Value Investing – Page 45

Little Things are Important

Posted on 22 May 2012 by David Merkel

One of the problems with many politicians, journalists, financial analysts, economists, etc., is that they don’t think systematically.? Go back to late 2006, when I wrote my piece Wrecking Ball Looms for Big Housing Spec, which was regarding the coming subprime crisis.? (Note: my editor often retitled my pieces; my original title was more circumspect.)? Or read my piece in mid-2005 regarding the impending unwind of leverage and prices in residential real estate, Real Estate?s Top Looms.? Both of those are inside the wall at RealMoney.? Apologies if you can’t read them.

At the beginning of the crisis, most economists, including the present Fed Chairman, said that problems ere limited, because they only affected limited areas of the residential real estate market.? Now, part of that response reveals that the Fed and other regulators beneath them had not been doing their jobs, because it is well-known now that underwriting quality of all residential mortgage lending had deteriorated.

When an economic system is overleveraged, with leverage that is layered, such that a domino effect can occur, small failures can have disproportionate results.? It is almost like the economic system during the bull phase self-organizes for the largest possible failure.? (Note: self-organizing systems do not always optimize for the long term.? Think: what other ideas could that invalidate?)

An overlevered residential real estate system had the possibility of a self-reinforcing decline in prices, once prices started declining nationally.? Now we face a still-overlevered residential real estate sector with a lot of the market inverted, where people owe more than the house is worth, though pockets on the low end of prices show recovery in some areas of the US.

Little things are important.? Some people say, “How can Greece pose so much risk to the rest of Europe?? It’s economy is so small relative to the rest of Europe.? Well, that’s where the leverage comes in again.

Core Eurozone banks have lent to Greek entities, and those banks are not well-capitalized.? If Greece left the Eurozone, and repaid loans in depreciated New Drachma, it would lead to a crisis in confidence regarding loans made to Spain, Portugal, and Italy.? The exposure of core Eurozone banks is significant, to the point where it could cause a broader crisis.

Little things are important where the system has been optimized; where something near perfection is needed to insure the proper performance of the over-evolved system where many entities are playing for a slice of the cash flow, and most have over-borrowed, and overpaid.

The optimized scenario is akin to the dominoes being set up, and they are beautiful, but woe betide the one who knocks over a domino.? (Note: as a kid, I would build domino structures, but would leave out every tenth domino, in order to create something where if I made a mistake, only a little would fall down.? The last dominoes were added with the greatest care.)

There are some worries in the US over European exposure.? I don’t think that is likely, except with some of the biggest banks.? Maybe that could spill over, but I doubt it.? If it does spill over, it will prove that the biggest banks should be broken up.? My favored way is to regulate banks like insurers.? You can do business across state lines, but you are tightly regulated by your state.? Much better than what we have currently.

Survivable systems exist when adequate returns are earned without high leverage.? That may sound vague, but vague is often the best we can do in economics.

When debts are complex, aim for simplicity.? Complex systems tend to die.? Simple systems survive.? This is a rule of value investing, measure simplicity versus reward.? Complexity has a price; avoid it unless well compensated for it.

Book Review: The Alpha Masters

Posted on 21 May 201221 May 2012 by David Merkel

This book has just been released.? I got an early copy.? The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?? This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.?? Have you been through anything similar to that?? If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.? Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.? They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.? What are they like?

Among their many attributes, they are:

Driven/competitive — though I have known my share of failures in investing that have that attribute.
Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
Patient — if opportunities are not promising, don’t do much.? It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.? Study what could go wrong, and see if there is a way to take advantage of the situation.
Team-builders — They develop talented teams/cultures and motivate them to excellence.
Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

Ray Dalio — Bridgewater
Pierre LaGrange & Tim Wong — MAN Group / AHL
John Paulson — Paulson & Co.
Marc Lasry and Sonia Gardner — Avenue Capital Group
David Tepper — Appaloosa Management
William A. Ackman — Pershing Square Capital Management
Daniel Loeb — Third Point
James Chanos — Kynikos Associates LP
Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.? That’s how she gained the contacts in order to write the book.? Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”? That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).? The former is an accomplished investor, but is not an expert on hedge funds.? Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.? If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Simple Stock Valuation

Posted on 12 May 201213 May 2012 by David Merkel

I appreciate Eddy Elfenbein.? He comes up with ideas that make me say, “Huh. Interesting.? Let’s test that.”? His recent article, World?s Simplest Stock Valuation Measure, put forth the idea that:

Growth Rate/2 + 8 = PE Ratio

Cool, reminds me of my 1993 formula for value investing:

Price per share < Tangible Book per share + 5 * EPS

Eddy’s idea is that you can buy a company that isn’t growing or shrinking earnings at a PE of 8, or alternatively, a E/P (earnings yield) of 12.5%.? In a weird environment like this, it means an earnings yield that is more than 9% over the long bond is a good purchase.? I like that idea, it offers a good reward for taking risk.

But as the growth rate rises, you can expand the PE multiple by half of the anticipated growth rate.? So, a company anticipated to grow at a 10% rate would warrant a PE multiple of 13, a 20% rate 18, etc.? I like his formula, because it is conservative.? It seeks growth at a reasonable price.? It will not overpay for high growth rates.

But now let’s test this statistically to see what validity it presently has.? I ran a regression on Current year expected PEs versus expected 3-5 year growth rates.? I excluded all companies with fewer than two analysts putting forth growth estimates.? Here were the results:

SUMMARY ?OUTPUT

Regression Statistics
Multiple R	0.15
R Square	0.0224
Adjusted R Square	0.0218
Standard Error	39.70
Observations	1,589

ANOVA
?	Df	SS	MS	F	Significance F
Regression	1	57,333	57,332.91	36.38	0.000000002
Residual	1,587	2,500,838	1,575.83
Total	1,588	2,558,170

?		Standard Error	t Stat	P-value	Lower 95%	Upper 95%	Eddy	T-test
Intercept	11.87	1.88	6.33	0.0000000003	8.19	15.55	8.00	2.06
eps_eg5	0.69	0.11	6.03	0.0000000020	0.47	0.91	0.50	1.66

Significant results statistically, but what a low R-squared.? Just shows us all how complex the market really is.? Look at this graph to see it as it is:

There really doesn?t seem to be much of a relationship.? But Eddy?s formula is conservative versus the estimates.? His formula invests in no-growth? companies ?at an earnings yield of 12.5%, the market does so at an earnings yield of 8.4%.? His formula increases the PE multiple at a 50% rate as earnings increases, but the market does so at a 69% rate.

Good for Eddy, and any that follow him.? His method builds in a margin of safety, which is a key to all good investing.

Before I close I would like to offer the 20 most mispriced companies, both positively and negatively.? Just be aware that the markets are complex, and this valuation method is simple, and most likely wrong? but it can provide a jumping-off point for due diligence.

Potential Buys

company	ticker	eps_eg5	PE
Seagate Technology PLC	STX	37.94	4.3
US Airways Group, Inc.	LCC	38.5	4.9
China Xiniya Fashion Ltd (ADR)	XNY	12	2.6
Exide Technologies	XIDE	15	3.4
HollyFrontier Corp	HFC	31.19	5.3
First Solar, Inc.	FSLR	20	4.2
Xerium Technologies, Inc.	XRM	20	4.3
YPF SA? (ADR)	YPF	13.69	3.9
Newmont Mining Corporation	NEM	54.68	9.6
Western Digital Corp.	WDC	20.84	5.1
Gulfport Energy Corporation	GPOR	48	9.1
Delta Air Lines, Inc.	DAL	17.25	4.9
KKR & Co. L.P.	KKR	22.43	5.7
Dana Holding Corporation	DAN	31.56	7.1
Perfect World Co., Ltd. (ADR)	PWRD	9.78	4
Marathon Petroleum Corp	MPC	25.16	6.3
Stoneridge, Inc.	SRI	35.2	7.8
GT Advanced Technologies Inc	GTAT	11	4.2
Telecom Argentina S.A. (ADR)	TEO	11.3	4.3
SUPERVALU INC.	SVU	11.1	4.3

Potential Sells

Company	Ticker	eps_eg5	PE
Rubicon Technology, Inc.	RBCN	15	125.6
NetSuite Inc.	N	34.79	204.1
Amazon.com, Inc.	AMZN	30.02	190.6
Clear Channel Outdoor Holdings	CCO	24.04	175.5
Servicesource International In	SREV	27	192.1
Wright Medical Group, Inc.	WMGI	9.43	117.1
Lamar Advertising Co	LAMR	4	96.8
Cogent Communications Group, I	CCOI	17	170.5
Shutterfly, Inc.	SFLY	18.75	182.6
Lattice Semiconductor	LSCC	11.5	165.3
Conceptus, Inc.	CPTS	17.5	201.6
Cepheid	CPHD	20	225
Black Diamond Inc	BDE	2.33	146.9
Quidel Corporation	QDEL	17.5	421.5
WebMD Health Corp.	WBMD	15	485.1
SL Green Realty Corp	SLG	-3.09	230.2
Diana Shipping Inc.	DSX	-16.62	11.4
Netflix, Inc.	NFLX	16.96	803.8
Citi Trends, Inc.	CTRN	10.67	942.7
Weatherford International Ltd	WFT	-30.72	11.4

That’s all for now.

Book Review: The Little Book of Emerging Markets

Posted on 11 May 201211 May 2012 by David Merkel

This book is written by one of the foremost stock investors in emerging markets, Mark Mobius.? This is a short book that has little to no math in it, and few graphs.? It can be read in 2-3 hours.

The edge that this book will give you is understanding the limitations of emerging market investing.? What are those limitations?

1) Emerging markets are volatile, and dependent on the overall health of the developed economies.? Companies in emerging markets often export to the developed nations.? Emerging market governments often gear their monetary policy to aid their exporters, which forces them to absorb the loose or tight monetary policy of the developed nations.

2) Emerging markets often lack legal safeguards on property rights that developed markets take for granted.? Remember that there is a difference between “rule of law” (governments are subject to a constitution), and “rule by law.” (governments make laws to enforce their will on everyone else)

3) Accounting methods may be less well-developed.? Typically this leads to valuation discounts, until the accounting is deemed as trustworthy as in the developed nations.

4) Corporate governance can be weak, with insiders getting significantly more benefits than shareholders.? Getting to know whether the board & management are honest, and acting for the good of all is critical.

5) Frontier emerging markets offer a lot of potential for profit, but they have all of the above problems, and much larger.? When there are few foreign investors in a market, safeguards are few.? Ask who registers the shares, and you may find that no one does, or the company does, so how can you prove you are the owner.

6) As a result, one must insist on a large margin of safety when investing in emerging markets.? That involves a good balance sheet, cheap valuation, and growth potential.

7) Emerging market investing is a hybrid — look at the country, the industry, and the company itself.? To buy, you have to have some confidence in most/all of them.

8) Opportunities are often best after a large pullback in the nation’s stock index.? Buy the strongest most liquid names after a crisis.? They will come back.

9) Privatizations are often good opportunities to buy; the company will do much better once there is a profit motive.

10) Banks are mirrors of the local economy; they lead the market down and up.? Anything affecting the economy in specific affects the banks, because usually bond markets are not active.

11) To be long emerging market stocks, you have to be an optimist.? It is similar to being a high-yield bond manager.? Investment grade bond managers are paid to be pessimists; there is little to no upside.? High yield managers have some upside that they play for; they are always more optimistic.? So it is for emerging market stock managers — there is a lot of upside to play for , so they have to be optimists.

12) As such, investing in emerging markets takes a lot of work to do it well.? And if you read the book, you might think by the end that you don’t have enough information to do it on your own, and I think you would be right.

Think for a moment about all of the scandals over Chinese reverse mergers with US shell companies — and these are listed in the US!? What hope does a US investor have of investing in emerging markets at a distance?? Accounting differences, disclosure differences, legal rights can be different… it could be a full time job.

This is why you need a manager of an open-end or closed-end mutual fund, or at least an exchange-traded fund [ETF] to invest in.? Mark Mobius explains how difficult it is to do it yourself, without saying that bluntly to you as I am doing.? Personally, I would encourage investing in a broad fund that can go anywhere, and not a country-specific fund, unless you have a very strong view of why a particular market will do well.

I recommend this book so that you can learn, but I think at the end, you won’t do much with it, except buy a mutual fund or an ETF.

Quibbles

This is a “little book.”? As such, you only get a taste.? If you want a full meal from Mr. Mobius, you might get this book: Passport to Profits: Why the Next Investment Windfalls Will be Found Abroad and How to Grab Your Share.

Who would benefit from this book:People who want an introduction to emerging market investing, including the market cycles would benefit from this book.? If you want to, you can buy the book here: The Little Book of Emerging Markets: How To Make Money in the Worlds Fastest Growing Markets (Little Books. Big Profits).

Full disclosure: This book was sent to me without my asking for it.

The Best of the Aleph Blog, Part 15

Posted on 10 May 201220 June 2017 by David Merkel

This stretches from August 2010 to October 2010:

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.? I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.? Also, how to make money in the bond market when you reach the risk limits. 😉

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.? Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.?? Also, the end of my time as a bond manager, and the parties that came as a result.?? Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.? Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Portfolio Rule Eight

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

The Portfolio Rules Work Together

How the portfolio rules work together to create a “margin of safety.”

The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

The Rules, Part XIX

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

?The Rules, Part XX

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

?Managing Illiquid Assets

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don?t trade often.

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

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That’s all for now.? Never thought I would do so many long series when I started blogging.

Book Review: The Little Book of Bull’s Eye Investing

Posted on 9 May 2012 by David Merkel

Before I start this evening, if you like my reviews generally, please go to Amazon and tell them that my reviews are helpful.? From this link, it does not take long to do so.? Thanks.

This was one of those books that grew on me.? The author, the well-known John Mauldin, strings together a bunch of ideas originated by others.? That’s not much different than what Tadas Viskanta does at Abnormal Returns.? He brings us the best ideas that he has culled from others.? That is a significant piece of work that should not be denigrated by others.

The beginning of the the book is consumed with 12-20 year market cycles.? There are times when investing in risky assets where you face headwinds and tailwinds. The headwinds and tailwinds are driven by valuation, often expressed through Q-ratio, CAPE, or Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).? It’s a Price-to-Adjusted Book value ratio as I see it.

Regardless of the method, if you buy in at high valuations, the wind is in your face, and you are not likely to earn much.? The opposite is true for low valuations, but at the valuation trough, everyone is disgusted, and few are willing to buy.

So it takes a strong stomach and mind to follow a method like this.? Strong stomach, because when it is time to buy one will fear that the money will be lost.? Strong mind, because near valuation peaks people will tell you that you are nuts to leave the party — it’s just getting started.

But what if a decent sized portion of institutional money did this?? The cycles would go away, or be muted.? That’s not likely to happen in my opinion: some men may change, but you can’t change mankind.? Emotions of fear and greed dominate over clear thinking.

The book touches on many other topics:

Why strategies go in and out of favor
Why to be skeptical of those who give investment advice (including Mauldin & me)
That the growth rate of the economy eventually limits the growth rate of any company.
The effect of demographics on the markets
Why chasing performance doesn’t work.
Why most newsletter writers strategies could never be as good as they state, or they manage money in tiny niches.
How to detect value in stocks.
How to use bonds and commodities in asset allocation.

I say “touches on” because in line with its title, it is a “little book.”? You are only getting a taste of what an intelligent investor who hires other managers to manage money for clients thinks.? This is especially true as you go through the section on value investing, which does not get much beyond dividend yield, dividend growth, and price-to-book (common equity).

As such, this book will not be a complete answer to any investor wanting to learn about the markets.? It introduces basic concepts in ways that most ordinary people could learn.? Reading time should be less than two hours.? One more thing, the book has very little in the way of math.

I appreciated the short summaries at the end of each chapter.? If someone wanted to get the gist of the book, they could read all of the short summaries in about 10 minutes, and then they would have the skeletal ideas of the book, allowing them to read all or part of the book with greater understanding.

Quibbles

The book could have used an index.

Who would benefit from this book:People who want an introduction to investing, including long-term market cycles would benefit from this book.? It would be of modest help to experienced investors who understand market cycles.? If you want to, you can buy the book here: The Little Book of Bull’s Eye Investing: Finding Value, Generating Absolute Returns, and Controlling Risk in Turbulent Markets (Little Books. Big Profits).

Full disclosure: This book was sent to me without my asking for it.

Buffett Musings

Posted on 7 May 20128 May 2012 by David Merkel

Buffett made a few comments over the weekend that I thought were significant.

Warren Buffett, who built Berkshire Hathaway Inc. (BRK/A) with stock picks before focusing on takeovers, said he recently opted against a $22 billion acquisition because he didn?t want to sell investments in marketable securities. (Article here)

and

Berkshire Hathaway Inc is adding to its shareholdings of two U.S. companies amid a market dip, billionaire investor Warren Buffett said on Monday. (Article here)

and

Mr. Buffett said he and Mr. Munger ?have nothing against? commercial insurance and pointed out that they?ve expanded in the medical malpractice field. ?If we could find a quality company in commercial lines? we would buy it in an instant,? he said.

…

Another analyst question prompted Buffett to discuss how he values Berkshire?s non-insurance operations. Rubalcava was excited by the answer, in which Buffett said he?d look to buy similar businesses for nine to 10 times earnings. (Article here)

1) On the first point, he does not want to sell marketable securities is quite a statement.? It means he expects more return off of public securities than whatever the target might have been.?? Given that he would only be liquidating $5 billion of securities to maintain the $20 billion buffer, it either could not have been that good of a deal, or Buffett has a high view of his current public securities portfolio.

But I sat down and thought about what Buffett might have wanted to acquire.? It could have been a private company; I have no data on that.? What if it were a public company and one with a low P/E and decent prospects, what could it be?

Well, the current market cap would have to be between $15-20 Billion, and so I came up with the following tickers:

PPG APD NOC RTN VFC BRFS PSX DFS AON ALL CME TMO BDX RCI TU PSO RUK WM ETN AEP

There are some with large moats: PPG, APD, NOC, RTN (Chemcials and Defense) AON, CME unique businesses, hard to challenge.? Other moats: VFC, TMO, BDX, RCI, TU, PSO, RUK, WM, ETN

Pipelines, which fit into other BRK subs: PSX

Free cash flow generators: PSX and DFS

Cheap providers of float: ALL? (Of course there would be issues merging Allstate and GEICO, if you merge them at all.? You could keep both systems whole, you could sell off Allstate’s Life companies, or you could merge them into existing BRK insurance subs.? Me?? I would sell the life subs,? and analyze whether having an agency force had value.? My guess would be no, and I would spread the Allstate inforce block onto the current GEICO support system after a year or two.)

Adds to the utility portfolio: AEP

I’m not saying BRK should buy any of these companies, but they seem to be reasonable possibilities for BRK to buy.

2) So BRK is buying two companies that they already own.? What could they be?? My two best guesses are General Dynamics [GD] and DirectTV [DTV].?? BRK bought them in the last reported quarter and the price hasn’t moved much.? Other possibilities include: WFC, SNY BK, INTC, USB, CVS, IBM, DVA, V, VRSK, and LMCA.

3) If BRK really wants to get into commercial insurance at a cheap price there is an easy choice — ACE.? Low P/E, P/B, reasonable reserving.? Yes, it is in Bermuda, but that offers BRK other ways to lower its tax bill, which Warren Buffett aggressively pursues.? He never pays a dime more than he has to!

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These are just my musings, don’t give them more emphasis than that.? Buffett offers a few crumbs at his buffet, and I make an effort to offer ideas consistent with what little he said.? I am very likely to be wrong, but I like a lot of the ideas here.

Full disclosure: long AEP, PSX & INTC for myself and clients

Sorted Weekly Tweets

Posted on 5 May 2012 by David Merkel

Market Dynamics

On Paradigm Shifts http://t.co/h68quEDX Hunter takes us through mental exercises 2 make us intelligently contrarian. “Invert, Always Invert” May 02, 2012
Hedgers’ net short position vanishes in US oil http://t.co/X0hLOWGB Commercial interests do not fear lower prices, could be bullish 4 crude May 02, 2012
There’s Plenty of Money for Junk http://t.co/vXML0Bao Presently the credit cycle is virtuous; vicious part is coming, but no appt set $$ May 02, 2012
Bad Models Mistook Housing Bust for Dot-Com Bubble http://t.co/IxC8m2mk Busts of assets that are heavily levered harder than unlevered $$ May 02, 2012
Best U.S. Real Estate With Self-Storage http://t.co/mxyHdK2U Self storage a winner in the past, may not do so well in the future; hi vals May 02, 2012
Marginal oil production costs are heading towards $100/barrel http://t.co/G2zNB5JS Same as my reasoning on high crude prices $$ May 02, 2012
Four-percent rule a relic, advisers say http://t.co/PrdHQy48 Better rule: 10y Tsy yield plus 0% if bearish, 1% if neutral, 2% if bullish $$ May 01, 2012
The remarkable resurgence in synthetic credit tranches http://t.co/1iIZ8ous Increases in the notional amounts of several corp bond swaps May 01, 2012
Contra: Black Scholes & the formula of doom http://t.co/flVNsYMx Debt levels & Asset-Liab mismatch largest causes of crisis not BS model Apr 30, 2012
Energy’s Pain is Consumer Discretionary’s Gain http://t.co/lM7UW0T7 I have been on the wrong side of this trade. Sigh. $$ Apr 30, 2012
Notes from the DoubleLine Lunch with Jeffrey Gundlach, Spring 2012 http://t.co/KDiqA5Sp Gives a good overview, w/a large topping of snark $$ Apr 30, 2012

China

China’s Auditing Train Wreck http://t.co/UeIZtw06 Any Chinese firm listed in the US, the auditors should be subject to SEC scrutiny. $$ May 05, 2012
China bear Pettis says world coming around to his view http://t.co/lo1nGc7e Pettis isn’t a bear but a realist; invt-led growth overplayd $$ May 04, 2012
The Family and Corruption http://t.co/R4NwZ6od Family ties & group affiliation dominate economic/political power among Chinese Communists $$ May 04, 2012
Who is Fu? Chinese exile is ‘God’s double agent’ http://t.co/plyQhwtg Story of a Chinese Pastor in US & escape of Chen Guangcheng $$ May 02, 2012
Microblogs Survive Real-Name Rules?So Far http://t.co/5UItJjwj Even the CCP would have a hard time shutting down their Twitter-apps $$ May 02, 2012
Beijing?s secret: It?s not really loosening http://t.co/3RPhAOwH There is not enough demand in China 2 pay all of the high prices. $$ May 02, 2012
China’s Left Behind Children http://t.co/OL0gmSFE Economic growth that separates parents from children imposes significant costs on China $$ May 02, 2012
China Closes Unirule Website http://t.co/ItkW0p0A Founder receives award from Cato Institute; China government shuts down his website $$ May 02, 2012
China?s property boom has peaked, forever http://t.co/aLC2U8F8 Amount of deadweight in China property is so large that prices have peaked $$ Apr 29, 2012

Financial Services

Caution: Contents May Be Hot http://t.co/cp9yjbH3 I worry about ETF slippage from bad creation/redemption unit design & bad trading by users May 04, 2012
Well, That Was Awkward? http://t.co/zS5f6zAI Bank Chiefs’ Regulatory Concerns Met With Official Silence; maybe regulators getting fed up May 04, 2012
A talent shortage looms as the industry booms http://t.co/QGLZzzg7 Financial planners getting old/retiring faster than the Baby Boomers $$ May 04, 2012
2nd attempt2 automate bond trading 1st failed RT @BloombergNews: Goldman preps trading system for corporate bonds | http://t.co/NceasmN7 May 04, 2012
Mortgage Rates in US for 30-Year Loans Fall to Record Low http://t.co/LPolAP5Q Mtge rates b nimble, MR b quick, MR go under limbo stick $$ May 04, 2012
Spending A Year On An M&A Bidding War Is Apparently Overrated http://t.co/tKguPYGy It’s well-known that scale acquirers underperform $$ May 04, 2012
Every liability has an asset, but not every asset has a liability. Some are owned outright. http://t.co/fB3ARju7 May 03, 2012
Canadians Dominate World?s 10 Strongest Banks http://t.co/qj6TOgA3 Ask again after their housing bubble pops, same 4 other fringe nations May 03, 2012
Pimco’s latest ETF shields against price spikes http://t.co/TmOrCIj2 I wonder if active ETFs will have more performance slippage. $$ May 02, 2012
Hedge Funds Hurt by Volatility http://t.co/ogoL62qT Hedge funds r vehicles that do better when credit spreads r tightening $$ May 01, 2012
Bond Market Is Creating A New Galaxy for Trading http://t.co/YgvNwz1j Dealer inventories thin; trading costs rise; electronic mkts start May 01, 2012
US banks still cutting commercial real estate exposure http://t.co/qsqIMRph Banks still rotating out @ an almost constant rate since 2009 $$ Apr 30, 2012
Largest U.S. Banks Resist Federal Reserve?s Credit Limits http://t.co/JndcrvWI Big banks need 2b broken up or shrunk; they don’t accept it Apr 29, 2012

US Fiscal/Regulatory Policy

CEOs rank Texas tops for business, California worst http://t.co/jWEIGP89 8th year in a row for this survey; high taxes/regs annoy CEOs $$ May 04, 2012
Exposing the Medicare Double Count http://t.co/HIVIx3lJ Same $$ being spent twice, must borrow the difference. May 02, 2012
Coburn: `We Ought to Totally Revamp Our Tax Code’ http://t.co/71WquMIf Very similar to my proposals; simplify code eliminate deductions $$ May 02, 2012
U.S. Considers Notes That Float http://t.co/jynXGcYG Intermediate-dated Tsy floaters would trade above par, neg yields like TIPS $$ May 01, 2012
Trying to Shed Student Debt http://t.co/0GmvckOn Lawmakers Rethink Bankruptcy-Law Ban on Walking Away From Education Loans $$ #slavery Apr 30, 2012
Can the US Economy Recover Without a Housing Recovery? http://t.co/Tqy4l8J3 It will probably have to try w/o housing’s assistance $$ Apr 30, 2012
Central Bank paper suggests house prices have ?over-corrected? http://t.co/KDrXCkzy Have Irish housing prices overshot? Tough 2 say. $$ Apr 30, 2012
http://t.co/KbnUO93s Treasury floaters could b issued @ premium 2 par 2 inflation speculators allowing the Tsy 2 finance @ negative rates Apr 30, 2012
U.S. Perfecting Formula for Budget Failure, Says Bowles http://t.co/vlLQzZ8q It’s nice 2b a part of a nation that is a global leader 😉 $$ Apr 30, 2012
Will TARP Make a Profit? That’s the Wrong Question http://t.co/MZBHaO51 Conflicting govt goals make policy hard 2 implement & interpret $$ Apr 30, 2012
You will buy more Govvies, or else http://t.co/DLrnyb9u Financial Repression, Quantitative Easing, Debt Monetization, Hyperinflation $$ Apr 30, 2012
On Student Loans, Accounting Gimmicks, Electric Cars, FX and a note on SS http://t.co/2BCB9nAi Hodgepodge of insight from @brucekrasting $$ Apr 30, 2012
?The Treasury should be issuing 100 year or perpetual bonds until the market can?t stand it anymore to lock in these ? http://t.co/gXMUXW4C Apr 30, 2012
The floating YTMs will probably be negative, as interest rate speculators will pay more than par for the floating rat? http://t.co/OSmE7QuJ Apr 30, 2012

Eurozone

The euro crisis just got a whole lot worse http://t.co/XSqmQnGv Election of Hollande may lead2 Euozone policy paralysis; growth v austerity May 04, 2012
Making eurozonians, or not http://t.co/JmuO5OXC The Eurozone was never a natural place to set up a shared currency. $$ May 04, 2012
Madness in Spain Lingers as Ireland Chases Recovery http://t.co/BXdYSX5e Ireland may b rebounding, as Spain’s slump deepens #austerity $$ May 02, 2012
Why the New York Times?s Paul Krugman is clueless about the European economic crisis http://t.co/xMuzZXC7 Aside frm Ireland no austerity yet May 02, 2012
Core infection and eurozone PMIs http://t.co/xr97yPgD Core of the EZone sluggish @ a time when it can least afford it $$ #depressionary May 02, 2012
ECB Measures Pushing Domestic Bonds Into Domestic Banks, Planting Seeds for Euro Disintegration http://t.co/HAITJJnX Yeh, this da future $$ May 02, 2012
The rise in the Eurozone money supply has not improved credit conditions http://t.co/rYazqcuP Euro M3 diverges from bank loans $$ May 01, 2012
The ECB lending to periphery governments via “backdoor SMP” http://t.co/uQeG2QQK How to stuff the ECB full of Eurofringe debt, c/o LTRO $$ May 01, 2012

Rest of the World

Brazil: cutting at any cost? http://t.co/mh3vN1Te Pushes up asset & price inflation, as currency held down 2aid exporters; unsustainable $$ May 04, 2012
Turkey Credit Rating Outlook Cut by S&P on Worsening Trade http://t.co/pFDzEhZl Wide current account def & hi external financing needs $$ May 02, 2012
Once poster child of crisis, Iceland recovers http://t.co/Sgr2wTGl Letting banks fail & stiffing foreign creditors -> winning solution $$ May 02, 2012
Which emerging economies are at greatest risk of overheating? http://t.co/olHdiYRE A gauge from the Economist on which Em Mkts r2 hot $$ Apr 29, 2012

Company News

Buffett?s CTB Adds Chicken Eviscerators in Dutch Purchase http://t.co/K6Q3NGt2 Buffett’s firm is no chicken; it has a lot of guts! 😉 $$ May 04, 2012
Sorry, really sorry… May 04, 2012
Ackman Rejects Canadian Pacific Deal Ruling Out CEO Pick http://t.co/KYe970NJ Pick is former CEO of $CP rival $CNI – Bad blood; good CEO May 02, 2012
Impressive work Mr. Einhorn. The analyst that wrote up the question deserves praise; if you did that… http://t.co/tSTWxqBa May 01, 2012
Phillips 66 aims to run more shale oil http://t.co/tC7NBfLO LD: + $COP $PSX First day of trading for the new $PSX. Combo up 2%+ so far $$ May 01, 2012
Value investing does not mean cheap. It means margin of safety. Cemex does not have that. Look at the debt. $CX $$ http://t.co/ydklVkth May 01, 2012
Falcone Agrees To Step Aside http://t.co/bYgLxMMV “a final agreement may not be reached, and a bankruptcy filing was still possible” $$ Apr 30, 2012
Delta to buy US refinery for $150 million http://t.co/IsK9xsDu If zero is dumb & 100 is very dumb, this one scores in the 90s. $$ Apr 30, 2012
Discuss “At $1.7 billion, Nook is worth more than Barnes http://t.co/xOz6skwP Spin off Nook 2 create value $$ $BKS $AMZN #interneteatsbooks Apr 30, 2012
@ampressman Would it have been value-enhancing to $BKS 2 sell the whole Nook unit 2 $MSFT, in your opinion? $$ Apr 30, 2012

Statistical Analysis

trading-and-the-null-hypothesis http://t.co/QpYutOTb Problem:No academic journal wants2 publish studies with ‘no result’ as their conclusion May 04, 2012
. @thenumb47 Allows for too much of a specification search; would be good to require disclosure of everything tried but not published $$ May 03, 2012
Have to allow for accidents! RT @incakolanews: just scrub the word “validate” and I think you have a great idea May 03, 2012
Thus my proposal for economists: come up w/research idea: goes 2a database. Randomly assigned economist will analyze & trash/validate it $$ May 03, 2012
Unlike double-blind studies, raw statistical research allows health analysts to inject their own bias into the analysis, as economists do $$ May 03, 2012
Analytical Trend Troubles Scientists http://t.co/bzcAIpHG Health researchers using statistics like economists find ambiguous results $$ May 03, 2012

Miscellaneous

14 Lessons From Benjamin Franklin About Getting What You Want In Life http://t.co/BWAjCz1l Advice from 1 of the wealthiest men of America $$ May 04, 2012
Is Wall Street Meeting God’s Expectations? http://t.co/5H5j2QGG Many Christians misuse the Bible; almost all non-Christians misuse it $$ May 03, 2012
What would Jesus trade? http://t.co/Dkrfwt9k Many Christians misuse the Bible; almost all non-Christians misuse it; another example $$ May 03, 2012
And in a more honest way than Google RT @SconsetCapital: Long good, short evil. May 03, 2012
Apparel-Swapping Millennials Eschew Stores and Malls http://t.co/B7jq2dcY “Is that a new outfit?” “Well, it’s new to me!” An odd trend $$ May 03, 2012
@TheStalwart Kasriel was different enough that he will be missed, kind of like the sound of one hand clapping $$ #littledoghasbuddhanature May 01, 2012
The record 4 tallest bldg s/b based on weighted average height; weighting based on cross-sectional area @ height http://t.co/03HNZ0BB $$ Apr 30, 2012
So if you have something thin at the top, it wouldn’t count 4 much. A rectangular parallpiped would get full credit 4 height $$ #usingmath Apr 30, 2012
That would work, simpler than mine $$ RT @Pollack7: @AlephBlog Meh.Highest continuous occupancy floor. Apr 30, 2012
As the smartest boss I ever had said “Make bets, but never bet the franchise.” http://t.co/qWdHX3BS Apr 30, 2012

Monetary Policy

Bernanke Charts New Mission For Fed: Financial Stability http://t.co/6RrWEQws Fed has a hard enuf time w/a double mandate, triple will b wrs May 02, 2012
Then again, if focusing on financial stability forces the Fed to be more restrained in its monetary policy, that would be good. $$ May 02, 2012
Bernanke: Be Humble! http://t.co/6icSHD1K The picture says it: http://t.co/OqOflqsI Humility in BB’s view: leaving monetary policy loose $$ May 01, 2012
My Speech Delivered at the New York Federal Reserve Bank http://t.co/DbAhOdQR An Austrian let loose amid the marble palace in NYC?! Wow. $$ Apr 29, 2012

US Politics

Renewed Hope that Jon Corzine, President Obama’s Top Tier Campaign Bundler, Will Face Criminal Charges http://t.co/wCLrXFve J. Tavakoli $$ May 01, 2012
Occupy Wall Street Plans Global Protests in Resurgence http://t.co/0FLjKfiJ #OWS won’t b effective until they organize as a 3rd party $$ + May 01, 2012
Or, organize to influence the Democrats the way the t-party does the Republicans. #OWS is irrelevant until then, b/c it doesn’t do anything May 01, 2012
Is that a bailout in your pocket? http://t.co/8xwW4Cbi Boyazny, panel’s populist, replied that the credit markets had become ?undemocratic? May 01, 2012

Correlating Risky Assets

Posted on 4 May 2012 by David Merkel

Asset allocation is tough, because the correlations are not stable.? Here’s an example: in the 90s, at many conferences that I went to, I was told that one of the smartest moves you could make was to invest heavily in every new class of Asset Backed Security [ABS] created, because they all tighten in yield spread terms after issuance, leading to price gains.

I didn’t believe it then, and that was a good thing, because the most exotic of ABS classes got whacked in the financial crisis.? As it was was, I had already seen debacles in Franchise Loan ABS (spit, spit), and Manufactured Housing (post-1997 vintage).? At a conference for Life Insurance, I was a skunk at the party in 2006, as one ignorant presenter suggested that AAA structured assets never went bad.? History already taught us better, and as I tried to say to the then-CEO of Principal Financial as he was exiting the conference, he needed to look at the mezzanine and subordinated structured product in his company.? Free consulting, but but worth more than the consensus.? As far as I can tell, he didn’t listen.? For many reasons the stock price is lower today.

I have many other tales where in fixed income (bonds), everyone “followed the leader,” which worked in the short run, but failed in the long run.? The point is that investor behavior correlates asset classes.? There may be underlying economic differences, such as owning a natural gas producer and utility that uses natural gas, but most of those differences get erased as most investors seek portfolios immune from factors of secular change.

So as new asset or sub-asset classes are introduced, in the short-run they are uncorrelated, and likely rally, because few own them.? But after the rally, many now own it, and the future correlations are high because so many own it.? The correlations ultimately depend on two things: the underlying economics, and investor behavior.? Investor behavior is the dominant aspect of pricing.

I don’t think there is a lot of diversification in most risky asset classes from an economic standpoint.? Does it matter whether a business is public or private??? I think the answer is no.

What that means in the present environment is that there is a gap between business risk, and those that finance business risk.? In other words, there is a difference between investment grade bonds, and risk assets.? That’s the negative correlation in this market.? Do you want diversification?? Buy some ETFs that invest in long high investment grade debt.? You will not get any effective diversification out of buying different classes of risky assets.? Those are already owned by those that compete with you.

Promises to pay from sound entities that can be relied upon in the future behave very differently than risky assets.? In your asset allocation, to the degree that you need real diversification, look at that as the critical distinction.? All other distinctions are secondary at best.

Book Review: Abnormal Returns

Posted on 2 May 20122 May 2012 by David Merkel

I consider Tadas Viskanta to be a friend of mine.? I write my eclectic blog, and Tadas occasionally features me on his daily curation of the economics/finance/investment blogosphere.

But it is not friendship that leads me to write the following: this is a really good book.? Why?? Every day, Tadas curates the best thoughts in finance.? He finds them, he motivates them, and links to them.? If I had just one site to visit everyday, it would be his, not mine.? He’s really good at finding the best content in finance.

But it goes a step further than that.? Tadas is a very good blogger in his own right.? It’s not that he comes up with new insights, but he is very good at taking the insights of others and weaves them into a greater insight than the separate thoughts of the individuals.? He finds themes, and he finds disagreements.? Each provides good food for thought.

Now, if Tadas can do this on a daily basis, let’s call him the Chief Synthesizer of the economics/finance/investment blogosphere — then, what happens if he decides to take several steps back, and synthesize the grand themes he has seen in six years of writing his blog.

It’s been a violent period, after all.? Tadas has been blogging from the peak of residential real estate (October 2005), through the tail of the boom (October 2007), to the bust (March 2009), to the present.? He keeps it relevant, and he doesn’t take sides, which allows him to source the best content better.

So as he synthesizes the themes of the last six or seven years, he comes down to really basic ideas for each chapter: Risk, Return, Stocks, Bonds, Portfolio Management, Does Active Investing Work, ETFs, Global Investing, Alternative Assets, Behavioral Finance, Using Media, and the Lost Decade.? He handles them deftly, highlighting differences, but giving a consensus opinion.

The book is modest, in that it does not promise you greater profits if you follow his advice.? It is a realistic book, because most of us know that the basic principles of investing are straightforward, but they get clouded by academics and hucksters.? After you read this book, you may or may not earn more, but you will probably be safer.

Also, the book is an easy read; I glided through it in less than three hours.

Quibbles

The editor could have done more work to make the index complete; I was surprised to find myself mentioned in the book more times than the index noted.

Who would benefit from this book: Most amateur investors would benefit from the book, and many, though not all professionals would benefit from the book’s basic approach. Think of it this way — what if you could explain basic concepts to the uninstructed more clearly? Wouldn’t it help you in your business?? If you want to, you can buy the book here: Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere.

Full disclosure: I asked the publisher for the book and he sent it to me.