Value Investing – Page 34

Classic: The Fundamentals of Market Tops

Posted on 15 April 2013 by David Merkel

I wrote the following at RealMoney on 1/13/2004:

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Market Analysis

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Watch out for a momentum-driven investor base.

Companies will take advantage of a topping market by raising cash.

A top in the market is not imminent.

I am basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out. The methods that I will describe in this column are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance.

At the end of this column, I will apply my reasoning to the current market to show what concerns exist and why there is reason for optimism.

The Investor Base Becomes Momentum-Driven

Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

You’ll know a market top is probably coming when:

The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
The recent past performance of growth managers tends to beat that of value managers. (I am using the terms growth and value in a classic sense here. Growth managers attempt to ascertain the future prospects of firms with little focus on valuation. Value managers attempt to calculate the value of a firm with less credit for future prospects.) In short, the future prospects of firms become the dominant means of setting market prices.
Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Corporate Behavior

Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.

Here are ways that corporate behaviors change near a market top:

The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

Other Gauges

These two factors are more macro than the investor base or corporate behavior but are just as important.

Near a top, the following tends to happen:

Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.
The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.

One final note about my indicators: I have found that different indicators work for market bottoms and tops, so don’t blindly apply these in reverse to try to gauge bottoms.

No Top Now

There are reasons for concern in the present environment. Valuations are getting stretched in some parts of the market. Debt capital is cheap today. There are an increasing number of momentum investors in the market. Making the earnings estimate is once again of high importance. Nonetheless, a top in the market is not imminent, for these reasons:

The Fed is on hold for now. Liquidity is ample, perhaps too much so.
Actual price volatility is muted.
Since all of the accounting scandals of the last few years, many corporations have cleaned up their accounting and become more conservative.
Cash flow from operations comprises a high proportion of current earnings. More dividends are getting paid.
Leverage has not declined, but most corporations have succeeded in refinancing themselves in a low interest rate environment.
Conservative asset managers have not been fired yet.
Most IPOs don’t seem outlandish.

Not all of the indicators that I put forth have to appear for there to be a market top. A preponderance of them appearing would make me concerned, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me out of the trouble in 1999 and 2000. I hope that I — and you — can achieve the same with them as we near the next top.

The current market environment is not as favorable as it was a year ago, but there are still some reasonably valued companies with seemingly clean accounting to buy at present. Right now, being long the market is more compelling to me than being flat, much less short.

Classic: Using Investment Advice, Part 4 [Tread Warily on Media Stock Tips]

Posted on 11 April 2013 by David Merkel

The following was published at RealMoney on 9/26/05.? I have augmented it at the bottom, so if you’ve read it before, at the bottom, there is more.

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Often investors, both professional and amateur, will run across what seems like a great investment idea in the media and run to act on it. My advice is simple: Wait. For months, perhaps.

I’ll lay out my approach to media touts, as well as a list of current stock tips, later on. But first, let’s see how the market reacts to them.

Say that the idea is to go long on a stock. At the market open after the story appears, a rush of orders will push the stock’s price higher. Then, as the day progresses, the stock will drop and end the day lower than at the open, but usually higher than the prior close.

For the first few days, the market responds to the supply/demand imbalance, and then the merits of the investment become clear. As Benjamin Graham observed, in the short run, the market is a voting machine; in the long run, it’s a weighing machine.

My experience has been that after the initial supply/demand imbalance period, the performance of media-touted investments is market-like on average, leaving the early buyers with assets that generally underperform.

The degree of underperformance varies with the size and character of the audience that saw the story. In general, the larger the audience, the larger the reaction.

The reaction also tends to be larger the lower the experience level of the audience (as long as there is some investment experience — people with no experience won’t do anything). Novice investors are the ones that jump at ideas that seem to be hot when under the media spotlight. Experienced investors tend to have their own idea-generation processes; they either ignore the idea or throw it into their process for later review.

Naturally, the bigger the media play, the bigger the splash. A front-page article makes waves; a tidbit mentioned in passing should have no impact, even though it might be powerful information in the hands of an informed investor. The impact is also greater depending on the fame, or perceived skill, of the source.

The potential size of the investment is negatively related to the degree of underperformance. A positive article on General Electric will have less impact on the price of GE than a similarly positive article on a smaller company. Naive investors place their market buy orders without thinking through the degree of liquidity of the investment.

Know Your Enemies

A number of media sources are particularly given to sensationalism, such as newsletters, online message boards, radio and sometimes television. The risk is particularly great when the “expert” speaking has an ill-defined financial interest in the idea under discussion.

The higher the level of emotion employed, the lower the level of humility, and the less the focus on what could go wrong, the more you should be skeptical. The adviser can sometimes be an enemy of wealth creation.

There are other enemies as well: sophisticated traders who watch for unusual trading activity off of media play and take a short-term contrary position. They short into bullish news and buy bearish news when they perceive that the money acting quickly on it is naive.

What to Do

My advice is simple: Wait. Invest in a subset of the ideas that still have value and have not fully reacted to the information after a period of time.

Also, compare new ideas as a group vs. each other and against the existing assets in your portfolio. Only add a new idea if you think it will beat the median idea in your portfolio. I have detailed these ideas in a piece titled “Become a Smarter Seller.” [DM in 2013: wish I had a link, it was a great piece.] I usually wait one to three months after I get an externally generated idea before I consider acting on it. I rank new ideas against my current portfolio and choose new ideas based on a mosaic of different factors — mainly cheapness, momentum (or anti-momentum) and industry exposure. I consider selling positions more expensive than the current median idea in my portfolio, and buying ideas that are cheaper than the current median. The following decision/reaction grid helps explain my actions:

Decision/Reaction Grid	Merit of the idea still good?	Merit of the idea bad?
Results have already occurred.	Can’t kiss them all.	Glad I missed that bad boy.
Results have not occurred yet.	Invest.	Don?t invest.

There is a cost to waiting: Some ideas get away from you. This is called implementation shortfall by some. I say you can’t kiss them all.

However, waiting has the positive effect that with the passage of time, some investment proposals are proved wrong. Missing wrong ideas is a real benefit for any investment program. ?Also, waiting takes some of the emotion out of the decision-making process, which helps to avoid errors.

After the waiting period, I ask whether the underlying investment thesis is still valid and whether that is reflected in the current stock price. The media piece that generated the initial interest is long since forgotten, so the emotion and excess stock price moves are gone. But the value might still be there, and with enough new investment ideas, some of them will present real opportunities for above-average investment returns.

Back to 2013

In 2005, I closed the piece with a list of stocks that were interesting, but that I did not own at present.? Look for my next ?Industry Ranks? piece in late April or early May.? You will get some ideas there.

One more thing to confess, I wrote this series with Cramer in mind, but not only Cramer.? I cringe when I hear people speaking or writing about specific investments with a high degree of certainty.

Investing is not certain, even for those of us who try to invest with a margin of safety.? The proper sense of investing engenders sobriety and caution.? That is the opposite of what sells newsletters, gets listeners on the radio, and viewers on television.

I?ve been invited onto TV three times more than I have been on TV.? In talking with a producer, I will explain the issues involved, and I will tell him they are complex.? This doesn?t make for good soundbites.? The producer either concludes there is no easy story here, or seeks out someone who will make the show snappy.

I leave you with this simple concept: if it is entertaining, it is probably not useful for investing.? (And as an aside, that is why you will not see a word related to entertain in my disclaimer.? I am offering opinions, not advice.)? Truly that?s all anyone in the markets can do, but because so many people dupe the credulous, of which there is one born every minute, that?s why we have extensive regulations for disclosure and advertising.

Be skeptical. Research, and be a buyer.? Do not let yourself be sold to.

Finally, avoid emotive media regarding investing.? Listen to those who write dispassionately or better, learn, and do your own research.

Classic: Using Investment Advice, Part 3

Posted on 11 April 2013 by David Merkel

The following was published on 3/29/2004:

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Investment Advice

Time horizon usually correlates with return size.

It’s good to have signposts as the investment plays out.

Free advice is seldom cheap.

In analyzing any advice, investors have to consider the adviser, personal character issues and the nature of the investment proposed.

In Part 1 of this three-part column, I focused on the adviser. In Part 2, I looked at issues centering on your personal character.

In Part 3 today, the emphasis shifts to the investment itself.

Many Things to Consider

Good investment recommendations give some idea of how much to play for and the likelihood of getting there, even if the appraisal of likelihood is subjective and squishy. Are we looking to scalp a dime, a buck, 10%, 100%, or are we looking to score the elusive ten-bagger?

Most often, the time horizon of an investment corresponds to the amount targeted to be earned. Under normal circumstances, gains are made a little at a time. Bigger gains ordinarily take more time. How long will it take to earn what is expected from the proposed investment?

What risks exist in realizing the value inherent in the investment? What could go wrong? Nothing is certain in investing, so beware of advice that tries to sell hard on the idea of safety. Appeals to safety, particularly with investments that are touted to earn an above-average return, are often dangerous. The price adjustments with supposedly safe investments that disappoint are sometimes severe. I experienced this firsthand with corporate bonds: The most dangerous bond was the one everyone knew was secure, and then accounting irregularities popped up. The price would drop 10% to 20%, and liquidity would drop to nil.

If the investment is going properly, what signposts will you see to validate that the investment idea is on track? Aside from price action, what will yield clues that the investment thesis is wrong or right? What should earnings look like? When is that new product going to be introduced?

What factors in the macroeconomic environment does the investment rely on? If inflation rises, what will happen? Does this investment resist recessions well? If the market falls, will this investment fall harder?

Finally, how well does this investment fit into your portfolio? Does it reduce risk for you, or increase it?? Too much of a good thing can be wonderful, but the more concentrated your bets become, the closer you must watch your positions. The higher the degree of concentration in a portfolio, the higher the amount of expertise relative to the market the portfolio manager must possess.

No one will give you all of this in advice, but these are things to keep in mind to aid in the evaluation of advice that comes your way. In general, a conservative and skeptical posture will serve you best. Keep a tight hand on your wallet, and remember that those who stay in the game the longest often do the best.

Finally, you can remember Ferengi Rule of Acquisition No. 59: “Free advice is seldom cheap.”

Value Investing Flavors

Posted on 4 April 2013 by David Merkel

I ran across this article, Value Investor or Value Pretender: Which Are You?, by John Mihaljevic who puts out The Manual of Ideas, along with Oliver Mihaljevic.? I appreciate what they do — you can learn a lot from their organization.

I told him that I was going to write this, and he said to me:

The piece was meant tongue-in-cheek but feel free to rip it apart 🙂

I will rip it apart, but gently, because every point he made is mostly true for value investors, but there are variations in the way that value investors operate, so you can do some of the things he says you can’t do, and still be a value investor — what matters is how you implement them.

There will be more parts to my “Education of a Risk Manager” series, and one of them will deal with all of the different managers that I met, and how much they varied in terms of what they thought were factors that mattered.

Thus, as I developed my own theories of value investing, I considered the range of opinion, and realized that there is a single model for value investing, but that it is complex enough that different parties use different approximations of the full model, and those approximations do better and worse in different environments.

Like a David Letterman-style Top 10 list, John Mihaljevic listed and described things that made you a value pretender.? Time to go through them:

Reason #10: You invest based on chart patterns

I don’t use chart patterns, but I do use momentum both positively & negatively.? There is decent evidence that investors are slow to react to new information, and so stocks with strong price momentum over 200 days tend to do better.? There is some evidence where there is lousy price momentum over a 4-year period, that things tend to mean-revert.

Granted, there is a tendency among some value investors to troll the 52-week low list.? I like doing that too, but you have to be careful, because maybe you are missing something that cleverer investors know.? The same would be true of short interest figures.? Whenever I see one of my stocks gain a high short interest ratio (shares sold short / volume, or % of mkt cap sold short), I do a review to see what I don’t know.? That’s why I am not afraid of the high level of shorting on Stancorp Financial.? This is a conservatively run firm that manages risk up front.? Even though disability claims rise when unemployment is high, they underwrite better than most of the industry.

There have been some very successful value plus momentum investors.? The balance is tricky, but blending two of the most powerful anomalies does bear fruit.

Reason #9: You assume multiple expansion in your investment theses

I never assume that, but if you are buying them “safe and cheap,” you often do get multiple expansion.? The challenge is figuring out where things are less bad then the implied opinion of the depressed valuation.

Reason #8: You try to figure out how a company will do vis-?-vis?quarterly EPS estimates

I don’t do that either, but I have known some value managers that incorporate prior earnings surprise data, because past earnings surprises are correlated with future surprises.? Often, near the the turnaround point for a company’s stock, there are some earnings surprises.

Reason #7: You base your decisions on analyst recommendations

I have few arguments with this, except negatively.? Sell-side analysts are trailing indicators.? I like buying companies where the sell-side is negative, but not very negative.? With very negative opinion, there are often reasons to stay away, unless you possess specific knowledge that the sell-side analysts do not have.

Reason #6: You use P/E to Growth (PEG) as a key valuation metric

I’m sorry, but PEG works, if indeed you have the growth rate right, which is a challenge.? I do try to analyze sustainable competitive advantage for the firms that I own.? That often leads to growth.? Now I am a growth skeptic, so it takes a lot to make me pay up for growth, but occasionally I will do so, when the PEG is low enough.

Reason #5: You use EBITDA as a measure of cash flow

EBITDA is not cash flow from operations, or free cash flow, but it is a valuable figure in value investing when it divides into Enterprise Value (Value of Debt + Value of Stock – Cash).? Low ratios of Enterprise value divided by EBITDA are very effective at identifying promising investments — it indicates cheap assets, and in a time when M&A is hot, it can really pay off.

Reason #4: You would worry about your portfolio if the market closed for a year

I could live with the market closed, but there are advantages to having it open.? With any given stock, there are times in a year to increase or reduce exposure — if you have a firm idea of what the firm is worth, you can buy more during dips, and sell a little into strong rallies.? Short term (one month) stock price movements are fickle, and commonly reverse.

Reason #3: You make investment decisions based on the activity or tips of others

But Manual of Ideas tracks the 13F filings of great investors.? I get good ideas from the best investors also, but you have to do your own research.? Many bright investors chat with each other, and I had many occasions at the hedge fund that I worked for where I disagreed with a friend of the boss.? I was right more often than I was wrong.

Perhaps a better way to phrase it is “choose your idea generators wisely, but do your own research as well.”

Reason #2: Your investment process centers on the market opportunity

This is largely true, but when I know a industry or sector is in horrible shape, I often buy the strongest name in the industry, realizing that they will do well as the competition dies, and they don’t.? Also, there are times when few recognize that pricing power has shifted, and it is time to take a position on a misunderstood industry that is about to grow faster than expected.? Particularly with cyclical companies this idea can be promising.

The same applies to countries where the markets are washed out.? Don’t try to time the bottom, but when a country is cheap, buy a promising/safe company in the country after things have turned up for 100 days or so.

Reason #1: Your investment theses do not reference the stock price

At some points, I like to own companies with strong management teams relative to their industry.? I will let valuation stretch at those points, because there is more of a sustainable competitive advantage there.? You get more positive surprises, and that definitely aids total returns.

That said, a focus valuation is key to all investing.? The only thing more important is margin of safety.

Margin of Safety

There are three elements to margin of safety:

Sustainable Competitive Advantage (Strong Gross Margins)
Strong Balance Sheet (Conservative Accounting)
Cheap Price vs Likely Value

This is different from other formulations of margin of safety, because one has to take into account factors that make it less certain that we can calculate value.? Many value managers were buying cheap financials up until September 2008, only to realize that their estimates? of value were wrong because credit losses would be far worse than expected.

Good stock analysis begins with good bond analysis.? If you wouldn’t buy a bond from the firm, you probably shouldn’t buy the stock.? Value investing is conservative, and looks for situations where there is little credit risk.

Conclusion

If you want to read? summary of my portfolio rules, you can find them here.? I am a firm believer in value investing, but I realize that there are many ways to approach the process.? I watch other value investors, and continue to learn.? Good value investors are lifelong learners, and generalists with broad knowledge.? It is not a narrow discipline, but one that can accommodate new knowledge.

Full disclosure: long SFG

Sorted Weekly Tweets

Posted on 30 March 2013 by David Merkel

Cyprus & The Eurozone

Betray Your Bank Before Your Bank Betrays You http://t.co/H0nRJk7pLB Deposits over insured limit r a sitting target 2b taken in a crisis $$ Mar 29, 2013
Demolishing some myths about the single currency http://t.co/F34IpRQIbF A euro in Nicosia isn’t worth the same as a euro in Berlin $$ #ulose Mar 29, 2013
http://t.co/cbKK6ZNfW6 Neatest thing about the Eurozone interactive graphic: crisis comes in fits & spurts; u think it is over,& it’s not $$ Mar 29, 2013
Eurozone crisis: three-and-a-half years of pain http://t.co/VI8BUD48I8 Cool graphic that allows u2 explore the Euro-crisis blow-by-blow $$ Mar 29, 2013
Lines Form as Cyprus Banks Reopen http://t.co/0XxAiCFrwq How 2 destroy your banking system & bungle rescue, courtesy of the EZ & #Cyprus $$ Mar 28, 2013
MANDATORY CREDIT: BLOOMBERG SURVEILLANCE http://t.co/7bORsyhW8b Marc Faber talks2 Tom Keene & Alix Steel on stocks, Europe, Cyprus & gold $$ Mar 28, 2013
Italy?s failure to form a government doesn?t bode well for the euro http://t.co/V9nPcWFR60 EZone a political creature w/lousy economics $$ Mar 27, 2013
Money fled Cyprus as president fumbled bailout http://t.co/gl1J9z80MV Give the Russians credit (figuratively) 4 squeezing $$ out of Cyprus Mar 27, 2013
Euro zone overrates ability to curb contagion: Moody’s http://t.co/LpRdQ5RG2B Taxing insured deposits has opened up a can of worms $$ #dumb Mar 27, 2013
As a kid, we had a rule, “You can’t beat up my little brother. Only I get to beat up my little brother.” Cyprus: deposit insurance & levy $$ Mar 27, 2013
Cyprus banks remain closed to avert run on deposits http://t.co/JLDXoGD0T8 Won’t help; trust broken. Better 2 take money home, buy gold $$ Mar 26, 2013
Cyprus: It?s not over yet http://t.co/2qiIs9aN1b There will be a lot of pushback from Russia & wealthy Cypriots. Taxing Insured deposits? $$ Mar 26, 2013
Spain?s Swelling Debt Seen Impeding Rajoy Deficit Battle http://t.co/mapViHkfpk Unsure how Spain can escape. After that comes France $$ #woe Mar 25, 2013
Cyprus: crossing the green line http://t.co/whW4YR5a9t If I had $$ in a Greek, Italian, French or Spanish bank, I would withdraw some #theft Mar 25, 2013
Cyprus: The Operation Was a Success. Shame the Patient Died. http://t.co/79agrH1Mb5 Misery of Cyprus is a feature, not a bug $$ #norelief Mar 25, 2013
Cyprus weighs big bank levy; bailout goes down 2wire http://t.co/rm0fHJIfBo Small depositors lose 4%, big 20%. Policymakers gain new tool $$ Mar 25, 2013

Financial Sector

Why Bad Directors Aren?t Thrown Out http://t.co/ZuzGVZk99A Large Institutional Shareholders go along 2get along. Y irritate powerful ppl? $$ Mar 29, 2013
Surging Student-Loan Debt Is Crushing the System http://t.co/ckFHBbDc4R Avoid student debt if u can; most onerous form of debt in US now $$ Mar 29, 2013
Wells Fargo Beats Rivals to Oil-Boom Deposits, Study Says http://t.co/Ygt4ENMJqz FD: + $WFC | WFC bot little banks, grew them organically $$ Mar 29, 2013
Swiss Re settles dispute w/Berkshire Hathaway http://t.co/ADJ0zdufv9 Hasn’t developed same expertise U/W life policies as P&C $$ FD:+ $BRK/B Mar 29, 2013
5 Financial Advisor Red Flags http://t.co/EKFVgc0poP There r2 many fake “credentials” in investing; the person matters more than letters $$ Mar 28, 2013
5th Anniversary of Credit Crisis: Should u Buy CLOs? http://t.co/2sJzKv6LEi All loan participation funds@ prem2NAV http://t.co/qCRczPY0Mu $$ Mar 28, 2013
We?ve Already Built the Next Banking Disaster http://t.co/QjYzT4A9gz At minimum, we need to break up biggest 4 banks $C $JPM $BAC $WFC $$ Mar 28, 2013
Citigroup looks to cut cash holdings to boost earnings http://t.co/5FAoe3egno Every bank hates 2 keep slack liquid assets. Lowers ROE $$ $C Mar 27, 2013
The Best Way to Save Banking Is to Kill It @Matthew_C_Klein http://t.co/UP6c1DsMox Separating deposit-taking from credit creation $$ #yes Mar 27, 2013
A successful failure by @researchpuzzler http://t.co/cOC4Cpu9L1 Amazing what @pimco can do when it has less money to invest $BOND $$ Mar 27, 2013
US Cracks Down on ‘Forced’ Insurance http://t.co/MiWI6a5C1X Restrictions on banks profits on force placed insurance won’t harm insurers $$ Mar 27, 2013
Warren Buffett and Goldman Sachs: Explaining the Math http://t.co/H6AZImEyTl Buffett receives $GS shares equal 2 his profits on the trade $$ Mar 27, 2013
http://t.co/1a1TUDLI6H 44% of Americans think they’re covered 4 weather-related floods. Only 15% have bought a supplemental flood policy. $$ Mar 25, 2013
Falcone Follows Michael Jackson Path Taking Fortress Loan http://t.co/697JnVvocq $HRG Falcone tapping every loan source he can $$ #desperate Mar 25, 2013
Dealer inventory slump threatens market stability http://t.co/XpsoTJkrl0 Intermediation brings stability 2 mkts if intermediaries solvent $$ Mar 25, 2013
Mortgage Securitizers Didn?t Know Housing Was Going Bust http://t.co/rbw2qR2z8H Many drank the same poison Kool-aid they served to others $$ Mar 25, 2013

Rest of the World

US Writes Its Worries About Buying IT Gear From China Into Law http://t.co/OZJt59gZ80 Just imagine the backdoors that could be installed $$ Mar 29, 2013
Grooms at $18 Fuel IPO Ambitions for Indian Matchmaker http://t.co/liu9239lyU India needs 2 have dowry go reverse way; husband pays $$ Mar 28, 2013
How Asia and Robotland have dramatically changed the US labor market http://t.co/Clo8eqpM3w Biggest thing killing off low-end jobs: tech $$ Mar 28, 2013
Mr Yen cautions on Japan’s ‘unsafe’ debt trajectory http://t.co/iX4GAYAfoR Takehiko Nakao warns of consequences from 2 much govt debt $$ Mar 27, 2013
John Mauldin:”Might I suggest that a good trade would be to be long German government debt, short French debt? ” $$ neg carry, long disaster Mar 27, 2013
North Korea?s Economic Outlook: Cloudy with a Chance of Statistics by @steve_hanke http://t.co/XXWyKDffB9 Communism often cre8s inflation $$ Mar 27, 2013
Japanese Investors Start to Cut the Cord http://t.co/9oDHAhiSp8 Mrs Watanabe starts to buy stocks, even foreign & many other investments $$ Mar 27, 2013
Chinese housing bubble fears grow http://t.co/sejx6Yaj0P China grew its economy by forced investing, & the central planning is failing $$ Mar 27, 2013
Abe?s Inflation Exceeds Merkel?s After 14-Year Lag http://t.co/4s9838al6a All a race to the bottom; sound $$ will produce greater growth. Mar 27, 2013
US shale no panacea for Japan’s crippling energy bills http://t.co/siPd1kiheZ Infrastructure doesn’t exist 4 getting lotsa LNG 2 Japan $$ Mar 27, 2013
Brazil Soy Boom Bottlenecked as China Left Waiting http://t.co/sUtvoyp8yw Need 2invest transport infrastructure; tax importers/exporters? $$ Mar 26, 2013

Companies

REITs Trigger Fed Warning as Kain Tops $100 Billion http://t.co/4Lq6xm6Ka3 Shadow banking returns amid unconventional Fed policies $$ #panic Mar 28, 2013
M&A Stumbles Amid March Deal Drought http://t.co/sJlM7ndlnr “Can u say overvaluation, boys & girls? I thought u could; you’re special.” $$ Mar 28, 2013
Here’s Why Marissa Mayer Is About To Spend ~$200 Million On A YouTube Wannabe http://t.co/E5A42QAZac Buy small $ grow organically, smart $$ Mar 27, 2013
Is the $DELL Stub the Right Investment for You? http://t.co/ut9Mg65gLa Gun to the head, I would say “no.” 2 much leverage & excess supply $$ Mar 27, 2013
Summaries of What’s Wrong w/ $YHOO ‘s Summly Buy http://t.co/npVsxAj7Hj & http://t.co/KudImnOcdL & http://t.co/OhZfXoUwM3 $$ Mar 27, 2013
How the Maker of TurboTax Fought Free, Simple Tax Filing http://t.co/CYUea9aT8O Intuit benefits from complexity in the tax code $$ #simplify Mar 27, 2013
Fredriksen Bets $2.6B New Ships Will Beat Glut: Freight http://t.co/QtxTQaxJZF A bold bet that may fail 4 lack of sufficient capital $$ $FRO Mar 27, 2013
The Scariest Stock Chart in Town @ReformedBroker http://t.co/mg54zsX9s8 Good example of analyzing balance sheet strength of stockholders. $$ Mar 27, 2013
Cisco Is Keeping Its Promise Not To Buy Companies In The US http://t.co/GtWyy2bLpx Makes sense given US Tax laws | FD: + $CSCO $$ Mar 27, 2013
T-Mobile Becomes First Major Carrier to Drop Subsidies http://t.co/7tJ0FdJYmJ Probably a good strategy; differentiates & unbundles $$ Mar 27, 2013
Customers Flee Wal-Mart Empty Shelves for Target, Costco http://t.co/PAvNMUUVEP I see it also http://t.co/83s4J9aGA2 $$ Mar 26, 2013
Dell Says Blackstone, Icahn Offers May Be Superior http://t.co/jgHkKo6Jna Not sure I would want 2 win $DELL game; fixing ops very hard $$ Mar 25, 2013
Blackstone?s $DELL Bid Sets Stage for Rare Buyout Bidding War http://t.co/8KAGIEETOw Michael Dell may lose control of company he built $$ Mar 25, 2013
Heinz Sells $3.1B of New Bonds http://t.co/kMUfvlkyys Deal upsized, rated B1/BB-/BB-, lowest financing cost ever 4a LBO@ 4.25% 7.5yrs $$ #no Mar 25, 2013

US Monetary & Fiscal Policy

How the Fed Can Create a Market-Friendly Exit Strategy: Jeremy Siegel?s Proposal
http://t.co/2VPzaCDnyg Listen 2 bank shareholders scream $$ Mar 29, 2013
Pentagon to Cut $41B After Getting More Funding http://t.co/SrcDNN4Fbn We could a lot of dead wood @ the Pentagon, expensive non-soldiers $$ Mar 29, 2013
Big Business Spars Over Rewriting Tax Code http://t.co/CRjZZzwLix Importer, Exporter, Services, REIT, MLP, PE: no common corptax position $$ Mar 29, 2013
The Exhausted US Consumer http://t.co/QgSkYM2onj Spent-up, not pent-up $$ Looks at Disposable Personal Income, which recently dropped Mar 28, 2013
Restaurant Chains Cut Estimates for Health-Law Costs http://t.co/Ed00DMDXAX Test Q: List all the ways that the PPACA fails $$ #needmorepaper Mar 28, 2013
Best Predictor of Financial Crisis: Huge Inflows of Foreign Money http://t.co/uOrBJ4OI96 Long assets financed w/short liabilities is why $$ Mar 28, 2013
Stockton Deficits May Total $100 Million, Forecast Shows http://t.co/Pu8oqu3zQA That’s the cash pmt curve of generous employee benefits $$ Mar 27, 2013
Stockton Bankruptcy Decision to Come Monday, Judge Says http://t.co/dulFxXxNwm $BEN $AGO & $MBI argue city didn’t negotiate in good faith $$ Mar 27, 2013
US Retail Sales: Very Soft Indeed! http://t.co/XSJSyChEHW Unusual in that seasonal adjustments typically go away on YOY figures $$ Mar 27, 2013
Brenner and Fridson: Bernanke’s World War II Monetary Regime http://t.co/RnHpvMlPL3 Sad but true. Bernanke robs savers to fund US Govt $$ Mar 26, 2013
States Build Cash Reserves, Raising Rainy-Day Debate http://t.co/uSiYVMjPGi State budgets should balance on an accrual basis. None do $$ Mar 25, 2013

Wrong

Wrong: Gold Declines in Worst Run Since 2001 as Economic Concerns Ease http://t.co/uB8EhvfpPk Gold is falling because of debt deflation $$ Mar 28, 2013
Wrong: Proving Greenspan Wrong Shows Why Rey Became Worthy to Bernanke http://t.co/PHHmWJpRgJ Proving Greenspan wrong is trivial $$ #tiny Mar 28, 2013
Wrong:Key US senator blames speculators for high ethanol RIN price http://t.co/PNvhTvVmXt Note Senator is from Iowa, which benefits most $$ Mar 27, 2013
Wrong: Why the Rich Don’t Give to Charity http://t.co/aHdPMnjTt1 The missing variable here is Christian faith; media is blind to that $$ Mar 27, 2013

Market Dynamics

Everybody is Furiously Looking for Bubbles http://t.co/gx4GTwxnTV Bubbles are financing phenomena; look 4 short finance of long assets $$ Mar 29, 2013
Morningstar: Stocks Are Close to Fair Value http://t.co/TLDpVrjF1M “US stock market is some 50 percent above its historic mean value” $$ Mar 28, 2013
Crises exist 2 eliminate things that don’t need 2b done; governments interfere w/ this process b/c they r in league w/those who skim society $$ Mar 28, 2013
When will the Bond Bubble Finally Burst? http://t.co/WomjY44B9I Fund flows, Fed, other CBs, Banks, & measured inflation supportive 4 now $$ Mar 27, 2013
Investors face a shrinking stock supply http://t.co/bC1ECjt2Xg Maybe we can get rid of Sarbanes Oxley b4 it kills the equity mkt entirely $$ Mar 27, 2013
Investing in a High Debt Environment http://t.co/3PxNmNg1Oz Concentrate on inflation, study interest rates & focus on business fundamentals Mar 27, 2013
Low Volume = Good Investment? Analysis of David’s “Neglected Stocks R Typically in Strong Hands” Thesis http://t.co/wbseitIGZF Good Stuff $$ Mar 27, 2013
Use free cash 4 buybacks when price < 90% of franchise value [FV], issue dividends above that. FV is where u rather issue stock than debt $$ Mar 26, 2013
Not Everyone Loves Dividends: Guy?s Argument is Worth Hearing http://t.co/BsMDyzazLZ Buybacks vs Divs: depends on undervaluation of stock $$ Mar 26, 2013
Warren Buffett and John Hussman On The Stock Market http://t.co/ynAhtJrDAY The Market Cap/GDP ratio indicates significant overvaluation $$ Mar 26, 2013
Investors Pile Into Housing as Landlords http://t.co/rteDMNUl0e Anytime investors become a large part of residential RE-> trouble $$ #bubble Mar 25, 2013
Buttonwood: Credit watch http://t.co/53WR3r3BW0 New book argues that investors should focus on the credit cycle, not economic growth $$ #duh Mar 25, 2013
How to Unlock That Stashed Foreign Cash http://t.co/qNOnrjyrVD If there are attractive foreign companies 2 buy, would b best use of $$ Mar 25, 2013

Other

Corn Supply Slumps Most Since ?75 on Ethanol Profit http://t.co/ScQ3slOlQ6 Corn supplies may tighten by summer, tough if another bad crop $$ Mar 29, 2013
Business Insider Just Told College Students Their Secrets of Success http://t.co/Yd1jLTzEl3 Sprinter & marathoner, act dumb, ask Qs, etc. $$ Mar 28, 2013
Leaked Photos of Johansson Expose Cloud’s Vulnerabilities to Social Engineering http://t.co/keayvi3iDL Take security seriously $$ Mar 28, 2013
Methadone Deaths Tied to For-Profit Clinics Prompt Bills http://t.co/GHEnOWPGpr They get paid per visit; few incentives 2 act ethically $$ Mar 28, 2013
6 Reasons You Should Have Cyber Liability Insurance http://t.co/LhbASLS9pD U can make your computer invisible 2 the internet in 15 mins $$ Mar 28, 2013
Arms Race to Grow World’s Hottest Pepper Goes Nuclear http://t.co/sYW6fX5bZH I don’t get this; I eat spicy food for taste, not 2b macho $$ Mar 27, 2013
The New US Industrial Renaissance http://t.co/18ni9ClWEF A bit overstated but cheap energy & rising wages in China aid US competitiveness $$ Mar 27, 2013
Falling US Gasoline Demand: A Weaker US Economy? http://t.co/3QRS8G59a2 Gasoline is fairly core 2 consumption, when it goes down, trouble $$ Mar 27, 2013
Case-Shiller: Home Prices Post Biggest Rise Since 2006 http://t.co/nzgY1dSoZs But after the huge drop, it’s really just a dead cat bounce $$ Mar 27, 2013
Wringing Out Laundered Cash http://t.co/Ary4tMyjCF Always easier 2 press a civil suit than a criminal suit; look at the bankers 4 proof $$ Mar 27, 2013
3D-Printed Polymer Skull Implant Used For First Time in US http://t.co/4rRlfPiVGP Offers high degree of customization 4 surgical repairs $$ Mar 26, 2013

Retweets & Replies

The local situation in the US can’t run too far ahead of the world. Too interconnected $$ RT @boes_ America http://t.co/8PaIt3uKR5 Mar 29, 2013
‘ @JaredKastriner As for me, I play banker for my children. I pay 4 tuition & unavoidable costs. They pay avoidable costs& I lend 2 them $$ Mar 29, 2013
@JaredKastriner No, but it should make us consider whether college is needed, and maybe borrowing against the house might b better $$ Mar 29, 2013
‘ @AndreCimini There r many incentives 4 politicians, regulators & businessmen 2 prolong a boom; I worked 4 a firm that foresaw it & made $$ Mar 25, 2013
I hold a CFA Charter, (and was an FSA — dues too expensive) but credentialing is overrated in almost all… http://t.co/kvogKAycVS Mar 28, 2013
Commented on StockTwits: Banks got bailed out after so many bad mortgage & other loans. A few hedge funds properl… http://t.co/4wMpKOQ8Nb Mar 28, 2013
@EddyElfenbein As a Christian, it embarrasses me. They misinterpret Revelation & it makes people think they can gauge when Christ will come Mar 28, 2013
‘ @kyles09 My point is this: in 2007, the last time I saw something like this, it was right before loan pricing fell apart. That’s all. $$ Mar 28, 2013
‘ @Nonrelatedsense I’m wrong, cancel that comment on the $PSX midstream assets. Thanks 4 the correction $$ Mar 28, 2013
Bitcoin $$ RT @groditi: OK, spill it, who’s gonna be the Big Short for BitCoin?. that parabola looks like it’s about to break any second now Mar 27, 2013
RT @SoberLook: Chart: Bitcoin’s unprecedented rally. Another way for Cyprus citizens to take funds out of the country – http://t.co/3cTt … Mar 27, 2013
I like it, thanks $$ RT @adamjbonesjones: @AlephBlog Short Frenchies vs EFSF bonds (over-collateralised, positive carry)…. Mar 27, 2013
Monster, yes. Greatest? No $$ RT @MattZeitlin: Whoever decided that tables and figures go at the end of papers is history’s greatest monster Mar 27, 2013
@Matthew_C_Klein Sometimes they hand out the Nobel Peace Prize 4 what they wish the world could b, hence Obama (drones), EZ (fantasyland) $$ Mar 27, 2013
RT @Matthew_C_Klein: For this they won the Nobel Peace Prize MT @SonyKapoor: EZ has made every country feel that they’ve been hard done by Mar 27, 2013
Patient is dying. More morphine. $$ RT @TheStalwart: RT @CNBC: Fed’s Kocherlakota: “Monetary policy is currently not accommodative enough.” Mar 27, 2013
Controlling system changes it RT @MatthewPhillips @CardiffGarcia:Fantastic NYFed paper financial risk monitoring http://t.co/vwJeUwzXDm $$ Mar 27, 2013
Extra points 4 USSR & Japan parallels RT @prchovanec: Apply these last three quotes (from “This Time is Different”) to China … discuss. Mar 26, 2013
[cute dog warning] I guess you did have to. RT @moorehn: Sorry. I had to. http://t.co/rJtgXqfQtx Mar 26, 2013
‘ @kyles09 Good point, the rule mostly deals with excess cash over and above a low regular dividend $$ Mar 26, 2013
@ToddSullivan I could live with the word “moderate” 🙂 Mar 26, 2013
“Thing about low vol investing is that it is a moderate risk strategy, b/c it invests in stocks?” ? David_Merkel http://t.co/NzG183hkzG $$ Mar 25, 2013

FWIW

My week on twitter: 57 retweets received, 2 new listings, 60 new followers, 57 mentions. Via: http://t.co/cPSEMLXpb8 Mar 28, 2013

Stock Buybacks vs Dividends vs Reinvestment

Posted on 28 March 2013 by David Merkel

This should be short.? Let me start with some facts.

Buybacks are preferred on a taxation basis to dividends.
But buybacks are especially good when the stock is trading below its franchise value, and especially bad the further above franchise value the stock is trading.
Using slack capital to improve operations, or do little tuck-in acquisitions is probably best of all.? Organic growth is usually the best growth, and small acquisitions can facilitate that.? Small acquisitions are usually not expensive.? Be wary of acquisitions to increase scale, they don’t work so well.
Paying a dividend makes management teams more cognizant of the cost of equity capital, which makes them more effective.
In the reinsurance business in Bermuda, companies with slack capital tend to buy back shares below 1.3x book value, and issue special dividends if they are above that level.

Franchise value is management’s best estimate of the value per share of the company’s equity.? If a management team does not have a firm handle on the value of the company, it has no business buying back stock.? Stock should never be bought back over franchise value.? If you want to reward shareholders then, issue a special dividend.

I am reminded of how in 2000 the CFO of The St. Paul cleverly bought back shares in the 20s, wisely bought back shares in the 30s, stupidly bought back shares in the 40s, and foolishly bought back shares in the 50s.? He was a Johnny One Note, except that he impaired the balance sheet so badly that he became the one of the main causes of why The St. Paul sold out to The Travelers.? Price matters with buybacks.

The reinsurance industry is a good example, because well-run reinsurers are simple companies.? The book of business is worth book value.? The reserves are conservative, which is worth ~0.1x book value or so.? Future underwriting profits are worth ~0.2x book value of so.

So the reinsurers have their standard — the companies are worth around 1.3x book value.? That gives them a discipline for capital — buying back at under 1.3x book, and issuing special dividends above that.

It is my opinion that most buybacks are a waste, even with the tax advantages, given that the buybacks occur at prices over franchise value, sometimes significantly over.? It’s also my opinion that a 2% dividend makes management teams think harder about their shareholders, which is a good thing.

If you get to talk to a management team doing buybacks, ask them if they have a model for what their stock should be worth.? If they don’t have one, tell them they should not be doing buybacks, unless they are buying back the stock cheaply.? Above franchise value, buybacks are a value destroyer.

Buffett’s Career in Less Than 1000 Words

Posted on 27 March 201327 March 2013 by David Merkel

This post is at the behest of my friend Tom Brakke of The Research Puzzle.? It is meant to briefly describe how Warren Buffett’s investing changed over the years.

Compounding Capital

The basic idea of Warren Buffett’s investing is simple.? Try to compound your capital at the fastest rate consistent with a margin of safety.? That margin of safety might be a strong balance sheet, or it might be a product with high gross margins that faces little competition.? But compound capital over the long haul.? Do it, whether it is public or private investing.? Do it, regardless of the form of the asset.? Do it, if you have to change in midstream from being an asset manager, to being the manager of an investment-oriented conglomerate.

Those are themes I will explore in this essay, but who can explain Buffett well in less than 1000 words?

Buying Cigar Butts

Ben Graham had a huge influence on Buffett, but Buffett was his own man.? He had made money in many ways prior to working for Graham/Newman — he was a very driven, determined man.? But buying dud companies where the price was far lower than what the net assets were worth was a simple strategy that few followed.? It had great returns from the mid-30s to mid-60s or so.

Why? The Great Depression left the stock market in disarray, and convinced a generation not to touch stocks; they were not able to be analyzed.? So a few enterprising men analyzed and made a lot of money.

After Graham-Newman folded in 1956, Buffett started his own investing partnerships, which he eventually consolidated into one partnership in

But there were limits to this exercise.? Companies were sold for a profit, and the number of companies selling at bargain basement prices shrank dramatically.? Ben Graham folded; Warren Buffett adapted.

End of Buffett Partnership

Buffett ended his investment partnership as opportunities declined, and distributed out the shares to holders around 1969.? After a little delay, he consolidated his holdings under Berkshire Hathaway.? This was a significant move because now Buffett was running a business as an investor.? He had permanent capital, and could use it were he thought best.? Berkshire Hathaway itself was a failing textile producer.? In hindsight Buffett was too kind, and gave it too many chances, it would have been better to shut down the textile company earlier.

Textile Company to Insurance/Conglomerate Holding Company

Buffett discovered insurance early, through GEICO in 1952, and then through Berkshire Hathaway bought insurance companies which became the bedrock of the company, including buying 50% GEICO in 1974 to rescue it.? This would provide the capacity to finance/leverage investment insights.

Influence of Charlie Munger (Growth/Moat)

His friendship with Charlie Munger began in 1959, and he affected the way Buffett thought about investing.? Companies that had protected boundaries, or, sustainable competitive advantages deserved a premium valuation.? That insight began to free Buffett from the Cigar Butts, i. e., dud companies that have no growth potential, only sellout potential.? Such businesses could be bought in whole or in part, but they had to possess a durable advantage.? This would play a role as Buffett wold buy Coke, Capital Cities, American Express, Wells Fargo, and many other high quality businesses.

Willing to work Public or Private, and increasingly Private

Though Buffett was known in the 70s and 80s as a public equity manager inside a public company, he increasingly bought private companies like:

See’s Candies
Fecheimer
Kirby
Nebraska Furniture Mart
Borsheim’s
Scott Fetzer
World Book (no one is perfect)
Buffalo News (who could have predicted the Internet?)

This changed his view of what he was up to, and made him willing to run an abnormal conglomerate, one that would operate on a disaggregated basis.? Buffett would take the free cash flow from controlled companies, and the dividends from partially owned companies an reinvest them in the areas he thought had the most promise.

Scale rules out Arbitrage / Distressed Debt / Small Cap Equities / not Derivatives

Over time, Buffett invested in many ways, doing deal arbitrage, buying distressed debt, and buying small cap companies.? As time went on he had to abandon these for two reasons: he had too much capital to put to work, and competition increased, driving returns down.

Derivatives were different, Buffett was willing to take bets during times of economic stress so long as he did not have to post margin.? He took bullish bets on US Credit and Global Equities.? Much as he criticized derivatives as gambling, he was willing to take an intelligent bet where his downside was limited.

Buying companies with no auction / Tuck-in acquisitions

Buffett became the home for men who wanted to sell their companies, but preserve the culture.? Buffett didn’t pay the highest price, but he did not interfere with the new subsidiaries.

His subsidiary companies would do little tuck-in acquisitions that would further the vitality of BRK, without spending a lot.

Increasing Insurance Scale

And over time, bought all of GEICO, Gen Re, and many other smaller insurers.? Supposedly, at one point, Hank Greenberg said to Buffett, “Call me when you have a real insurance company!”? The two were frenemies for some time.? But today, the show is on the other foot — the largest insurer in the US in BRK.

The increased scale of insurance provided all the more capital to finance Buffett’s asset buys.? The underwriting discipline provided additional profits.

Opportunistic Provider of Capital

During the crisis in 2008-9, Buffett provided capital to well-regarded companies like GE and Goldman Sachs.? He was ready for odd opportunities like Burlington Northern, Lubrizol, and Heinz.

He was also willing to change his view on buying back shares, setting a line in the sand where he would but back shares, rather than doing a dividend.

Conglomerate Manager

Buffett never intended to run a conglomerate, but that is what he did, and did it very well, much like Henry Singleton, who was another compounder.

That’s what he does now.? There it is, in less than 1000 words.

On Stock versus Flow Measures in Valuation

Posted on 26 March 2013 by David Merkel

In valuing companies or indexes, one must look at the earnings or cash flow statements, and the balance sheet.? The former are flow measures, measuring performance over a period, versus the balance sheet which attempts to measure the value of the company on an amortized cost basis (with varying accuracy).

There are advantages to each method.? My view of it is over the short-run, flow measures are the most meaningful.? Over the long-run stock measures are the most meaningful, because over the long run the returns from assets or net worth are more regular than those versus other flow measures.

That is why I focus on longer term valuation measures among short-term valuation measures that are neutral at best at present,? Mean-reversion eventually takes hold.

Most Large Acquisitions Are Errors

Posted on 23 March 201324 March 2013 by David Merkel

Hubris:? “We can do it better than [the target company].? With additional scale, we will be able to gain operating efficiencies and marketing opportunities. We will be a big company in our industry, and we will control our own destiny.”

So some CEOs think.? It is easy to propose a large merger, wave your hands at the details, and the deal takes on a life of its own.? But large deals:

Attract competition.? If a large piece of market share is up for grabs, many will try to grab it.? Premiums to get a large deal are often uneconomic, akin to the guy who shows of a jar of nickels? in a crowded room, and invites people to bid for it.? He never clears less than a 20% profit on the jar.
Have to meld two different cultures.? This is not trivial.
Have to meld two different information technology departments.? Also not trivial.
Have synergies and cost savings that are often overestimated.
Face greater scrutiny from the government, which slows things down, and results in greater restrictions on the combined enterprise.
Have a CEO that will be severed, and he will require handsome compensation to go. Sadly, the remaining CEO will get a pay boost, after all, he is running a bigger company.
Run into the problem of Too Big To Manage.? This may not apply to large energy companies, because they are relatively simple, but with most other companies with market caps over $100 billion, performance deteriorates.? It is difficult to keep incentives sharp for employees and managers.
Have a buyer who may not appreciate some strengths of the target company.? In two insurance acquisitions, I saw the acquirer throw away valuable divisions that they could not understand, firing people more talented than the acquirer was.? At least they should have sold the division to someone else.
Generates goodwill, which makes the company harder to analyze, an lowering its valuation versus book.

That’s why I don’t buy companies that do scale acquisitions.? They tend to flounder and lose money.

But I do buy companies that do tuck-in acquisitions.? Tuck-in acquisitions are buying a little company that adds:

A new technology
A new marketing channel
A new product or service

Which is complementary to their existing business, and they will grow it organically.? With a tuck-in, the competition is less, integration issues are less, almost every difficulty versus large acquisitions are less.? Prices are low.

One use of free cash flow is acquisitions.? Companies that focus on small acquisitions and organic growth use free cash flow wisely.? Large acquisitions overpay to buy a trophy asset that the acquirer may unintentionally destroy.? Avoid such acquisitive companies.? The company? may grow, but the stock price likely will not.

A Bond Deal Requiring Caution, Completed

Posted on 23 March 201329 August 2013 by David Merkel

A friend of mine told me the price talk for the Fidelity?& Guaranty Life Holdings, Inc. bonds was 6.5%, but yield lust must have prevailed, because the coupon was 6.375% when the deal closed.? Almost all corporate bonds are priced at a slight discount, so the actual deal yield may have been higher.

So much for my warning.? Anyway, here is the press release:

Harbinger Group Inc. Announces Pricing of Fidelity & Guaranty Life Holdings, Inc.?s $300 Million Senior Notes

NEW YORK–(BUSINESS WIRE)– Harbinger Group Inc. (?HGI?; NYSE: HRG), announced today that its wholly-owned subsidiary, Fidelity?& Guaranty Life Holdings, Inc. (?FGL?), priced an offering of $300.0 million aggregate principal amount of its 6.375% senior notes due 2021. The notes were priced at par with a coupon of 6.375%. The notes will mature on April 1, 2021. The offering is expected to close on or about March?27, 2013. FGL expects to use the net proceeds from the issuance of the notes for general corporate purposes, to support the growth of its subsidiary life insurance company and to pay a dividend to HGI.

The notes were offered to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the ?Securities Act?) and to persons outside the United States under Regulation S of the Securities Act.

I got one thing wrong in my initial piece, domestic retail investors could not buy it — it was a 144A deal.? That said, if it has registration rights, it could be resold to retail in the future.

If anyone buying the bonds is reading me, let me suggest a swap for you, while the market is still liquid.? Sell this bond and swap it for the recently issued subordinated bonds of The Hanover Insurance Group.

The Hanover Insurance Group, Inc. (THG) announced that it has priced a registered offering of $175 million of subordinated debentures due March 30, 2053 with a coupon of 6.35%, and redeemable in whole or in part after March 30, 2018 at a redemption price equal to their principal amount. ?The debentures are also redeemable in whole, and not in part, before March 30, 2018 in case of specified changes in the tax or rating agency treatment of the debentures. The Hanover plans to use the net proceeds from this offering for general corporate and working capital purposes, which may include repurchases of its common stock.

The yields are almost the same but the risks are far lower on The Hanover Insurance Group’s subordinated debt.? There is no complexity here.? The structure is simple.? It’s a short duration P&C company that has not lost money for the last seven years.? FGLHI may be improved from the past, but it had a really bad past.? Improvement might not be enough for FGLHI.

Risk Summary: Sell complexity, buy simplicity.? Pick up rating. Add duration, drop convexity. Take on the risks of a smaller deal.

I would do this trade in a heartbeat.? It’s not perfect, but I prefer simpler bonds to more complex bonds, unless I am one of the few that understands the complexity.

Full disclosure: I am long the common stock of THG