?It gets a lot harder when you can short or go leveraged long, because you no longer have full control over what you are doing — the margin clerks will have some say over your assets.

Also, understand your circle of competence. ?What is your edge, and where does it apply? ?I avoid investing in biotechnology because I can’t tell a good idea from a bad one there, aside from estimating how long the company has before it needs to raise more capital. ?I do more with insurance than most do, because I intuitively understand how the companies work, and what a good insurance management team is like.

That doesn’t mean you can’t broaden your strategy or increase your circle of competence. ?But it does mean that you will have to study if you want to do it well. ?This is a business if you are going to make active bets in a big way. ?You will need to spend time equivalent or greater than that of a significant hobby.

11) Trade Aggressively

In general, you don’t make money when you trade. ?You make it while you wait. ?Most ideas in investing take time to work out, unless you are gambling on a short-term event, or speculating on a move in the stock price.

Most of the studies that I have done on investment in mutual funds of all sorts, including ETFs, show that buy-and-hold investors typically do better than the average investors in the mutual funds. ?On average, the losers are the ones who do the trading. ?That’s not to say there aren’t some clever traders out there. ?There are, but you are not likely to be one of them. ?Frequent trading, unless carefully controlled, is more likely to result in a lot of losses, and few gains, because fear causes many to panic in the short-run.

Even if successful, most aggressive traders get taxed more heavily than those with long-term gains. ?Most of my investment income qualifies for the lowest tax rates, and since I use big gains for charitable giving, my effective rates are lower still.

12) Short incautiously

This may affect the fewest number of my readers, but I have seen even professionals struggle with making money from shorting, particularly when they think an asset is worth nothing ultimately.

Shorting is a difficult way to make money, because your downside is unlimited, and your upside is limited to 100% if the asset goes to zero. ?Another way to say it is that your risk gets larger with shorting as the position moves against you. ?The risk gets smaller when long positions move against you.

if you must short, then treat it like a business and do it tactically.

Diversify shorts much more than longs.
Be tactical, and go for lots of little wins rather than a few big wins.
Set a time limit on your short positions at inception, and close out the positions no later than that.
Be aware that you are likely embedding factor bets on steroids, which can blow up in the wrong market environment. (E.g., short size, long value, short quality, short liquidity, short momentum, etc., would be common for a value oriented hedge fund)

Conclusion

Be aware of the foibles that exist in investing. ?There are many of them, as described in this article and the last one. ?If you want to profit over the long haul, act to avoid the traps that derail most retail investors. ?If you get knocked out of the game, and no longer invest as a result of a trap, you forgo all of the gains that you might have otherwise gotten with more diligence and patience.

From Stream to Shining Stream

Posted on 11 April 201512 April 2015 by David Merkel

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say? ?That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish. ?Few people develop a habit of saving when they are relatively young. ?Try to make it as automatic as possible. ?Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

Emergencies
Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding. ?The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, you don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or Research Affiliates. ?Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.

3) Value investing: Find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be?market timing, but be willing to take risk when things are at their worst. ?That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present. ?This applies to risky debt as well as stocks and hybrid instruments. ?The best returns come out of investing near the bottom of a?panic. ?Do your homework carefully here.

5) Avoid losses. ?Remember:

Margin of safety. ?Valuable asset well in excess of debts, rule of law, and a bargain price.
In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new?opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

You don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.

Also consider the risks you may face, and how your assets may fare. ?How are you exposed to risk?from:

Inflation
Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use. ?In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.

Be wise and?aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, you can’t rely on the markets or the policymakers to make income opportunities easy. ?Choose wisely.

Opinions on the Market, Redux

Posted on 31 March 2015 by David Merkel

Here’s the second half of my most recent interview with Erin Ade at RT Boom/Bust. [First half located here.] We discussed:

Stock buybacks, particularly the buyback that GM is doing
Valuations of the stock market and bonds
Effect of the strong dollar on corporate earnings in the US
Effect of lower crude oil prices on capital spending
Investing in Europe, good or bad?

Seven minutes roar by when you are on video, and though taped, there is only one shot, so you have to get it right. ?On the whole, I felt the questions were good, and I was able to give reasonable answers. ?One nice thing about Erin, she doesn’t interrupt you, and she allows for a few rabbit trails.

One Potential Weakness of Berkshire Hathaway

Posted on 4 March 2015 by David Merkel

As I mentioned yesterday, there wasn’t anything that amazing and new in the annual letter of Berkshire Hathaway. ?Lots of people found things to comment on, and there is always something true to be reminded of by Buffett, but there was little that was new. ?Tonight, I want to focus on a few new things, most of which was buried in the insurance section of the annual report.

Before I get to that, I do want to point out that Buffett historically has favored businesses that don’t require a lot of capital investment. ?That way the earnings are free to be reinvested as he see fit. ?He also appreciates having moats, because of the added pricing power it avails his businesses. ?Most of his older moats depend on?intellectual property, few competitors, established brand, etc. ?Burlington Northern definitely has little direct competition, but it does face national regulation, and dissatisfaction of clients if services can’t be provided in a timely and safe manner.

Thus the newer challenge of BRK: having to fund significant capital projects that don’t add a new subsidiary, may increase capacity a little, but are really just the price you have to pay to stay in the game. ?From page 4 of the Annual Letter (page 6 of the Annual Report PDF):

Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the?year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can?badly hurt their businesses.

BNSF is, by far, Berkshire?s most important non-insurance subsidiary and, to improve its performance, we?will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad?has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or?depreciation charges.

There’s more said about it on pages 94-95 of the annual report, but it is reflective of BRK becoming a more asset-heavy company that requires significant maintenance capital investment. ?Not that Buffett is short of cash by any means, but less will be available for the “elephant gun.”

Insurance Notes

Now for more arcane stuff. ?There are lots of people who write about Buffett and BRK, but I think I am one of the few that goes after the insurance issues. ?I asked Alice Schroeder (no slouch on insurance) once if she thought there was a book to be written on Buffett the insurance CEO. ?Her comment to me was “Maybe one good long-form article, but not a book.” ?She’s probably right, though I think I have at least 10,000 words on the topic so far.

Here are two articles of mine for background on some of the issues involved here:

Here’s the main upshot: reserving is probably getting less conservative at BRK. ?Incurred losses recorded during the year from?prior accident years is rising. ?Over the last three years it would be -$2.1B, -$1.8B, and now for 2014 -$1.4B. ?(See page 69 of the annual report.) ?Over the last three years, the amount of reserves from prior years deemed to be in excess of what was needed has fallen, even as gross reserves have risen. ?In 2012, the amount of prior year reserves released as a proportion of gross reserves was greater than 3%. ?In 2014, it was less than 2%.

In addition to that, in general, the reserves that were released were mostly shorter-tailed reserves, while longer-tailed reserves like asbestos were strengthened. ?In general, when longer-tailed lines of business are strengthened in one year, there is a tendency for them to be strengthened in future years. ?It is very difficult to get ahead of the curve. ?Buffett and BRK could surprise me here, but delays in informing about shifts in claim exposure are a part of longer-tailed lines of insurance, and difficult to estimate. ?As I have said before, reserving for these lines of business is a “dark art.”

From page 91 of the annual report:

In 2014, we increased estimated ultimate liabilities for contracts written in prior years by?approximately $825 million, substantially all of which was recorded in the fourth quarter. In the fourth quarter of 2014, we?increased ultimate liability estimates on remaining asbestos claims and re-estimated the timing of future payments of such?liabilities as a result of actuarial analysis. The increase in ultimate liabilities, net of related deferred charge adjustments,?produced incremental pre-tax underwriting losses in the fourth quarter of approximately $500 million.

This was the only significant area of reserve strengthening for BRK. ?Other lines released prior year reserves, though many released less than last year.

There were a few comments on insurance profitability. ?In addition to asbestos, workers’ compensation lost money. ?Property-catastrophe made a lot of money because there were no significant catastrophes in 2014, but rates are presently inadequate there, and BRK is likely to write less of it in 2015.

My concern for BRK is that they are slowly running out of profitable places to write insurance, which reduces BRK’s profitability, and reduces the float that can be used to finance other businesses.

Maybe BRK can find other squishy liabilities to use to create float cheaply. ?They certainly have a lot of deferred tax liabilities (page 71). ?Maybe Buffett could find a clever way to fund pensions or structured settlements inexpensively. ?Time to have Ajit Jain put on his thinking cap, and think outside the box.

Or maybe not. ?Buffett is not quite to the end of his “low cost of informal borrowing” gambit yet, but?he is getting close. ?Maybe it is time to borrow at the holding company while long-term rates are low. ?Oh wait, he already does that for the finance subsidiary.

Final Notes

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. ?A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish. ?Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway. ?The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

Full disclosure: long BRK/B for myself and clients, for now

The “Secret” of Berkshire Hathaway

Posted on 3 March 20153 March 2015 by David Merkel

Photo Credit: Chuck Coker || Another Dynamic Duo and their secret Batcave

This piece has kind of a long personal introduction to illustrate my point. ?If you don’t want to be bored with my personal history, just skip down to the next division marker after this one.

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There will always be a soft spot in my heart for people who toil in lower level areas of insurance companies, doing their work faithfully in the unsexy areas of the business. ?I’ve been there, and I worked with many competent people who will forever be obscure.

One day at Provident Mutual’s Pension Division [PMPD], my friend Roy came to me and said, “You know what the big secret is of the Pension Division?” ?I shook my head to say?no. ?He said, ” The big secret is — there is no secret,” and then he smiled and nodded his head. ?I nodded my head too.

The thing was, we were ultra-profitable,?growing fast, and our financials and strategies were simple. ?Other areas of the company were less profitable, growing more slowly, and had accrual items that were rather complex and subject to differing interpretations. ?But since the 30 of us?(out of a company of 800) were located in a corner of the building, away from everyone else, we felt misunderstood.

So one day, I was invited by an industry group of actuaries leading pension lines of business to give a presentation to the group. ?I decided to present on the business model of the PMPD, and give away most?of our secrets. ?After preparing the presentation, I went home and told my wife that I would be away in Portland, Oregon for two days, when she informed me we had an important schedule conflict.

I was stuck. ?I tried to cancel, but the leader of the group was so angry at me for trying to cancel late, when I hung up the phone, I just put my head on my desk in sorrow.

Then it hit me. ?What if I videotaped my presentation and sent that in my place? ?I called the leader of the group back, and he loooved the idea. ?I was off and running.

One afternoon of taping and $600 later, I had the taped presentation. ?It detailed marketing, sales, product design, risk control, computer systems design, and more. ?If you wanted to duplicate what we did, you would have had a road map.

But the presentation ended with a hook of sorts, where I explained why I was so free with what we were doing. ?We were the smallest player in the sub-industry, though the fastest growing, and with one of the highest profit margins. ?I said, “The reason I can share all of this with you is that if you wanted to copy us, you would have to?change an incredible amount of what you do, and kill off areas where you have invested a lot already. ?I know you can’t do that. ?But maybe you can imitate a few of our ideas and improve your current business model.”

So my colleague took the tape to the meeting, and when he returned, he handed me a baseball cap that had the word “Portland” on it. ?He said, “You did it, Dave. ?You won the best presentation of the conference award. ?Everyone sent their thanks.”

Sadly, that was one of the last things I did in the Pension Division, as corporate management chose me to clean up another division of the company. ?That is another story, but one I got few thanks for.

Today I call that hat “the $600 hat,” and I wear it to my kids baseball and softball games as I keep score.

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The secret of Berkshire Hathaway is the same as my story above. ?There is no secret.?Buffett’s methods have been written about by legions; his methods are well known. ?The same applies to Charlie Munger. ?That’s why in my opinion, there were?no significant surprises in their 50th anniversary annual letter. (There were some small surprises in the annual report, but they’re kinda obscure, and I’ll write about those tomorrow.) ?All of the significant building blocks have been written about by too many people to name.

Originally, this evening, I was going to write about the annual report, but then I?bumped across this piece of Jim Cramer’s on Buffett. ?Let me quote the most significant part:

…Cramer couldn’t help but wonder if things in the business world could be different if we approached other CEOs the way that Buffett is approached.

Perhaps, if the good CEOs were allowed to stay on longer like Buffett has or if people treated them as if they were their companies the way that Buffett is treated in relation to Berkshire, things could be different?

“Clearly something’s gone awry in the business world if we can praise this one man for everything he does, and yet every other chief executive feels shackled into being nothing like him,” Cramer said.

Cramer is very close to the following insight: the reason why more companies don’t imitate Berkshire Hathaway is that they would have to destroy too much of their existing corporations to make it worth their while. ?As such, the “secrets” of Berkshire Hathaway can be hidden in plain view of all, because the only way to create something like it would be to start from scratch. ?Yes, you can imitate pieces of it, but it’s not the same thing.

Creating a?very profitable diversified?industrial conglomerate financed by insurance liabilities is a very unique strategy, and one that few would have the capability of replicating. ?It required intelligent investing, conservative underwriting, shrewd analysis of management teams so that they would act independently and ethically, and more.

Indeed, an amazing plan in hindsight. ?Kudos to Buffett and Munger for their?clever business sense. ?It will be difficult for anyone to pursue the same strategy as well as they did.

But in my next piece, I will explain why one element of the strategy may be weakening. ?Until then.

Full disclosure: long BRK/B for myself and clients