Category: Value Investing

On Fourth Quarter 13Fs

On Fourth Quarter 13Fs

Posted on by David Merkel

I often look through 13F filings to get investment ideas.? The last time I did it, one of my readers asked a question like this:

It?s nice to see how large the positions are of the investors that you track, but wouldn?t it be better to track the changes in positions?? After all, new allocations are more indicative of better value than older holdings.

That?s probably correct, though for my own investing it might not be as accurate, because I rank current positions against challengers ? my current positions have to justify their existence to stay in the portfolio.

But I thought it would be worth trying to do that, and also do it as a percentage of each stock?s market capitalization.

Now, there are difficulties in doing an analysis like this:

  • CUSIP changes
  • M&A (takeovers, spinoffs
  • CUSIP formats (some managers make it difficult to read)
  • Deliberately difficult formatting
  • One firm fills out the from wrong, swapping fields
  • Multiple holders within a given firm
  • You have to create a CUSIP/ticker database (paid my 13-year old assistant $50 to do that.)
  • In short, a lot of data scrubbing.

Now the results of looking at 13Fs can be valuable, and there is a small cottage industry doing so.? Mebane Faber has done good work with this, as has Insider Monkey, Manual of Ideas and Street of Walls.? Following the ideas of some of the best investors leads to better returns, even if there is a lag involved.

And the lag doesn?t matter much.? Most of these investors invest for years not months, so if you get a signal it should be valid for some time after it is received.

Anyway, I calculated the positions for 74 investors that I have some respect for (listed at the bottom).? My objective is to look at them as a group.? For the most part, I don?t care which of them is investing in a given company.

Following this are a variety of tables with some commentary on what might be going on.? I think you might find some valuable ideas in the companies where ?there are large additions or holdings as a proportion of market capitalization.

Tables

Stocks with the most new investors:

New Ticker Name

9

 DLPH Delphi Automotive PLC

6

 LVLT LEVEL 3 COMMUNICATIONS INC

6

 LMCA LIBERTY MEDIA CORP NEW

5

 ORCL Oracle Corp

4

 TRIP TRIPADVISOR INC

4

 KORS MICHAEL KORS HLDGS LTD

3

 BAC BANK OF AMERICA CORP

3

 CVX CHEVRON CORP NEW

3

 DELL Dell Inc

3

 EP EL PASO CORP

3

 VRUS PHARMASSET INC

3

 TDC TERADATA CORP

 

Stocks that had the most investors increase positions (including new owners):

Increased Ticker Name

15

 GOOG GOOGLE INC.

9

 DLPH Delphi Automotive PLC

9

 AAPL APPLE INC

8

 ORCL Oracle Corp

7

 LMCA LIBERTY MEDIA CORP NEW

7

 C CITIGROUP INC

7

 LOW LOWES COS INC

7

 PEP PEPSICO INC

7

 MSFT MICROSOFT CORP

7

 V Visa Inc-Class A Shares

6

 LVLT LEVEL 3 COMMUNICATIONS INC

6

 INTC Intel Corporation

6

 SYY SYSCO CORP

 

Stocks that have the most owners at the end of the fourth quarter:

Owned Ticker Name

22

 GOOG GOOGLE INC.

21

 MSFT MICROSOFT CORP

17

 AAPL APPLE INC

14

 CSCO CISCO SYS INC COM

14

 WMT WAL-MART STORES INC

14

 WFC WELLS FARGO & CO NEW

13

 JNJ JOHNSON & JOHNSON

12

 ORCL Oracle Corp

12

 C CITIGROUP INC

12

 MA Mastercard Inc – Class A

11

 BAC BANK OF AMERICA CORP

11

 BRK.B BERKSHIRE HATHAWAY INC-CL B

11

 BRK.A BERKSHIRE HATHAWAY INC-CL A

 

Stocks with the most selling out entirely (including M&A-related):

Sold Ticker Name

6

 EXPE Expedia Inc.

6

 LVLT Level 3 Communications

5

 C CITIGROUP INC

5

 SINA SINA CORP

5

 Acquired NALCO HOLDING COMPANY

4

 EBAY EBAY INC

4

 CVI CVR Energy Inc

4

 CCE COCA COLA ENTERPRISES INC NE

3

 LINTA LIBERTY INTERACTIVE CORP-A

3

 CVS CVS CAREMARK CORPORATION

3

 AMZN AMAZON COM INC

3

 VIAB Viacom Inc Cl B

3

 EXC Exelon Corp

3

 DVN DEVON ENERGY CORPORATION

3

 COV COVIDIEN PLC

3

 XOM EXXON MOBIL CORP

3

 MOS The Mosaic Company

3

 RL RALPH LAUREN CORP

3

 IRM IRON MTN INC

3

 HFC HOLLYFRONTIER CORP

3

 GR GOODRICH CORP

3

 CTXS CITRIX SYS INC

3

 Acquired CEPHALON INC

3

 ELNK EARTHLINK INC

3

 TIN TEMPLE INLAND INC

 

Stocks with the most decreases in positions (including selling out in entire):

Decreased Ticker Name

12

 MSFT MICROSOFT CORP

10

 WFC WELLS FARGO & CO NEW

10

 C CITIGROUP INC

8

 BAC BANK OF AMERICA CORP

8

 PFE PFIZER INC

8

 EBAY EBAY INC

8

 NWSA NEWS CORP

8

 LINTA LIBERTY INTERACTIVE CORP-A

7

 AAPL APPLE INC

7

 CSCO CISCO SYS INC COM

7

 WMT WAL-MART STORES INC

7

 BRK.B BERKSHIRE HATHAWAY INC-CL B

7

 CVS CVS CAREMARK CORPORATION

7

 DELL Dell Inc

7

 AON AON CORP

7

 AMZN AMAZON COM INC

7

 EXPE Expedia Inc.

 

With a few exceptions, the above reads like lists of common large cap stocks, with a few midcaps thrown in.? It doesn?t look that much different when the lists are done by dollar amount of change.? But what if we do this as a fraction of market capitalization?

(Please note, the 13F filings measure as of 12/31/2011, and my market caps are from mid-February.? That induces some distortion, but I don?t think that much.? Also note that large holdings as aproportion of market cap often come from one hedge fund and not necessarily many.

Here is a list of new purchases, in declining order of percentage of market capitalization:

New Ticker Name

16.50%

 TRGT TARGACEPT INC

15.02%

 DLPH Delphi Automotive PLC

10.73%

 CMVT COMVERSE TECHNOLOGY INC

10.54%

 NTK NORTEK INC

7.54%

 ARO Aeropostale Inc

6.41%

 MTG MGIC INVT CORP WIS

6.21%

 HII HUNTINGTON INGALLS INDS INC

5.76%

 IRE Bank of Ireland

5.64%

 TRIP TRIPADVISOR INC

5.08%

 LMCA LIBERTY MEDIA CORP NEW

4.75%

 AVY Avery Dennison

4.58%

 SEMG SEMGROUP CORP

4.41%

 VPRT VISTAPRINT N V

4.25%

 MPC MARATHON PETROLEUM CORP

3.92%

 CSTR COINSTAR INC

3.49%

 SBH SALLY BEAUTY HLDGS INC

3.44%

 KMT Kennametal Inc.

3.34%

 SIRO Sirona Dental Systms

3.18%

 EP EL PASO CORP

3.10%

 HGG HHGREGG INC

3.06%

 CVI CVR Energy Inc

3.04%

 NTAP NETAPP INC

 

Here is a list of position increases, including new purchases, in declining order of percentage of market capitalization:

Increased Ticker Name

16.50%

 TRGT TARGACEPT INC

15.02%

 DLPH Delphi Automotive PLC

10.77%

 CP CANADIAN PAC RY LTD

10.73%

 CMVT COMVERSE TECHNOLOGY INC

10.54%

 NTK NORTEK INC

8.55%

 WBMD WEBMD HEALTH CORP

7.54%

 ARO Aeropostale Inc

6.57%

 NAV Navistar International Corp

6.41%

 MTG MGIC INVT CORP WIS

6.21%

 HII HUNTINGTON INGALLS INDS INC

5.76%

 IRE Bank of Ireland

5.74%

 AVY Avery Dennison

5.64%

 TRIP TRIPADVISOR INC

5.19%

 LMCA LIBERTY MEDIA CORP NEW

4.58%

 SEMG SEMGROUP CORP

4.48%

 EPAX Ambassadors Group Inc.

4.44%

 CBG CBRE GROUP INC

4.42%

 CSTR COINSTAR INC

4.41%

 VPRT VISTAPRINT N V

4.25%

 MPC MARATHON PETROLEUM CORP

4.08%

 PCLN PRICELINE COM INC

 

Here is a list of position decreases, including total sales, in declining order of percentage of market capitalization:

Decreased Ticker Name

-17.83%

 VGR VECTOR GROUP LTD

-13.66%

 EMMS EMMIS COMMUNICATIONS CORP

-10.43%

 DIOD DIODES INC

-9.12%

 CLX Clorox Co

-9.02%

 NEWP NEWPORT CORP

-8.93%

 IWM ISHARES TR

-8.61%

 EXPE Expedia Inc.

-6.86%

 GEN GENON ENERGY INC

-6.60%

 PANL UNIVERSAL DISPLAY CORP

-6.43%

 LVLT GLOBAL CROSSING LTD

-6.32%

 AAMRQ AMR Corp

-6.22%

 NIHD NII HLDGS INC

-6.15%

 CVI CVR Energy Inc

-6.03%

 AMED AMEDISYS INC

-5.85%

 CIS CAMELOT INFORMATION

-5.60%

 SINA SINA CORP

-5.46%

 CQB CHIQUITA BRANDS INTL INC

-5.44%

 STE STERIS CORP

-5.37%

 CJES C&J ENERGY SERVICES INC

-5.30%

 PDLI PDL BIOPHARMA INC

 

Here is a list of positions sold out in entire, in declining order of percentage of market capitalization:

Sold Ticker Name

-17.83%

 VGR VECTOR GROUP LTD

-13.66%

 EMMS EMMIS COMMUNICATIONS CORP

-10.43%

 DIOD DIODES INC

-9.08%

 CLX Clorox Co

-9.02%

 NEWP NEWPORT CORP

-7.41%

 EXPE Expedia Inc.

-6.60%

 PANL UNIVERSAL DISPLAY CORP

-6.56%

 IWM ISHARES TR

-6.43%

 LVLT GLOBAL CROSSING LTD

-6.32%

 AAMRQ AMR Corp

-6.22%

 NIHD NII HLDGS INC

-6.03%

 AMED AMEDISYS INC

-5.85%

 CIS CAMELOT INFORMATION

-5.60%

 SINA SINA CORP

-5.27%

 CQB CHIQUITA BRANDS INTL INC

-5.10%

 CVI CVR Energy Inc

-4.97%

 IT GARTNER INC

-4.90%

 ACFC Atlantic Coast Financial Corp

-4.73%

 BIDZ BIDZ.com Inc.

-4.55%

 CVC CABLEVISION SYS CORP

-4.52%

 SAFM SANDERSON FARMS INC

-4.32%

 LEA LEAR CORP

-4.31%

 TIN TEMPLE INLAND INC

-4.05%

 WGO WINNEBAGO INDS INC

 

Holdings by Total Dollar Amount at the end of the Fourth Quarter

Held Ticker Name
? 15,763,863,000 KO COCA COLA COMPANY
? 13,896,920,000 WFC WELLS FARGO & CO NEW
? 11,801,570,000 IBM INTERNATIONAL BUSINESS MACHS
???? 7,498,749,000 AXP AMERICAN EXPRESS CO
???? 7,124,564,000 PG PROCTER & GAMBLE CO/THE
???? 5,561,149,000 WMT WAL-MART STORES INC
???? 4,965,749,000 KFT KRAFT FOODS INC-CLASS A
???? 4,828,136,000 MSFT MICROSOFT CORP
???? 4,720,375,000 GOOG GOOGLE INC.
???? 4,539,055,000 NWSA NEWS CORP
???? 4,504,224,000 AAPL APPLE INC
???? 4,007,205,000 HPQ HEWLETT PACKARD CO
???? 3,387,821,000 MSI MOTOROLA SOLUTIONS INC
???? 3,285,855,000 GLD SPDR GOLD TRUST
???? 3,261,413,000 GSK GLAXOSMITHKLINE PLC-SPON ADR
???? 3,137,451,000 JNJ JOHNSON & JOHNSON
???? 3,106,083,000 USB US BANCORP DEL
???? 3,089,445,000 FDX FEDEX CORP
???? 2,986,973,000 COF CAPITAL ONE FINANCIAL CORP
???? 2,869,898,000 EP EL PASO CORP
???? 2,836,729,000 IEP ICAHN ENTERPRISES LP
???? 2,809,578,000 SLB Schlumberger Ltd
???? 2,807,657,000 NVS NOVARTIS AG-ADR
???? 2,776,985,000 BK BANK OF NEW YORK MELLON CORP
???? 2,762,244,000 COP CONOCOPHILLIPS
???? 2,704,595,000 PEP PEPSICO INC
???? 2,620,576,000 CMCSA COMCAST CORP-CLASS A
???? 2,618,651,000 PFE PFIZER INC
???? 2,524,873,000 DELL Dell Inc
???? 2,475,713,000 GE GENERAL ELECTRIC CO
???? 2,321,383,000 OXY OCCIDENTAL PETE CORP DEL
???? 2,314,288,000 TWX TIME WARNER INC
???? 2,290,333,000 MRK MERCK & CO. INC.
???? 2,252,588,000 AON AON CORP
???? 2,246,712,000 DTV DIRECTV-CLASS A
???? 2,205,486,000 PCLN PRICELINE COM INC
???? 2,166,225,000 MMI MOTOROLA MOBILITY HLDGS INC
???? 2,124,678,000 SNY SANOFI-ADR
???? 2,075,367,000 QCOM QUALCOMM INC

 

And the greatest holdings by percentage of market capitalization:

Held/MC Ticker Name

73.30%

 IEP ICAHN ENTERPRISES LP

71.98%

 BAGL EINSTEIN NOAH REST GROUP INC

69.22%

 HRG HARBINGER GROUP INC

65.92%

 FDML FEDERAL MOGUL CORP

51.38%

 SPB SPECTRUM BRANDS HLDGS INC

46.89%

 ARII AMERICAN RAILCAR INDS INC

40.88%

 CDCO Comdisco Holding

38.77%

 NOA NORTH AMERN ENERGY PARTNERS

37.92%

 DYN DYNEGY INC DEL

36.46%

 BFLY BLUEFLY INC

32.11%

 LEAP LEAP WIRELESS INTL INC

29.37%

 QUAD QUAD / GRAPHICS INC

29.34%

 TXI Texas Industries Inc.

28.92%

 BIOF BIOFUEL ENERGY CORP

27.83%

 ENZN ENZON PHARMACEUTICALS INC

27.56%

 HPP HUDSON PAC PPTYS INC

27.54%

 BKU BANKUNITED INC

27.54%

 OSTK OVERSTOCK COM INC DEL

27.35%

 SIX SIX FLAGS ENTMT CORP NEW

26.41%

 DIN DINEEQUITY INC

26.27%

 WPO Washington Post

26.04%

 LORL LORAL SPACE & COMMUNICATNS INC

25.12%

 LGF LIONS GATE ENTMNT CORP

25.00%

 VSAT VIASAT INC

24.85%

 JEF JEFFERIES GROUP INC NEW

24.71%

 INS INTELLIGENT SYS CORP NEW

24.59%

 LVLT LEVEL 3 COMMUNICATIONS INC

24.21%

 ZLC ZALE CORP NEW

23.40%

 ABH ABITIBIBOWATER INC

23.19%

 CTO Consolidated Tomoka Land Co

22.71%

 XCO EXCO RESOURCES

22.34%

 THRX THERAVANCE INC

22.28%

 MLI MUELLER INDS INC

21.96%

 MSI MOTOROLA SOLUTIONS INC

21.49%

 SNBC Sun Bancorp Inc

 

I appreciate the analysis as a portion of market capitalization, because it reflects the limitations of what managers can do.? Again, I will look most closely at current holdings and additions as a proportion of market capitalization.

Investor list:

  • Akre
  • Altai
  • Ancient Art
  • Appaloosa
  • Atlantic
  • Bares
  • Baupost
  • Blue Ridge
  • BP Capital (Pickens)
  • Brave Warrior
  • Breeden
  • BRK
  • Capital Growth
  • Centaur
  • Centerbridge
  • Chou
  • Coatue
  • Dodge & Cox
  • Dreman
  • Eagle Capital
  • Eagle Value
  • Edinburgh
  • Fairfax
  • Farallon
  • Fiduciary
  • Force
  • FPA
  • Gates
  • Glenview
  • GoldenTree
  • Greenhaven
  • Greenlight
  • H Partners
  • Harbinger
  • Hawkshaw
  • Hayman
  • Hound
  • Hovde
  • Icahn
  • Invesco Private
  • Jana
  • Jensen
  • Joho
  • Lane Five
  • Leucadia
  • Lone Pine
  • M3F
  • Markel
  • Matrix
  • Maverick
  • MHR
  • Montag
  • MSD
  • Muhlenkamp
  • PabraI
  • Parnassus
  • Passport
  • Paulson
  • Pennant
  • Perry
  • Pershing Square
  • Sageview
  • Scout
  • Soros
  • Southeastern
  • Third Point
  • Tiger Global
  • Tweedy Browne
  • ValueAct
  • Viking
  • Weitz
  • West Coast
  • Wintergreen
  • Yacktman

 

Full disclosure: Long WMT, ORCL, INTC, VOD, HPQ, COP, Short SPY

Notes on the 2011 Berkshire Hathaway Annual Report, Part 3 (On Acquisitions)

Notes on the 2011 Berkshire Hathaway Annual Report, Part 3 (On Acquisitions)

Posted on by David Merkel

Though part of a series, this post is different.? I went back through the last 35 years of shareholder letters to analyze Buffett’s approach to acquisitions.? As Charlie Munger has said, Buffett is scary smart.? I say this because he adjusted through many different eras, while running a business that was part conglomerate, part closed-end fund.

In some ways the early years were different — more arbitrage, public investments take up more time in the shareholder letter.? But what I find fascinating is that from the earliest days, it didn’t matter to Buffett whether he owned whole businesses, or parts of them.

Part of this feeds off of Felix Salmon’s recent piece on acquisition language, where he contrasts tuck-ins and bolt-ons, correctly concluding that the difference is only one of size, even though that is an informal distinction.

But since the ’80s Buffett has always talked about acquisitions. Here’s a graph indicating Buffett’s use of the term acquisition(s):

 

You will note that his use of phrases like “tuck-in” and “bolt-on” occur only in the 2000s.? But the ideas were there long before that.? There were many cases in the ’90s, and to a lesser extent, the ’80s, where subsidiaries of BRK made acquisitions.? Buffett was always looking for ways to profitably deploy excess capital, and he knew that acquisitions facilitating organic growth was often far more effective than buying something totally new.? Buffett was doing tuck-in and bolt-on acquisitions for 15 years before he mentioned the terms.

Buffett always saw the public and private markets as being complementary.? He doesn’t care where he makes money; he just wants to make money.? Below there is a list of BRK acquisitions by year, with slight commentary.

One thing to understand about BRK is that full and partial ownership of private public businesses was always a part of the plan.? Growing out of a textile manufacturing business as a holding company, that should be obvious, as it should be when considering See’s Candies, BRK’s first acquisition.

Public and private, full and partial did not matter to Buffett.? He was simply interested in what could grow the intrinsic value of the the overall enterprise best, within the concept of a margin of safety.

1987-1989 was kind of an inbetween era for BRK, where Buffett would talk about his Sainted Seven private firms inside BRK, until he bought Borsheim’s in 1989, which gave him no good way to describe his private holdings with a simple moniker.

As it is, when he began doing more acquisitions, the 1991-1993 era included the “Shoe Group,” which was not among his finer moments.? But starting in 1995, with the purchase of the remainder of GEICO, is the start of the modern BRK.? Acquisitions become a regular part of the plan.? What makes that plain, was that post-1990 in years where BRK had no acquisitions, Buffett would discuss his theory on acquisitions for shareholders.? He did this because when there are few promising targets to invest in, it is usually a sign that valuations are stretched.

And in general, Buffett chose wisely with the private businesses.? Yes, there have been some that ended up being losers, or, not big winners, like the “Shoe Group,” and Scott & Fetzer’s untimely purchase of World Book, which was about to be obsoleted by Encarta, and then Wikipedia.

Buffett understood the need for sustainable competitive advantage.? He also knew how much he could afford to risk in acquiring private firms.? His “bite size” increased gradually until he could take down monsters like Burlington Northern.? He bought businesses that would be hard to obsolete.

One thing I found interesting about reading through the older letters of Buffett was that his ideas on acquisitions were developed early, long before BRK ceased to be predominantly a public company value investor, which is the way that many still regard BRK.

And as a result, it should be no surprise that as BRK grew, given Buffett’s desire for owning as much of great businesses as he could, that BRK became a conglomerate, albeit one dominated by its leading insurance businesses.

Though we can look at the different strategies employed by Buffett over the years, and see how some played a larger role early on like arbitrage and distressed investing, Buffett had a singular focus for the investments that offer decent returns in the size range that will make a difference for BRK investors.

Once BRK got big, that meant becoming a conglomerate, albeit a special one, was the logical outcome.? And I could be wrong, but that is the final corporate form for BRK.? There may come a day in a post-Buffett era when it may do many things, such as spin off companies, or centralize functions.? At present that won’t happen because BRK is the acquirer of choice for those that want to cash out, but don’t want the unique character of their organizations to change, which Buffett points at in the present Shareholders’ Letter as a unique competitive advantage.? BRK does not compete on price in acquisitions; it does compete by saying that unless something goes badly wrong, BRK will be more than happy to let the management do its thing.? It’s as if Buffett says, “Just make money, and send us back the excess.? If you have need of cash for promising opportunities, let us know.”

And then, it lets a thousand flowers bloom, and a thousand schools of thought contend, so long as you make money and grow the value of the business.? BRK is a unique business, and reflects the character of its founders (including Munger here).? No other large firm that I know of offers as much latitude to its operating units.

One final note: Buffett has also had a very good nose for sniffing out good insurance enterprises.? That’s the backbone of BRK.? It’s interesting to see over the years how he assembled the various pieces.? It would be interesting to see pre-1977 data on the insurance side, to look at how Buffett initially entered the insurance business, and transisted out of running a textile firm.

Tomorrow should have my final installment on BRK.? I will review the 10-K and provide commentary.

Notes on the 2011 Berkshire Hathaway Annual Report, Part 2

Notes on the 2011 Berkshire Hathaway Annual Report, Part 2

Posted on by David Merkel

Picking up where the last post left off:

13) So Buffett told us he has a successor lined up, but won’t tell us who, but will tell us that the successor doesn’t know that he is the successor.? Really does not seem like much of an improvement over the past, except that the CIO function is getting better defined with Todd and Ted.

14) Todd & Ted share their performance 80/20 — 80% of their own and 20% of their colleagues performance.? Seems like a fair idea, balancing the team vs the individual.

15) The regulated subsidiaries, and manufacturing, services and retailing did well. That operating income growth is what drove the year.? The turnaround at NetJets was also a help, and that was fast.

16) We are still waiting to see what problems BRK’s decentralized system can develop.? To this point, the flexibility for managers within a structure that oversees reinvestment of cash flow is admirable.

17) The economic spread of BRK businesses is significant, and I would argue, unrivaled in terms of conglomerates.? It almost makes me think that Buffett is aiming for owning an extra-productive slice of US/World GDP.? It makes acquisition criteria #1 less relevant, because if you are small and private, and want to be acquired by BRK, it means that you analyze BRK, identify the portion of it that you are most similar to, and talk to the CEO of that segment, not Buffett.

18) That brings up my view of Buffett at present.? He has changed as the amount of assets under management has grown.? The last phase for Buffett is not large cap value manager, but private equity manager / conglomerateur.? He uses the float that his insurers produce to invest in a wide number of enterprises that will produce excess returns.? He does not run a closed end fund, but runs a conglomerate.

19) Interesting to see Nebraska Furniture Mart open its third store.? Logical to do, if the experience is replicable.

20) ?We do not talk one-on-one to large institutional investors or analysts.? Bravo.? Would that this would be true of more companies.? When I represented a large holder of Safety Insurance, the management asked me what we wanted in terms o market disclosure.? I said that it did not matter to us, and that we would be happy if they never talked to the media/analysts, and only emitted 10-Qs and 10-Ks, even without notifying us as to timing.

21) Buffett notes that a decent number of borrowers that lost their homes did well in the crisis, because of all the money they extracted from loans.? That might be similar to a private equity manager profiting through deals to borrow where he pays himself a dividend.

22) Owning 11% of Munich Re gives Buffett additional influence over the reinsurance market.

23) Because of the need for collateral, BRK will not be making any more significant derivative bets.

24) Buffet repeats his screed that he issued to Fortune regarding bonds and gold.? I repeat my screed.? It’s all logical, Warren, but you have to think more broadly and read about the gold medal gold model.

25) It makes sense that flying to Kansas City is a better strategy than going to Omaha.? But as this becomes widely used, make sure you reserve a car early.

26) If you want to ask Buffett a question at the annual meeting, you can do it by e-mailing the following:

(In your e-mail, let the journalist know if you would like your name mentioned if your question is selected.)

27) There will be insurance analysts at the annual meeting, and they are Cliff Gallant of KBW, Jay Gelb of Barclays Capital and Gary Ransom of Dowling and Partners.? I have a lot of respect for Gary Ransom — listen to the questions that he asks.

28) Minus & Plus: Negative change in AOCI & comprehensive income of noncontrolled interests down.? Strong CFO, net of capex, supports goodwill.

29) At for BRK’s big options: BAC in the money, GS at, GE/DOW out of the money.

30) Do parts of all asbestos liabilities eventually go to Berkshire Hathaway for reinsurance?? Who don?t they reinsure?? “The liabilities for environmental, asbestos and latent injury claims and claims expenses net of reinsurance recoverable were approximately $13.9 billion at December 31, 2011.”

I know that Buffett thinks he can earn money off of the float on these claims in excess of the implied interest rate.? But when he begins to become the preferred habitat for reinsurance, he makes BRK more volatile with respect to legal judgments.

31) “Without prior regulatory approval, our principal insurance subsidiaries may declare up to approximately $9.5 billion as ordinary dividends before the end of 2012.” And that is because only 10% of the regulatory surplus of $95 billion can be released.

32) BRK, unlike many firms, has more reasonable assumptions on DB pensions: expected return: 6.9%, discount rate 4.6%.

33) To date, share repurchases have been insignificant.? Looks like $67 million from the Statement of Shareholders Equity.

34) “On January 31, 2012, we issued an additional $1.7 billion of parent company senior unsecured notes, the proceeds of which were used to fund the repayment of $1.7 billion of notes maturing in February 2012.”

Why not pay down short-term debt?? BRK has the cash, and you state that you have an aversion to debt, particularly at the holding company level, but you are not acting like you have an aversion to debt over the last 10 years.

To Buffett: is there a level of debt at which you would be uncomfortable at the parent company, or subsidiaries?? Also, would you ever make an effort to get the AAA rating back?

35) BRK has a very diversified reserving book if you look at page 84 of the annual report — impressive.

36) I appreciate acquisition principle 6, which deal with aspects of value that accounting does not capture.? Buffett takes the right position to value those fully, because you will eventually get that value, and others will not pay up for it.

37) Buffett makes a lot out of the virtues of deferred taxes and float. He argues “they are liabilities without covenants or due dates attached to them.”? This is true, though deferred tax liabilities assume that you will make money, and will continue to grow.? Float is similar, it assumes you will underwrite well, and it would be nice if you grew.

38) Buffett says toward the end of the annual report:

There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.

I’ve written about this before.? Some managements teams with skill should retain all earnings, and not pay a dividend.? Management teams without skill should act like REITs and pay out 90% of taxable income (or free cash flow).

39) Buffett says he was wrong on housing.? I think he is still wrong on housing; it will take a lot longer for this situation to normalize.? The key variable is the proportion of houses with debts exceeding a 90% LTV.? Those houses are illiquid; can’t be sold except in a short sale.

40) One final wild idea: would BRK consider buying out the corpus of AIG?? I have better small insurance acquisition targets than that, but buying out AIG would be delicious given the comments Greenberg made to Buffett back when BRK was smaller.? He was very dismissive of BRK.? Also, Buffett could fold ILFC into NetJets (or vice-versa), sell off the life companies, and impose greater discipline on the P&C underwriting.? Personally, if BRK made a bid for AIG at $32, I think Buffett could make a lot out of it, and he would not have to worry about a lot of fuss, because the major holder is the US Government.

Notes on the 2011 Berkshire Hathaway Annual Report, Part 1

Notes on the 2011 Berkshire Hathaway Annual Report, Part 1

Posted on by David Merkel

Start with the basics, this is on the Annual Report, not just the shareholder letter.? I may have a second report out after the 10K is released.

1) One thing that was fascinating was the large number of low level acquisitions happening in the subsidiaries, and the desire for more of them.? There is interest at Lubrizol, McLane, TTI, CTB, Marmon, etc.

2) With BRK and IBM, Buffett hopes that public buyers and sellers will be stupid, and sell their shares at levels far below what the eventual prices will be, allowing the remaining shareholders to do better, as management buys in shares at a bargain, benefiting the persisting shareholders.

3) Buffett makes it clear, though that no matter how much cash has has, if prices are dropping rapidly, he won’t put a floor under the stock.? He’ll let the stock fall, and buy bit-by-bit through the whole process.? Indeed, it might be to his advantage to let the price fall below the 110% of Book level for a time to unnerve those that may be gaming the situation.

4) BRK does not talk its book as a result.? They would rather have the stock cheap for buybacks.? (Eeenh… but wouldn’t they rather have the stock higher to aid acquisitions?)

5) And if they firmly know what the value will be in the long run, they would love it if other investors would be scaredy cats and sell out to management at cheap levels so that they could have more of the value as they do not sell.? (Buffett does not phrase it that way, but this is a zero-sum game as far as trading goes.)

6) Buffett talked a lot about goodwill this year, much more than in prior years.? Goodwill makes up about 30% of BRKs book value.? I appreciated his argument regarding goodwill at the insurance companies — if your underwriting profits over nine years exceed goodwill the goodwill is most secure.

7) That said, partly due to lower interest rates, underwriting profitability has been higher for the P&C industry as a whole.? BRK may be better in aggregate, but some of Buffett’s industry comments are not warranted.? BRK is better in degree, not kind.

8 ) Buffett has the key of good P&C underwriting/management when he says ?be willing to walk away if the appropriate premium can?t be obtained.?? That’s the only way to do it, with the price that your company will shrink when the rest of the industry is nuts.

9) All that said, the insurance lines did not do well this year, particularly not BH Reinsurance Group, which is Ajit Jain’s baby.? Part of that was the large catastrophes this year, some of it seems to come from not knowing how to run a life reinsurer.

10) Retroactive reinsurance showed gains, because losses on Swiss Re’s P&C experience was better than expected.? However, that was wiped out by?Swiss Re Life & Health America’s business doing much worse than expected.

In one sense, a big question for BRK is whether they will spend the money to get the expertise necessary to run a big life reinsurer profitably.? So far, the answer seems to be no.? In my opinion, they need to hire experts, or buy out RGA.? Why buy the line from Sun Life when you could have RGA?

11) On principle 11 — BRK distinguishes itself among private equity buyers by leaving distinctive corporate cultures in place , and not interfering with them.? That may not help the present, but it helps the future, as wealthy people selling out take less, because they know their friends in the business will be left intact.

That won’t attract all sellers, but it will attract some.

And note that BRK will cut their losses on hopeless subsidiaries, or those beset by labor woes.

12) As usual, BRK’s reserve development is good, with releases coming from prior years.

More in the next part on Monday.

Full disclosure: long RGA

Thinking about the Insurance Industry

Thinking about the Insurance Industry

Posted on by David Merkel

Recently I decided to spend some time analyzing the insurance industry.? It?s a different place today than when I became a buy-side analyst nine years ago.? Why?

First, for practical purposes, all of the insurers of credit are gone.? Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.? The rest have disappeared.? In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.? I?m not even sure it is possible to have that.

Second, the title insurers are diminished.? Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, recently buying up a restaurant chain.

Third, health insurers face an uncertain future.? Obamacare may disappear, or Obamacare could slowly eliminate insurers.? It?s a mess.

But beyond all of that, valuations are depressed across the insurance industry.? Part of that may stem from ETFs.? Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.? Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.? There are other aspects, which I will try to address as I go through subindustries.

Offshore

By ?Offshore? I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.? Most of them are located in Bermuda.

In 2011, many of them were challenged by the high levels of catastrophes globally.? But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].? For more details, you can read my article here.? The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.? The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

 

Companies above the line may be overvalued, and companies below the line may be undervalued.? ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.? The companies that are possibly overvalued are: Arch Capital [ACGL] and Global Indemnity [GBLI]. Possibly undervalued: Everest Re [RE] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.? Arch Capital may be that.? But with an expected ROE of less than 10%, it is hard to justify their valuation, when the average stock in this group needs an expected 13% ROE to be valued at book.

Why such a high ROE to get book?? Earnings quality.? Reinsurers have noisy earnings due to catastrophes.? You don?t give high valuations to companies that run hot or cold.? But the trick here is to see who is accumulating book value the fastest ? they tend to be the stars over time.

Life

The life insurance business would be simple, if it indeed were only life insurance.? Much of the industry is handed over to annuities, and all manner of asset gathering.? Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.? When I see those products, my reaction is usually, ?How do they hedge that?!?

Thus I am concerned for insurers that are ?equity-sensitive? as I reckon them.? Here is the PB-ROE scatterplot:

 

A very tight fit.? The insurers that are undervalued are equity-sensitive ones: Phoenix Companies [PNX], American Equity Investment {AEL] , Lincoln National [LNC], and ING [ING].? Those that are overvalued are FBL Financial [FFG], and CNO Financial [CNO].? CNO has issues from long-term care, a coverage I dislike a great deal.? FBL is worth exploring.

One more note: to get book value in Life Insurance, you need an 11.7% ROE on average.? That?s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

 

It?s a good fit.? Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include Hallmark Financial Services [HALL], Hilltop Holdings [HTH], Eastern Insurance Holdings [EIHI], Old Republic International [ORI], and Erie Indemnity [ERIE].? Below the line: Hartford Financial Services [HIG], Allstate [ALL], Tower Group [TWGP], and Horace Mann [HMN].

Because of the lower risk in P&C insurers, a firm only needs to earn an ROE of 6.6% to have a book value valuation.

Health

With Obamacare, I don?t know which end is up.? It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.? You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I?ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That?s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It?s a pretty good fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and CIGNA [CI].? And the following overvalued: ?Molina Healthcare [MOH] and Wellcare Health Plans [WCG].

I don?t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.? I include it for completeness, because I think the PB-ROE concept has value in insurance.? One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 7.8%.

Other Insurers and Insurance-Related Companies

This is a group that is a non-group.? It? comprises brokers, service providers, title and financial insurers.? Here?s the PB-ROE graph:

Pretty tight for a non-group.? Perhaps it is because it derives off of a much larger group, some of which has died off, leaving behind profitable entities.

As it is the potential outperformers include? Assured Guaranty [AGO], the largest remaining financial guaranty insurer, Fortegra Financial Corporation [FRF] a third party administrator of sorts, and what remains of the title insurance industry, Fidelity National [FNF], First American [FAF], and Stewart Title [STC].? That is one beaten-down group, and, one that would benefit a lot if housing bounced back.? There is a lot of potential earnings power there, and it trades for little above book value.

Potential underperformers include AJ Gallagher [AJG] and E-Health [EHTH].? I?ve dealt with AJ Gallagher professionally, and have respect for their management team, but maybe the valuation is stretched there.? E-Health is a health insurance broker, and over its existence hasn?t done anything deserving of a premium valuation.

And, for this non-group, it is riskless enough that you only need a 4% ROE to have a book value valuation.? This is one beaten-down sector of the market, and one that I do not own any of, but that I will eventually return to, because I have owned I in the past.? Should residential real estate finally normalize, many of these companies will fly.

I write this as one that was bearish on housing-related stocks since 2005.? There is potential here.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.? But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when so much of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

Full disclosure: long ENH, but I may take other positions for clients in the next month

Recent Sorted Tweets

Recent Sorted Tweets

Posted on by David Merkel

Finance Business

 

  • Breaking Ranks: Former Broker Turns Bomb Thrower http://t.co/q1vpz9dh @reformedbroker interview previews his book: http://t.co/Yigg2sEE $$ Feb 24, 2012
  • Why CLO managers continue to struggle http://t.co/a13j8jVG Low issuance, warehousing is tough, need more subordination, fewer senior buyers Feb 24, 2012
  • My Favorite Quote from Baupost’s 2011 Annual Letter http://t.co/VOvbqab3 DIstressed bond mgrs get itchy in bull phase & buy new junk @ par Feb 24, 2012
  • SEC IFRS Plan Endorsement http://t.co/8xguvs2G IFRS is not worth giving up comparability or sovereignty for. Project is a total loser. $$ Feb 24, 2012
  • Very cool, congrats RT @Finovate: @AlphaClone to offer Alternative Alpha ETF from U.S. Bancorp http://t.co/srufb3qd Feb 23, 2012
  • SEC May Ticket Speeding Traders http://t.co/oNCbF7pa Worthy of an experiment like the kind they did to study the “uptick rule” $$ Feb 23, 2012
  • AQR?s Aaron Brown on Red-Blooded Risk http://t.co/ZM7hn5P4 When I was a bond mgr, could sense some aspects of risk listening 2 broker’s tone Feb 23, 2012
  • The Volcker Rule is not going to bring your house back http://t.co/ADKMABfE Prop trading was not a leading cause of the financial crisis. $$ Feb 23, 2012
  • Pimco Said to Quit Mortgage Bond Group http://t.co/YsQZs1IE Feels wrong parties (their clients) r paying 4 bad servicing,instead of banks Feb 23, 2012
  • ?If you want, I can dig up an old research piece on analyst coverage — there are basically 3 factors that explain 70? http://t.co/tBinshJJ Feb 21, 2012
  • Stressed VAR is still a “protractor in the jungle” http://t.co/GRGgwvsd Risk management sh/not b done w/central measures but stress tests $$ Feb 21, 2012
  • How One Company Teaches Employees the ABCs of Finance http://t.co/fqO19foq More companies should do this, they would b more profitable. $$ Feb 18, 2012
  • Gross Fund at 66% Premium Shows Pimco Allure in Quest for Yield http://t.co/LY8Rv4SS Yield illusion distracts many investors. Avoid it. $$ Feb 17, 2012
  • Read:Which three of DOL’s new 401(k) rules represent the biggest land mines for financial advisors and plan sponsors? http://t.co/ZVoMPmQu Feb 15, 2012
  • The 400% Man http://t.co/nrRhYIZl Wish I could meet some of his disappointed investors who came to kick the tires and were disappointed. Feb 15, 2012
  • Contra:Foot-Dragging on IFRS Decision Could Strip SEC of Power http://t.co/VNUFhWD5 The US could lose representation on IASB. Good, drop out Feb 14, 2012
  • Notes from iGlobal’s Global Distressed Investing Summit: Part 2 http://t.co/9iOty0Iz Leveraged loan market seems to be in decent shape $$ Feb 14, 2012
  • Pimco: $25 Billion Foreclosure Deal to Hit Pensions Harder Than Banks http://t.co/DKFtMI9B Gives MBS buyers a reason 2 sue originators $$ Feb 13, 2012
  • Missing at MF: $1.6 Billion http://t.co/QSUMYbNO Included for the 1st time is roughly $700 million in client money residing in the UK $$ Feb 13, 2012
  • Stockbrokers: A Guide to Private Placement Due Diligence http://t.co/tbwtu6Jy Illiquid investments are ways to cheat average people. $$ Feb 11, 2012
  • Why illiquid? Can’t recover the commission otherwise.? Can deceive people that their investment is worth more than it? http://t.co/cYjvUhWx Feb 11, 2012

 

Market Strategy

 

  • Jim Stack was right, and he?s still bullish http://t.co/GfEqtTKl Basically a forward P/E plus momentum argument, & lack of sharp falls $$ Feb 24, 2012
  • S&P 500 Gets 9% Cheaper on Record Profits http://t.co/DWPGz5Y2 Makes a P/E argument; profit mrgns will eventually revert, may take a while Feb 23, 2012
  • The dangers of dividend-paying stocks http://t.co/FymTmAAi Hint: they are stocks. No maturity date, no certain cash flow, low BK priority $$ Feb 23, 2012
  • Falkenblog: Low Vol Commodity Timing Strategy http://t.co/M4FFRoCx Low volatility seems to work in a large number of areas, this is one $$ Feb 23, 2012
  • Retro Investing?Look Back to Get Ahead http://t.co/vYiPCu9J The 50s, w/post-WWII financial repression, recurs as a current investing meme $$ Feb 22, 2012
  • The Intelligent Investor: Are Index Funds Messing Up the Markets? http://t.co/VAoFtksw May also be traders following each other $$ Feb 21, 2012
  • If history is any indication, high dividend stock outperformance should continue http://t.co/C5GaWmW8 Uses 40s & 50s as analogy $$ Feb 20, 2012
  • Breakout or consolidation? http://t.co/GTSkBjIT Many market seem to be at inflection points. Which way will they go? Wildcards: EZone, China Feb 20, 2012
  • RE: @alea_ Interesting analysis.? I would be wary of teasing too much out of the cluster analysis of sector correlati? http://t.co/zirdOJ8v Feb 18, 2012
  • MORGAN STANLEY: January Exhibited This Tell-Tale Sign Of A Market Top http://t.co/IQqidpUE When everything rises at once, look out! $$ Feb 18, 2012
  • Apple Stock May Not Be as Cheap as It Looks http://t.co/2dgfjfPq Earnings quality has declined, and so has the PE multiple $$ Feb 18, 2012
  • @ampressman Common summary stat 4 acctg quality 4 $AAPL Net Operating Accruals / Assets, has been deteriorating 4 last 7 years + Feb 18, 2012
  • @ampressman $AAPL acctg used to be very conservative, now modestly liberal by that statistic. It’s a bad direction, not a bad position, yet Feb 18, 2012
  • Should the Rich Invest Like Colleges? http://t.co/M9OaPEPA Better question: what are your goals? Do you have an infinite horizon? $$ Feb 18, 2012
  • High Yield Bonds as Equity Indicator | The Reformed Broker http://t.co/OXUtZrWG Meet my friends & former colleagues Ed Meigs & Sean Slein $$ Feb 17, 2012
  • When Earnings Slow, Focus on Big Cap, Quality http://t.co/zjD3RPKA High quality is the place to be at present, credit cycle shifting some $$ Feb 16, 2012
  • A Lesser Known Indicator http://t.co/8oivTJFl Cash enters market through IPOs, employee grants, & exits through cash buyouts, buybacks $$ Feb 16, 2012
  • Parabolas have 2 end somewhere $$ RT @ReformedBroker: $AAPL sold off because people were getting impatient with how slowly it was moving up. Feb 15, 2012
  • FPA Capital?s Bryan Beats Peers Embracing Oil Volatility http://t.co/7ebuGmrb A clever focus on absolute retruns, w/a long horizon $$ Feb 15, 2012
  • Paulson Gives Activism a Go http://t.co/dkHb3cht Not as easy as it looks w/ $HIG. Acctg may not fairly capture variable liabilities $$ Feb 15, 2012
  • RE: @SoberLook DB hedges its bets.? Average years rarely happen in high yield, they are either good or bad. http://t.co/0C51uulu Feb 14, 2012
  • THE 1987 MYTH?. http://t.co/mHSU4nM3 ?Illusion of stability within disequilibrium? Very well said, in one short phrase. $$ Feb 14, 2012
  • America Inc. Faces Margin Stall http://t.co/RbqvqbT9 US companies have begun to see rising costs eat into the bottom line. Finally. $$ Feb 13, 2012
  • Hulbert: Insiders Selling at Heavy Pace http://t.co/qOPk2cbY Just another straw blowing in the wind, but insiders usually have good sense $$ Feb 10, 2012

 

Greece

 

  • Greek PSI outcomes tree: credit event probability at 93% http://t.co/jcLBc04c Clever grraphic shows high likelihood of Gk CDS triggering. $$ Feb 23, 2012
  • The market is now pricing in Greek sovereign CDS trigger http://t.co/w5vJ42Fa Upfront prices for Greek CDS moving up $$ Feb 22, 2012
  • Despite Pact, Unease Lingers for Greece http://t.co/Urp7mmag “Many Problems Remain Even Under Best-Case Scenarios” Shrink, shrink… $$ Feb 22, 2012
  • Greek Rescue Is Not the End of the Story http://t.co/IOCVcCTb Won’t save Greece on its own & there r other fringe nations 2 deal with $$ Feb 20, 2012
  • ECB Greek Plan May Hurt Bondholders While Triggering Debt Swaps http://t.co/Aya9urfV ECB may get better treaqtment than private holders $$ Feb 20, 2012
  • So, what would your plan for Greece be? http://t.co/SAd2f28O Play the game, and let Keynes sneer @ u as u attempt 2 solve the impossible $$ Feb 18, 2012
  • Greek Economy Shrinking Rapidly http://t.co/VzXi375M And it may shrink more rapidly depending on what the rest of Europe does $$ Feb 14, 2012

 

Eurozone

 

  • ECB’s Mario Draghi magic corrupts bond markets http://t.co/r0ZCmYpb Banks become dependent on ECB, bank bondholders more subordinated $$ Feb 24, 2012
  • European Banks May Tap ECB for $629 Billion Cash http://t.co/Re5TjLR5 ?There is a ?lose-lose? air around the ECB?s auction next week,? $$ Feb 24, 2012
  • The Eurozone should be prepared for a new government in France http://t.co/qGFPC20S And that govt will be more hostile to current actions $$ Feb 22, 2012
  • Spain Sinks Deeper Into Periphery on Debt Rise http://t.co/wkuef6tS As debts grow higher, the probability of escape gets lower. $$ Feb 22, 2012
  • Iron Lady Merkel Bucks German Street on Greek Aid http://t.co/Wc95xI47 Strategy working 4 now, but what if colleagues lose their seats? $$ Feb 20, 2012
  • Moody?s Cuts European Sovereigns http://t.co/GvJuES7t Spain, Italy, Portugal, Slovakia, Slovenia & Malta all cut. France & UK -> neg outlook Feb 15, 2012
  • Unlisted in euroland http://t.co/AQQrJMUf Didn’t catch this in Jan. Private bonds can offered 2 ECB as collateral; helps French banks $$ Feb 13, 2012

 

The Well-off Fringe Nations

 

  • Icelandic Anger Brings Debt Forgiveness http://t.co/P4BH8HKN If the debt problem is not severe, austerity. If it is severe (Iceland) default Feb 22, 2012
  • Nordic Currencies Stung in Crisis http://t.co/teorxG1P Much of the world, looking for a store of value, drive fringe currencies up $$ Feb 21, 2012
  • Canada housing market: poised 4 ‘severe correction,’ George Athanassakos says http://t.co/05kaVIAD Canada is used to the boom/bust cycle $$ Feb 21, 2012
  • @joshuademasi You’re right, but most of the fringe currencies are facing the same dilemma; who to favor, consumers vs exporters, etc… $$ Feb 21, 2012
  • Israel Safest as Investors Discount War Threat http://t.co/3oXTlILj Well-capitalized banks & balanced economy w/much high tech $$ #warrisk Feb 20, 2012
  • A hedge fund bets big on a Canadian mega quarry http://t.co/k7OZBC9u Property rights r tough here. What if an existing farmer tried this? $$ Feb 18, 2012
  • Australia?s Gillard Urged to Increase Mortgage Purchases http://t.co/ylsCuvq4 A mistake, far better to let the market fail. $$ Feb 17, 2012
  • You’re right, reminds me of an old piece I wrote: http://t.co/XkgO7z7A Thanks $$ RT @joshuademasi: The 5 stages of USD grieving ! Feb 15, 2012
  • Norway?s Rate Policy Dilemma Pits Household Debt Against Krone ?Headache? http://t.co/Ud4FCOsI Cut rates, asset bubble grows, Krone weakens Feb 15, 2012

 

 

China

 

  • Plan B for China’s Wealthy: Moving to the U.S., Europe http://t.co/X9jRPy6q Wealthy Chinese know their govt, thus the need for flight $$ Feb 22, 2012
  • China?s FDI and Trade Outlook Horrible Says Commerce Spokesperson http://t.co/LIlvmxIL Hard 4 Comm Party 2command domestic consumption up $$ Feb 18, 2012
  • ‘Mother of all bubbles’ will pop China stocks: GMO http://t.co/OMENKZOI Low prob: China successfully navigating soft landing out of a bubble Feb 18, 2012
  • China’s excess exports turn negative http://t.co/CiLgTKqC Key Q: how will China grow its economy by stimulating domestic consumption? $$ #uh Feb 18, 2012
  • Too many bearish on China, but I’m bearish also.? What to do? Seek out China bulls.? If their arguments sound dumb, d? http://t.co/vrhUIdsh Feb 17, 2012
  • The Silent Victims of the U.S.-China Currency War http://t.co/6DXAnE3m Smaller nations get caught in crossfire of competitive devaluation $$ Feb 17, 2012
  • China’s Military Spending to Double by 2015 http://t.co/5Va8kiLr I think it take some losses before DC takes this seriously. $$ Feb 17, 2012
  • China?s Tenuous Hold on Peace http://t.co/dOFr68tL Tibet is restive, China blames its problems on the economic mismanagement of foreigners Feb 14, 2012
  • Glimpses of a Chinese Town Under Lockdown http://t.co/AFoW0zsM some reporters managed to get there to document the heavy security presence Feb 14, 2012
  • Liu Mingkang Outlines the Reforms China needs to Undertake http://t.co/L0cXMoIf Will the communist party willingly reduce its power in China Feb 13, 2012

 

Japan

 

  • Japanese Equities Herald Return to Inflation http://t.co/rxlt5OhI If Japan bond market breaks, ructions will be felt the world over. $$ Feb 23, 2012
  • Energy imports will pressure Japan’s trade deficit http://t.co/lieDm3T4 But, Japan has a current account surplus from its net foreign assets Feb 23, 2012
  • Japan Suggests No Quick G-20 Deal on IMF Funding http://t.co/RZYF5EB2 non-European members of the IMF waiting on the Europeans to act $$ Feb 22, 2012
  • Tokyo Small-Caps Set for Longest Win Streak http://t.co/mD3ySrzh Unnoticed but true, look @ this CEF: http://t.co/VcdMQDxL FD: long $JOF Feb 22, 2012
  • Yen Slumps After Japan Expands Bond Buying http://t.co/L6yImwzC Competitive currency devaluations driving Forex $$ #beggarthyneighbor Feb 15, 2012

 

Iran

 

  • Japan Refiners Said to Stall on Iran Deals http://t.co/uEq1DYtb Life is harder on those that need Iranian oil, like India, China, Japan $$ Feb 21, 2012
  • Iran Says It Loaded Locally Made Fuel to Nuke http://t.co/6HkMaEFj Not sure I believe this, but if it’s true, the Israelis will know 😉 $$ Feb 15, 2012
  • Iran presses ahead with dollar attack http://t.co/Hd4Qtnvz Unlikely to work, but it’s all they can do w/oil transport shut down $$ Feb 14, 2012
  • Letter Writers Break Iranian Taboo http://t.co/M3NMfmk1 They are so desperate that they write the Ayatollah and criticize conditions. $$ Feb 14, 2012
  • Iran Sanctions Tighten as Shippers Stop Loading http://t.co/ubEtI6om Risk goes up, shipping insurance premiums rise, shipping stops $$ Feb 13, 2012

 

Rest of the World

 

  • Record Redemptions Loom Amid Akbank $1.3 Billion Loan Talks http://t.co/x5iDTSwE Never knew Turkish firms financed w/so much Short debt $$ Feb 18, 2012
  • Chavez Missing $10 Billion a Month by Curbing State Oil Investment http://t.co/uTG1Z8d8 PDVSA falls behind Pemex? How low can you go? $$ Feb 15, 2012
  • Ch?vez Opposition Faces Hard Election http://t.co/YBWi9PaW Chavez controls media & oil wealth; tough for Capriles, but he can still win. Feb 14, 2012
  • Gunfights in Saudi Arabia Show Spread of Tensions http://t.co/dNxhg2ij Shia in Saudi Arabia fight the govt. Biggest split in Mideast $$ Feb 14, 2012
  • The Real Reasons the Rich Are Moving Cash to the Caymans http://t.co/gh7d85ZA Litigation risk, and US political risk; diversify yr govts Feb 13, 2012

 

Federal Reserve / Monetary Policy / Fiscal Policy

 

  • Those believing the Fed is on hold for the next 3 years will be in for a rude awakening http://t.co/VYggm431 FF futures & TIPS betray mkt $$ Feb 24, 2012
  • Exported Inflation to Return Home, but When and in What Form http://t.co/UHT61w4Y The Fed will find it hard to shrink its balance sheet $$ Feb 24, 2012
  • Healthcare expenses will overwhelm the US federal budget http://t.co/lLUABMYy Suspect a deal will b driven 2 reduce benefits somehow $$ Feb 23, 2012
  • ?Fiat Money and Collective Corruption? http://t.co/lRAa2xnG Hard money would help, the bigger problem is light regulation of banks/credit $$ Feb 23, 2012
  • Fed Writes Sweeping Rules From Behind Closed Doors http://t.co/UtozNgly Q: Why? 2 avoid bank influence, or 2 hide bank influence? $$ Feb 21, 2012
  • The Race To Debase In All Its Glory http://t.co/rPtS9EqD Balance sheets of major central banks expand rapidly $$ #racetothebottom Feb 21, 2012
  • Wealthy Enriched by Double-Dipping U.S. Plan http://t.co/YtGTfakC Long article describing unethical use of SBA $$ . #eliminatetheSBA Feb 21, 2012
  • Over-regulated America http://t.co/uMKtg2W0 The home of laissez-faire is being suffocated by excessive and badly written regulation $$ Feb 18, 2012
  • Geithner: GOP Walked Away From Tax Overhaul – Bloomberg http://t.co/yupPqVeO Articles like this indicate another stalemate in the making $$ Feb 17, 2012
  • Potomac Divide Shows Foreclosures Thru Courts Slow Home-Price Recovery http://t.co/kilW75GM MD has slow foreclosures, housing mkt lags VA Feb 16, 2012
  • Sober Look: Regulate it all, ask questions later http://t.co/qnpfakfJ New regulations reduce the liquidity of the corporate bond market $$ Feb 16, 2012
  • FHA is almost broke. What will DC do when it goes critical? RT @HousingWire: FHA defaults up for ninth straight month http://t.co/TSZFHCeD Feb 15, 2012
  • Pentagon May Oust Troops Involuntarily to Meet Reductions in Budget Plan http://t.co/VnY4At7J Tough time 2b let go if you r a veteran $$ Feb 14, 2012
  • What a surprise! $$ RT @pdacosta: Bernanke’s big housing speech makes no mention of the Fed’s regulatory laxity in run-up to the crisis. Feb 10, 2012

 

Bonds

 

  • Contra: Should Mortgage Rates Even Be Lower? http://t.co/lODEFb1P Mortgages do not price off of Tsys, but swaps and bank bond yields $$ Feb 22, 2012
  • Wall Street Crowds Into Trader Joe?s http://t.co/dHZT83VK CMBS mkt getting heated; loans linked 2 retail rose to 45% 4 bonds sold in 2011 Feb 22, 2012
  • ?Have a lot of friends who have lost a lot of money waiting for $TLT to break. FD: long TLT http://t.co/Lw6Rqn02 Feb 21, 2012
  • A $360 trillion confidence trick http://t.co/Kar0f3Cz I have argued that LIBOR should be based off of binding offers to borrow/lend $$ Feb 14, 2012
  • http://t.co/VOIG2gUk W/TIPS NY Fed concentrates on the long on-the-run & nearby, w/nominals opposite. Makes implied inflation look higher $$ Feb 10, 2012

 

 

Muni Bonds

 

  • Stockton, CA, to Weigh First Steps Toward Bankruptcy http://t.co/d2lsCmx8 Start of negotiations to reduce emplyee pensions & healthcare $$ Feb 24, 2012
  • Good piece, thx RT @munilass: Evaluating Chapter 9 Bankruptcy for City of Detroit: Reality Check or Turnaround Option? http://t.co/PxWo5qHA Feb 21, 2012
  • Yes. http://t.co/4DUVVTKi $$ RT @BarbarianCap: @munilass isn’t this the muni book that @AlephBlog reviewed very favorably a few days ago? Feb 20, 2012

 

Pensions

 

  • New Rules Wreak Havoc forRetirement-Plan Sponsors http://t.co/HzHWTTtL I would expect rules to be modified, else headaches 4 DC plans $$ Feb 24, 2012
  • @BarbarianCap Looking at the RFP, that is one of the few things *not* under consideration, pity too, because it is more important. #DumbOCPP Feb 23, 2012
  • @BarbarianCap The audit is a test of methods and data, not assumptions. That’s actually pretty normal unless you an assumptions outlier $$ Feb 23, 2012
  • @BarbarianCap I’ve said it many times b4, if life insurers have 2b conservative in accounting, DB plans s/b more so, but they r less so $$ Feb 23, 2012
  • @BarbarianCap Some cases, deals will be driven to reduce benefits, depends on state/muni laws, Ch 9 allowable; not protected by ERISA/PBGC Feb 23, 2012

 

Stocks

 

  • The Capabilities Premium in M&A http://t.co/9CdZIugk Long piece that explains why some mergers work; they aid organic growth & r small $$ Feb 22, 2012
  • Elemental to Raise $1.7 Billion Next Year to Mine Potash http://t.co/w7GNsA2H Potash pricing has been volatile lately, cross-currents $$ Feb 22, 2012
  • Gamestop to J.C. Penney Shut Facebook Stores: Retail http://t.co/zSui0fCf $FB may have a more difficult time w/retail than some expect $$ Feb 20, 2012
  • Hewlett-Packard’s Message: We’ve Been Here All Along http://t.co/vU8piGMt Note: long $HPQ . HPQ definitely sounds more certain now. $$ Feb 16, 2012
  • Icahn Pushing CVR?s Sale Means $1 Billion Gain for Shareholders http://t.co/TfBKGErf What refiner wants more capacity now & fertilizer? $$ Feb 16, 2012
  • Hedge Funds Switch Positions, While Paulson Switches Investing Style http://t.co/MznmLhci Issue w/ $HIG is value of Variable product biz $$ Feb 15, 2012

 

Miscellaneous

 

  • The Control Revolution And Its Discontents http://t.co/FY4XgPde There is a “sweet spot” for market efficiency, too much & things get chaotic Feb 24, 2012
  • The Decline In Inventory Right Now is NOT a Good Sign http://t.co/Ra1Iz65H Fall in seller confidence & decline in new distressed inventory Feb 23, 2012
  • Spring Lambing in UK Turns Deadly as New Virus Kills Young http://t.co/PrO4neT1 Infects pregnant sheep, cows and goats, 5% infection rate Feb 22, 2012
  • Midwest Farmland Prices Update for the Year 2011 http://t.co/se9DbEgB Good discussion after a good article; things r getting a little bubbly Feb 22, 2012
  • Finding Treasures Among Insurer’s Wreckage http://t.co/jiFZiydE Never bot Atl Mutual’s Surplus Notes, but historical curiosities, wow $$ Feb 18, 2012
  • @StockTwits Insurance is boring, but antiquities at the oldest companies are fascinating. Wonder what Nationwide did w/Provident Mutuals? $$ Feb 18, 2012
  • @StockTwits I would hold meetings every now and then in Provident Mutual’s underused antiquities room; would start good conversations $$ Feb 18, 2012
  • Why Is Violent Crime Declining in US Cities? http://t.co/SLgD8bEL & http://t.co/RRRI2m8X Smarter law enforcement makes DC safer. Wow! $$ Feb 18, 2012
  • Thanks, liked it. RT @onwrdnupwrd: you will like this one from this weeks economist http://t.co/DMqhgXBB Feb 18, 2012
  • Interracial Marriages in US Reach a Record http://t.co/RJjWnTso Interesting that it is more prevalent with college educated people. $$ Feb 18, 2012
  • Harvard Mapping My DNA Turns Scary http://t.co/m5stl0d2 Journalist learns hard things about his DNA. Would he be better off not knowing? $$ Feb 18, 2012
  • Groupthink: The brainstorming myth http://t.co/7VBlhzKC People do better solving problems on their own, and sharing ideas w/the group $$ Feb 18, 2012
  • Fear, Submission, and Authoritarianism; a Disturbing Trend http://t.co/0lb32tOw Negative social mood leads to loss of liberties $$ Feb 16, 2012
  • Santorum?s Electability Pitch Undermined by 2006 Senate Re-Election Loss – Bloomberg http://t.co/8xglQQPJ Shouldn’t be an issue, here’s why: Feb 15, 2012
  • As the late Bob Casey said, “You can’t lose if you are a pro-life Democrat.” This is true, and it is why Santorum lost to his son. $$ Feb 15, 2012
  • Cracking the Long-Jump Code http://t.co/MN9d9EdJ Fascinating science applied; the key seems 2b2 jump higher, not just longer $$ Feb 15, 2012
  • The Best Foods for Thought, Literally http://t.co/tMyLW9E2 Perhaps the Mediterranean diet can aid brain function, or a lowcal diet $$ Feb 14, 2012
  • Contra: Almost Half the Price of Oil is Speculative Premium http://t.co/z8t51JOl It should be impossible to so overprice such a large mkt $$ Feb 14, 2012
  • The Hunt Brothers thought they could corner a much smaller silver market, and were not able to do it.? The oil compan? http://t.co/MLYVH5w3 Feb 14, 2012
  • So, What’s Your Algorithm? http://t.co/lC4voWCI Being able 2 crunch large amounts of data can lead to more objective decisions $$ #ornot Feb 13, 2012
Musings on the “400% Man”

Musings on the “400% Man”

Posted on by David Merkel

When I read the following article at SmartMoney, I said to myself. “I have done almost as well, I am more diversified, and I am willing to explain more of what I do.”

Truth is, clever investors, or lucky investors can get an attitude, saying that they don’t have to explain themselves to outsiders.??? Not a good place to be. I am not saying that the performance is due to luck but there is a certain amount of respect due to investors for investing with you.

Before I write more, let me state that I respect Allan Mecham.? He manages more money than I do, and has a better track record.? If I were in the shoes of the investors who were analyzing him, I probably would have placed $5 million with him, and would have watched what he did carefully.

Why would I take the risk?? It’s tough to find non-consensus views that make significant money.? I wouldn’t want to make it a huge allocation initially, but I would put a toe in the water to see what he would actually do.? If it didn’t work over 5 years, I would pull the plug.

All that said, when you run a very concentrated portfolio, it is possible for a few decisions to drive a lot of performance.? I would feel more confident regarding someone who had made more correct decisions, because it would indicate a higher likelihood of a repeatable process.

Let me give you an example from my own portfolio.? I own SABESP [SBS], one of the largest water utilities in the world, which provides water and other services for the city of Sao Paulo in Brazil.? I got the idea from Cramer.? It’s the only idea I have ever gotten from Cramer and acted on.? I have held it for eight years, and the stock has quintupled.? Beyond that, I have made trading gains, because it has been somewhat volatile, as most Brazilian stocks have been.? And what proportion has this been in my portfolio?? Around 3%.? The largest position in my portfolio over the last 12 years has been 8%, and it has been rare to have a position larger than 4%.

One strength of what I do in asset management is that I don’t force trades.? I’m patient.? I trade 3-4 times a year, swapping out 2-6 companies each time.? The portfolio turns over once every three years.?? But that means that roughly one-third of the portfolio I have held more than three years.? It’s not that those companies are old friends, but they continue to survive the tests that I give the whole portfolio.? That said, when I sell one of those held longer, I do feel a slight sense of loss; it’s like losing a close friend.? I know I contradicted myself here, but that’s because my views are ambiguous here.? My summary would be that I love the companies that I have held for a long time, but they have to pass the test 3-4 times a year.? There are no free passes, and no sentimentality.

I know more about my own processes than I do of Mecham’s.? But I have felt the cold appraisals from institutional managers over the last five years, with the implicit complaint — “you have done well, but you don’t manage enough money, so we are not going to invest with you.”? This is the same response as “we don’t buy anything other than IBM.”

I can talk about my own processes until my face turns blue.??? They will still work in most environments.? But the article tells a story of investors that are risk-averse, but without any good sense of what true risk is.

For those that are looking for the next great investor, he does not look like the next great investor, but he looks odd, like Buffett did in the 50s and 60s.? Take the chance, and invest with the odd value investor.? Invest with several of them, diversify.

If I were managing assets for a pension fund, I would assemble a stable of new-ish value managers, and that would be 70% of my portfolio, with 30% investment grade bonds.? Boring and beautiful.

Without reviewing Allan’s trades, I can’t say how certain I am of his abilities.? But I would have a bias in favor of small value managers with good track records, particularly those who have been diversified.

Full disclosure: long SBS

 

Individual Investing Can Be Tough

Individual Investing Can Be Tough

Posted on by David Merkel

I am glad I began investing 20+ years ago.? If I were considering starting now, I would likely not do it.? Why?

1) Too much data.? There are too many factors to consider in investing. That there is a wealth of data to consider is certain, but what are the right factors to look at?

2) Crowded.? More people and firms are investing.? The competition is higher.

3) There are more games in trading.? Makes it a lot harder to get good executions.? The low costs of transaction have created monsters.

4) ETFs affect the market as a whole.? They allow average people to speculate on broad trends, without telling most of them that they are noise traders, and are getting taken for a ride.? Dollar-weighted returns are far less than that for buy-and-holders in ETFs.? The traders are getting creamed.

5) Social media leads to groupthink, which lowers overall returns, at least for those that get there late.

6) ETFs allow investors to play well outside their circle of competence.? Beyond that, some ETFs don’t always do what they promise because of the derivatives that they use, roll, etc.

7) We are in a macroeconomic environment where we are delevering.? That is not the best environment for making money.

In general, I think most individual investors are cows for the institutions to milk.? But there are a few ways to immunize? yourself from this:

a) Hold very short or very long.? I lean toward the latter.? Don’t give up quickly on your investment ideas.? Buy and hold for years, not months.? Ignore the chatter, and read the data from the company and trusted third parties.

b) Use a value bias, and focus on companies where there is a margin of safety.? Buy the shares of companies with lesser growth prospects, that are selling cheaply.? Who cares if earnings aren’t growing if the earnings yield is over 15%.

 

On Multiple Asset Allocation Methods

On Multiple Asset Allocation Methods

Posted on by David Merkel

From a reader who is a dear friend of mine:

There are obvious many disparate approaches to asset allocation.? Similar to the disparate approaches of any style of investing, each asset allocation approach has its own particular pitfalls.? Some of these you can plan for and perhaps hedge against or at least mitigate the potential negative impact from those pitfalls, while some booby traps spring up out of nowhere.? Risk Parity issues revolve around leverage, negative skew, and potential negative returns from certain levered asset classes.? Long-term strategic asset allocation may suffer from the quality of initial assumptions and typically relies on stable volatility profiles and correlations between asset classes.? And so on.? Every professional investor ? let?s take an endowment for instance ? diversified its portfolio among several asset classes and styles of management.? But what is interesting to me is that I?m not sure I?ve ever seen an institutional (or even HNW) investor diversify its portfolio among multiple asset allocation approaches.? Theoretically, splitting up a portfolio between 3-5 different AA approaches (strategic, risk-based, tactical with an opportunistic value lens, tactical with a momentum/trend-riding lens, etc.) mitigates the pitfalls of each one.? What are your thoughts here? ?I have a few of my own, but I don?t want to muddy your own intellectual waters ahead of time.? 🙂

My personal approach to asset allocation is similar to Warren Buffett, or Value Line.? I invest mostly in stocks, and keep a bunch of safe assets for liquidity.? As the market rises, I add to my safe assets.? As the market falls, I buy stocks.? In October of 2002, things were so bad that I depleted my safe assets, an everything was in stocks.

In general, I think most complex asset allocation strategies are overly complex.? In general, there are safe and risky assets.? Asset allocation should first focus on the division between the two.? Typically the safe assets are high quality bonds and cash equivalents.? Sometimes there are more opportunities, sometimes fewer.? Safe asset levels should reflect that.

The second focus of asset allocation should be liquidity needs.? Even if there are a lot of promising opportunities to deploy cash, if the liability that funds the assets needs cash, have cash ready for it.? If you invest in limited partnerships or private companies where the assets are locked up for a period of time, have a sense of what your maximum level of illiquidity is (what will you with certainty never need to tap?), and ladder the investments so that like a laddered bond portfolio, you always have some illiquid investments maturing each year, providing fresh cash for deployment where current opportunities are most promising.? These top two ideas are very basic, but even experts neglect them at times.

The third focus of asset allocation is choice of risk assets, which is how I view your question.? There my view of asset allocation is like that of GMO.? Forecast future returns off of free cash flow yields; invest accordingly.

Don’t pay much attention to volatility, but aim for what is most likely, and bend a little in the direction of what can go wrong.? Most of the time, over longer periods of time, what is most likely happens on average; that’s why it is most likely.

Maybe “Too many cooks spoil the broth.”? I have enough trouble trying to work with momentum versus mean reversion.? I would lean toward having one AA strategy that fits with my broader asset management practices.? But on the other hand…

Suppose we did have five asset allocation models, and what their results were encouraging various investors to do.? If we thought that one of the models had been too hot of late, and was attracting too much money, and distorting ordinary market relationships, maybe that could give us a signal to make sure our asset allocation de-emphasized the results of that method.? Timing of course would be difficult, it always is, but seeing the results of the five methods could provide a fuller view of choices faced by our competitors.

I’m not sure that using the average of a number of asset allocation models will provide the best result, but I think that understanding what other players in the market are doing could lead to better decisions.

I’m open to your thoughts, and the thoughts of other readers here.? Anyone have a better idea?

Against Risk Parity, Redux

Against Risk Parity, Redux

Posted on by David Merkel

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.? For additional support consider my article Risks, Not Risk.? Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.? There are many risks.? Interest rate risk and credit risk are different topics.?? There are bonds that have interest rate risk but not credit risk — long Treasuries.? There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.? For fixed income, I described those in the two articles linked in the last paragraph.? During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.? But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.? The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.? The second moves in line with 5-year Treasury yields, and short senior bank spreads.? The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.? But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.? History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That?s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

?It?s called risk parity,? Gundlach says. ?There?s only two investors who seem to understand it?me and Ray Dalio,? the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.? I’ve run the regression of Treasuries vs junk bond index yields many times.? It’s barely significant for BBs, and insignificant thereafter.? Second, look at stock market indexes of industries that lever up and issue junk debt.? Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.? With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.? Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.? Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.? Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.? Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.? Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.? You can’t be certain that you will be able to ride through the storm.? The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.? But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.? If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.? I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.?? First in the hands of the master, last in the hands of a sorcerer’s apprentice.? Be careful.

PS — I have respect for the skills of Gundlach and Dalio.? I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.? And, here is a nice little piece about Bridgewater and its strategies.

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