Value Investing – Page 55

Book Review: Best Practices for Equity Research Analysts

Posted on 15 April 201115 April 2011 by David Merkel

My friend Tom Brakke, liked this book and said I would too.? He was right, and soon afterward, I heard the author speak at the Baltimore CFA Society.? Hearing James Valentine speak is an advantage here.? He summarized what is most important, which if you are reading the book, it would be chapter 20 (out of 27).? It is his FaVeS framework: Forecast, Valuation, and Sentiment, in that order of importance.? Remember that as a key to the book if you read it; it tells you what to focus on as an analyst.

Another key, since the book is long, is to look at the shaded summaries which are usually at the back of each chapter.? If stretched for time, read those first, and then read the chapter if you didn’t get it.

This book aims to focus analysts on information that matters.? Aim for information that makes a difference, and that few others have.? Create an information web that maximizes the value of your time, and creates value? for your research.

This book covers both the buy-side? and the sell-side, telling each how to best use the other side.? As a former buy-side analyst, to me it means fewer analyses, and better analyses.? Aside from that, it is a game: buy-side: identify the? better sell-side analysts and listen to them.? Sell-side: identify clients that will generate commissions and market their best insights to them.

Regardless, analysts must identify the few factors that account for 80% of the performance in a given industry, and focus on those intensely.? It helps to get into the industry organizations, which can help drive insight into the industry as a whole, and provide a backdrop for questions to ask when talking with executives in the industry.

Learning this will give an analyst a leg up on other analysts.? Analysts should also understand the basic accounting structures of their industry so that they can identify companies that are not playing fair — over-reporting income.? I would add don’t get negative too quickly.? Frauds can develop a momentum of their own.? Wait until the fraud gets large relative to the size of the industry before issuing a sell call — wait for price momentum to go to zero.? (Note: for investigative journalists, this does not apply.? Jump on early, so that you can say that you warned everyone.)

Basic forensic accounting skills help, as do modeling skills, and basic statistical skills.? I was surprised to learn a bunch of Excel shortcuts that I haven’t seen elsewhere, and I have used Excel for nineteen years at a high level.? The summary of accounting deviations is cogent, as well as pointing readers to Mulford and Schilit.

One idea that I heartily agree with: set up your spreadsheets to differentiate data and formulas.? Cells with data series should only contain data.? Formulas should have no numbers in them, unless they are trivial.? This makes analysis a lot easier and cleaner in the long run.

The book also brings out the need to consider multiple scenarios, which help an analyst to flesh out his analysis.? Being willing to consider what can go wrong, or right, richens an analysis.? Also, the book warns against common pathologies that overcome analysts, notably — Confirmation bias, overconfidence, Self-Attribution-bias, Optimism, Recency, Momentum, Heuristics, Familiarity, Snakebite (won’t go back to one that hurt you), Falling in love, anxiety, over-reaction, loss-aversion, etc.? I have experienced a few of those myself, and would have benefited from thinking these through before becoming an analyst.

Quibbles

I would warn any analyst trying to use simple or multiple regression that they are playing with fire, unless they understand the weaknesses of the data, and the limitations of the general linear model.? In twelve-plus years working on Wall Street, I never saw regression used right once.

The author seems to favor DCF over multiples.? Truth, neither works well, and one must live with the weaknesses of any approach.? DCF embeds a lot of assumptions that are known, though some may be wrong — multiples embed unknown assumptions.

The author does not like price-to-sales.? For industrials and utilities I would say look at a chart of price versus price-to-sales.? In most cases, they track, because sales don’t vary that much in the short run.? If you know the high and low P/S ratios for companies in an industry (P/B for financials) you have valuable information.? It gives you boundaries to look at in buy and sell decisions.

I would also warn analysts against using Damodaran and those like him.? I don’t think his models are wrong so much as impractical.? I would rather use a simple model that catches 80-90% of the action, versus one that catches 100% of the action, bet cannot practically be calculated.

Who would benefit from this book:

All equity analysts would benefit from this book.? It is detailed, and yet practical.? Some of our competitors will benefit from it, and if you don’t read it, you will wonder why.

If you want to, you can buy it here: Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts.

Full disclosure: This book was sent to me because I asked the author to review it after he spoke to the Baltimore CFA Society.

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.

Vote Your Proxies

Posted on 12 April 2011 by David Merkel

Part of being a shareholder is corporate governance.? It is incumbent on us to vote the proxies we receive.? To my left, I have ten or so proxies I will vote tomorrow.

If we don’t vote our? proxies we have no right to complain about corporate governance.? And, for those who own mutual funds, have you told your mutual fund company what you care about?? They may or may not listen to you, but if they hear a decent number saying the same thing, they might take your position, multiplying your opinion by ten or more.

Voting proxies is a matter that helps keep shareholder capitalism morally legitimate.? Without it, corporation managements are tempted to do as they please, which generally leads to worse results for all but management.

And if I might get on the soapbox for a moment, I would like to say that we all as investors should begin to vote down management pay and incentive packages where we can.? Let’s engage in brinkmanship.? They are paid well enough already.? If they don’t get the increase, where will they go?? And, isn’t there a lot of talent in the wings that could replace them?? My view is the best management teams are those that love what they do for the challenge, rather than the money.

Incentives for the rank and file are another matter, and should be approved, unless they are excessive.? Also, ignore the special interests of the loony left who own stock only to affect corporate policy.

That’s all.? I have been traveling and am rather tired.? But vote your proxies!

Everything Old is New Again in Bonds

Posted on 6 April 2011 by David Merkel

Unconstrained strategies for bonds are hot now with yields so low.? But wait. Let’s take a step back.? What do we mean by a constrained strategy?

A constrained strategy is one that limits the investments one can engage in either through:

Specifying an index that the manager is charged with beating
Specifying percentage limits for investments, split by categories such as credit quality, interest rate sensitivity, asset subclasses (ABS, RMBS, CMBS, Corporates, Agencies, etc.), and other variables
Barring investment in more funky fixed income instruments such as preferred stock, trust preferreds, junior debts, CDOs, ABS, RMBS, CMBS, etc.
Or some combination of the above.

There have been unconstrained strategies in fixed income before — they just weren’t called that.? Many value investors in the old days didn’t care what the legal form of the investment was — they only looked for an adequate margin of safety.? Their portfolios were a hodgepodge of debt and equity instruments.? Specialization in only doing debt instruments wasn’t common.

Most debt-only investments were constrained, particularly those from bank trust departments.? Of course, this was an era where investing in junk debt was not respectable for all but the most intrepid of investors.

With the advent of the 1980s we had two innovations: junk bonds and bond index funds.? The first took the world by storm with the demand for yield; I experienced that at the first insurance company that I worked for — they overloaded on junk bonds.? This was before the regulators began regulating bond credit quality more strictly.

The second took a longer time to germinate.? The first bond index fund came into existence in 1986 at Vanguard.? They couldn’t call it a bond index fund, because they could not exactly replicate the index.? There were too many bonds that were illiquid, and they could not buy them at any reasonable price.? Instead, they took an approach that we would call “enhanced indexing” today.? Match the interest rate sensitivity of the index, and the credit quality, but choose bonds that had more potential than the bonds in the index.

In that sense, though the SEC allows bond funds to be called index funds today, all bond index funds are enhanced index funds because there is no way to source all of the bonds.? And from my own days as a corporate bond manager, I learned that bonds in major indexes always trade rich.? From my piece, The Education of a Corporate Bond Manager, Part IX:

There was another example where I crossed bonds where it was legitimate ? if it was done to help a broker in distress.? One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se.? After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them.? He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went).

The whole set of two transactions took 15 minutes, and made $15,000 for my client.? What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids.? They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say ?Hi,? ending with the then three-year old girl who squeaked ?Hi.?? He said something to the effect of, ?I knew you had a large family, but it only really struck me now.?

That three-year old is now a beauty at twelve, and bright as anything, but I digress.? (They grow so fast… the nine-year old girl is cute as a button too.)

Bond management was once unconstrained by those who looked for total returns in the old days, and constrained in the old days by those who looked for yield.? (Many managers would not buy bonds that traded at a premium.)? Then the bond indexes became popular as a management tool.? In one sense, it freed bond management, because rather than hard constraints, they matched credit and interest rate sensitivities of the index.

But what that constrains is credit policy and interest rate policy.? One managing to beat a benchmark index has limited options.? What if you want to position for:

Widening credit spreads
Narrowing credit spreads
Rising interest rates
Falling interest rates
Yield curve steepening
Yield curve flattening
Outperformance/underperfomance of a given sector

Any sort of directional bet could go wrong, and more often than bonds that fit the idea of replicating the index parameters, but are special in ways that the index does not appreciate.? So rather than going “whole hog” with the bet, you merely lean toward it, such that if you are wrong, you won’t destroy the outperformance versus the index.

But in this modern world where derivatives are widely accepted as fixed income instruments, a la Pimco, fixed income managers can do a lot more.? There is more freedom to make or lose a lot of money.

The unconstrained strategy can be thought of? in two ways: always trying to earn a positive return with high probability (T-bills are the benchmark, if any), or being willing to accept equity-like volatility while the bond manager sources obscure bonds, or takes large interest rate or credit risks.

I prefer the first idea, because it is more conservative, and fixed income management should aim for safety on average.? As I have said before, I only believe in taking risks that are well-compensated.

But here’s a hard one.? With the yield curve so wide, shouldn’t a bond manager with an unconstrained mandate put a little into long bonds or long zeroes?? I would think so, but I wouldn’t put a lot there unless the momentum started to favor it.

I like the concept of the unconstrained strategy; indeed, it is what I am doing for clients, but it is of the first variety, try to make money for clients in all markets, and not just be a wild man in search of yield or total return.

I find the move to unconstrained mandates to be a return to what value managers did long ago, but in a more complex fixed income environment.? I wonder though, as to whether the future failures will invalidate the idea for most.? It is tough to manage any asset class while adjusting the risk level to reflect what should not be done in a given era, whether in equities or debt.? The danger comes from trying to maintain yield levels that are higher than what is sustainable.

Three Years from Now

Posted on 19 March 201120 March 2011 by David Merkel

With my portfolio management rules, one implicit idea is that I am not managing for the near future.? The near future is a crowded trade.? How is it crowded?

High frequency traders schnitzel away at the bid-ask.
Day traders and swing-traders play with chart patterns, and generally follow the trend, perhaps to some advantage on average, or not.
Quantitative equity managers turn their portfolios over rapidly.? What?s the average holding period, three months?
Mutual fund managers and many institutional equity managers turn their portfolios rapidly.? The average holding period may be in the vicinity of ten months.
Long-short equity hedge funds have short holding periods as well.
ETF trading tends to be rapid, but how much effect that has on the underlying is less certain.

The Buffetts of the world are rare, where the favored holding period is forever.? Marty Whitman also rarely sells.? Maybe my mother comes close, with holding periods around a decade, and she has done well over the years.

I set up my methods to get into a less crowded game.? When much money plays for the short-run, why not play for the intermediate-term?? You don?t have to play for the Buffett-like forever ? after all, he is playing a different game as he builds a conglomerate that can likely prosper after his death in most scenarios where the US survives.

Even Buffett did not play for forever when he had less capital; he would do some arbitrage, which was short term.? He would buy stocks that he would trade away a few years later.? Forever became the mantra as the assets to deploy grew large.

I manage money for a small but growing number of clients.? I don?t have the constraints that Buffett does.? But I would rather choose a less crowded area in which to compete.? Thus I aim for three years out.

Pimco and Value Line

There are others that institutionalize a longer view.? I will mention two of the better known in the retail community.? Value Line, for its data service does an economic projection 3-5 years out, assuming economic growth and no major wars going on.? I often think their projection is too bullish, but the point is to give a common set of factors off of which to base financial projections for the companies that they follow.

As an aside, Value Line as a service has hit hard times largely because the short-cycle aspects of the service that go into the Timeliness Rank are overanalyzed by the market ? price momentum, earnings momentum, and earnings surprise.? But that doesn?t mean that the data service is useless ? where else do you get so much data on a page?? Even Buffett uses it.

Pimco does a three-year projection to analyze where the various bond markets and economies will likely be.? That feeds into their overall asset allocation across the fixed income asset classes.

Mean-reversion?

My view is that we have to look past the present day, and ask what will things will be like three, maybe five years from now.? During times of crisis, ask whether there is a permanent change going on, or one that will likely be fixed.? Most problems will likely be fixed, so crises are times to add more cyclicality to the portfolio little by little.? Don?t be a barbarian and make bold moves.? You could be wrong.? But don?t be a ?fraidy cat and panic, lest you be the one that loses the most.

True structural shifts are rare.? Absent war on your home soil, plague, famine, rampant socialism (not seen in the US or Western Europe yet), most change tends to happen gradually, often due to social or technological change.? More often than not, the politicians and regulators are behind the curve, reacting slowly to a societal/business environment that has already changed.? This applies to emerging markets as well.

So, during a crisis, leg into investments that you think people and businesses will still need 3-5 years from now.? In fixed income, think of what cashflow streams might be in demand relative to inflation rates.? Think in terms of industry mean-reversion, while avoiding buggy whips like newspapers, bricks and mortar booksellers, fixed-line telephones, etc.? Most of the areas I avoid are areas where the internet is collapsing margins of offline businesses.

But when things are running well, think of taking a little off the table, particularly in areas where the economy is running hot.? Again, little-by-little ? the peak of the credit cycle is not a peak but a mesa, where it may take 2-4 years before the credit bust hits.? But, the longer we have been on the mesa, become more aggressively conservative.

Risk Control Done Up Front

Risk control is difficult to do on a spur-of-the-moment basis, when an event has happened, and your stock is down 10% or more.? And that?s not to say that I don?t experience events like that on single stocks every now and then.? The point is to think ahead now, and minimize the odds that your total portfolio will not be badly positioned for the next three years, taking account of what might go right or wrong, and the approximate odds thereof.

To manage a portfolio in this way is businesslike, like a flexible diversified company that invests in more promising business lines, while selling/reducing capital to business lines that are less promising.? It also gives ideas time to develop; mean reversion is typically a 3-5 year process, so allow time for this.? Patience in a good idea will be rewarded.

Industry Ranks March 2011

Posted on 13 March 201113 March 2011 by David Merkel

I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I like technology names here, some utilities, and healthcare-related names, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

I?m looking for undervalued and stable industries.? Human resources ? sure, more part time workers.? Healthcare information?? A growing field, even with the new ?health bill.?? Same for Biotech, though I can never find companies that I can understand.

Even in a double dip, phone calls will still be made, and the internet will still be accessed.

I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is more highly cyclical than I have seen in quite a while.? I will be very happy hanging out in dull stocks for a while.

That’s why I’m not digging through any red zone stocks this time.? I don’t see the value, especially if we have a slowdown globally, and/or in the US.? I don’t trust this economy.

On the Reinsurers

Posted on 11 March 2011 by David Merkel

Insurance is a part of my life.? I’ve spent more than half of my life working with insurers in one way or another, and when unusual events happen, my phone rings, or I get e-mails, with people seeking insight.? Recently it has been regarding AIG, but in the last day it has been regarding reinsurers.

Full disclosure: my clients and I own shares in PartnerRe [PRE].? I may take positions in other reinsurers, but I am not planning on that anytime soon.

So, one friend of mine who writes a pseudonymous blog wrote me, saying:

Hi David – perhaps you can shed some light on this – for years I’ve heard the logic that catastrophes are bullish for insurers, as it allows them to raise rates.? I REFUSE to believe this.? I cannot for one second imagine that insurers would choose A) catastrophic payouts and rate increases vs B) no payouts and lower rates.

Here was my response:

They are bearish for insurers with large exposure to the contingencies, and bullish for insurers with no/little exposure to the contingencies.? But in aggregate, it is bearish ? think of the ?brick through the window? fallacy on GDP.

David

PS ? the better managed, less levered insurers/reinsurers do tend to do relatively better out of big crises, because they will have the capital to write the juicier business in the next year?

Now, PartnerRe was off a little today, but that doesn’t surprise me much — they usually have a little exposure to everything.? Very diversified in their liabilities, and conservative in the way they run their business.? My kind of reinsurer.

But then Flagstone Re was off over 12% today.? I owned this at one point in time, but don’t now.? After today’s losses, I may revisit them, but I am not in a rush.

Story: in 2004 and 2005, working for a hedge fund, I found the reinsurers to be some of the most intriguing companies to invest in, or short.? Particularly in hurricane season, there were a lot of trading opportunities.? Whenever there are significant events, you start keeping a spreadsheet, and as companies report likely losses, you populate your table.? You have to talk with investor relations, or the CFO, to see whether a company plays in that area of reinsurance, and to what degree.? Most of this is not in documents filed with the SEC, until results come afterward, through press releases, and 8Ks.

In 2005, one company, Montpelier, admitted no significant losses after Katrina, and it really stood out as an anomaly on my spreadsheet.? This was the only time I have ever gone from long to short on a company, ever.? Eventually Montpelier admitted the claims that were coming, and the stock price adjusted lower, and we covered.

Now, I am not up on all of the exposures of reinsurers at present.? Were I back in the saddle as a buyside analyst, I would be building my spreadsheet, and calling reinsurers to get an idea of how much exposure (not losses per se, but did they write business there?) they have to the recent troubles:

Last year?s New Zealand earthquake
Flooding in Australia in December and January
Tropical Cyclone Yasi (Northern Queensland)
This year?s New Zealand quake
The current Japan quake

Now if I were more of a trader, after research I might be inclined to take positions in Aspen, Axis, Flagstone, and Platinum.? But there is a lot of research to be done here, and I would not take any positions without significant due diligence, which I have not done here.

So be careful.? Rule number one is don’t lose money.? Rule number two is don’t forget rule number one.

Full disclosure: long PRE, for me and for clients

Book Review: Value: The Four Cornerstones of Corporate Finance

Posted on 11 March 2011 by David Merkel

I was pleasantly surprised by this book.? Given the nature of the authors, for McKinsey & Company, I was predisposed to dislike it.? But I liked it.

What is the value of a corporation?? It is the value of the free cash flows discounted at the cost of capital.? That’s basic.? And yet, they unpack this simplicity into basic elements, without going overboard into a ton of detail.? Value derives from:

Return on invested capital
Revenue growth
Cost of capital

But value does not derive from growth in EPS.? I think that Peter Lynch brainwashed a lot of investors, and made them think that growth in EPS is everything.

What this book suggests is a need to unpack accounting statements to get a sense of whether value is being created or not.? Following the income statement is not enough; reviewing the level of accruals on the balance sheet helps a lot.

There are many things that don’t affect value:

Capital structure
Earnings management
Accounting rules

What does matter is finding new products and processes that change the value of the future free cash flow stream.

Quibbles

They spent little time on the cost of capital.?? They could have done more there.? That may seem small, but given all the errors that have occurred there, particularly from those that took on too much debt, it would have been valuable to spend more time guarding against aggressive liability structures.

Who would benefit from this book: Most investors would benefit from this book a little.? If you are familiar with the arguments, as I am, there is no benefit.? If you are inexperienced, the book is probably too advanced for you.? Those who would benefit the most have moderate experience with fundamental investing.

If you want to, you can buy it here: Value: The Four Cornerstones of Corporate Finance.

Full disclosure: The publisher sent this to me after asking me if I wanted it.

NO, Buffett is NOT going to buy that firm

Posted on 3 March 2011 by David Merkel

BERKSHIRE HATHAWAY INC.
ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are ?turnaround? situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can?t supply it),
(5) Simple businesses (if there?s lots of technology, we won?t understand it),
(6) An offering price (we don?t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.

We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.

We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer ? customarily within five minutes ? as to whether we?re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don?t participate in auctions.

Charlie and I frequently get approached about acquisitions that don?t come close to meeting our tests: We?ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: ?When the phone don?t ring, you?ll know it?s me.?

There have been a variety of article recently suggesting what Warren should buy.? Examples:

Well intended as these articles are, Buffett has already said that he needs no advice on public companies.? Buffett is a price-sensitive buyer, and does not pay up for most acquisitions.

Beyond that, until he has bought more industrial companies, and float is scarce, he won’t buy other insurers, cheap as they are.? He has too much cash as it is.

If I were to write an article on this topic, I would look at the largest private businesses in the US, and even some mutual or government owned corporations like the TVA or NRUC, and try to analyze which of them would fit well in Berky.

Berky does best with private companies that want to preserve their culture.? With big private companies, it is less likely to preserve culture, so Buffett acquires a lot of special smaller firms.

But I don’t expect Buffett to buy what pundits are predicting.? It is not his way.

Musings on Yield

Posted on 1 March 2011 by David Merkel

When I closed my piece on Warren Buffett’s Annual Letter, I ended with an important statement tat when I read it in the morning, I thought many would find it cryptic.? Here it is:

And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

And I would add “With an eye toward safety.”

When I say there is no such thing as yield, I am overstating a matter to make a point.

Will the debtor make the interest (or principal) payment?
Will the company pay the regular dividend?? Will they increase it?
Will you be able to hold the instrument so that you can realize the yield over the long haul?

During times of stress, yield has a nasty tendency to disappear, often with significant principal losses.? Thus I am skittish whenever I hear someone say that they need to get a certain yield.

Individuals and Institutions, for better, but usually for worse, often rely on getting a certain yield from fixed income investments.

If I don’t get this yield, I won’t be able to meet my monthly expenses.
If I don’t get this yield, my quarterly earnings will miss.
If I don’t get this yield, our ability to support our charitable endeavors will suffer.

Sigh.? Look, this could have been entitled “Education of a Corporate Bond Manager, Part 13,” but I didn’t because this is more broad and important.? It affects everyone.

Once there are no wages/nonfinancial profits, investors usually move into a yield-seeking mode.? I experienced this in spades for the insurance company that I helped to manage money for.

And yet, in the midst of the furor 2001-2003, we often acted against the insurer’s wishes in order to save their hide.? Particularly me; I could not bear doing the wrong thing, thinking that I would have the failure of an insurer on my conscience.

So in the midst of the nuttiness of 2002, I often did up-in-credit trades, reducing complexity trades, etc., when the market favored it.? Lose yield, gain safety, when the market is hot.? (Not when it is cold.)

I preserved the capital of the insurer, and it survived.? I even made extra money for them in the process, which they wasted on writing underpriced annuity business.

There was no level of yield that could have satisfied that client, even assuming that we could get it with safety.

But now as I start my asset management business, I deal with clients that are aiming for a certain yield.? To my surprise, even my Mom, the one who taught me the rudiments of investing is seeking for yield now.

You might or might not recall that the fourth real post at this blog was entitled Yield = Poison.? There are times to look for yield, and times not to.? The times not to are when yields and spreads are low.? At such a time, the best decision is not to reach for yield, but rather to forgo yield and preserve capital.? Buy TIPS, foreign bonds, and move up in quality and down in maturity in dollar terms.

I did this for an internal client 2004-2007, and made money for them, but it was utterly unconventional.? They could afford to deal with my idiosyncracies, because they didn’t need a current yield.

So, as I move to offer a fixed income strategy, I find myself butting heads with those that want a reliable income from bonds, and other fixed income instruments.? I’m sorry, but preserving principal is more important than getting yield.? Far better to eat into principal a little when spreads are tight, than to meet the spread target and get whacked in the bear phase of the credit cycle.

So, do I have a market for such investing in bonds, or is human nature so unchangeably mixed up that there will be few if any takers for my fixed income management?? Sadly, I think the answer is the latter.

Critical Analysis of Buffett?s Annual Report

Posted on 1 March 20111 March 2011 by David Merkel

After reviewing what I wrote Saturday night on Buffett’s Annual Letter to shareholders, I said to myself, “That wasn’t very critical.”? Now perhaps I have less to criticize him over — he isn’t boasting about risk free retroactive profits, or being a significant player in life settlements, two things I find morally dubious at best.

But today I reviewed the Annual Report and the 10-K.? The two are very similar; I will only mention one thing from the 10-K, but that one thing is big.

But let’s start with basic blocking and tackling.? Start with the income statement, balance sheet, and cash flow statements of Berky.? The balance sheet and income statements split out by division, but the cash flow statement does not.? The cash flow statement has the fine distinctions for the company in aggregate, but the income statements and balance sheet do not.

I want the best of both worlds. I want the cash flow statement segmented, and I want enterprise-wide income statements and balance sheets for Berky, with fine levels of detail.? I want those without eliminating what is being done now.? That would not be a lot of extra work, and it would only add a few pages to the 10-K — the work is probably done already; all that needs to be done is the formatting.

Notes

1) Berky trades at 1.9x tangible book.? Not saying that it is fair or unfair.? It is what it is.? (When one of my kids says that, I reply, “Except when it’s not.”)

2) From page 44, Buffett made some tremendous deals during the crisis, but the lesson here is to have dry powder.? Buffett made great decisions with respect to Goldman Sachs, GE, Dow Chemical, Swiss Re, and Wrigley.

3) On page 50 there is positive prior year reserve development for the last three years.? I don’t know how far that goes back; I will have to research that.? But as I reviewed their reserving policies, I thought they were more than reasonable.? They seemed to be a good mix of methods and judgment.

4) I don’t fault Buffett on derivatives.? One can use them wisely while decrying their stupid use.

Where I have more difficulty is trying to justify the amounts on the balance sheet.? My view of level 3 assets is that those holding them should spill the calculations in detail.? We don’t have that here with Berky, though it is better than many companies.

That Berky does not have to post collateral for the most part is significant, and lends to their creditworthiness.

5) Statutory surplus had to increase at the main P&C insurance subsidiaries, because of the acquisition of Burlington Northern.? Why?? I’m not sure.? Ideas?

6) On page 60, the expected return assumption should not have risen 2009 to 2010.? 7.1% is too high as a long-term assumption — something in the 5-6% range is reasonable.

7) Berky is half an insurance company, and half and industrial/utility company.? It is neither fish nor fowl, and that is what helps make analysis difficult.

8 ) If I were made President/COO of Berky, would I centralize hiring and procurement?? No, but I would hesitate before answering.? Berky is so unstructured, that there have to be some gains from centralizing, but that said, you don’t want to negatively affect the culture of Berky, which allows acquisitions to continue as if they had not been acquired.? That might be changed cfter the death of Buffett, but who can tell?? There is a competitive strength in Berky for leaving operations alone — many sellers who love their employees like that.

9) ?We view insurance businesses as possessing two distinct operations ? underwriting and investing.? So it says on page 68.? And how beautiful, underwriting gains every year in every segment.? I have not traced the history here, though I know that Berky has been better than most companies.? I would only note that the value of float depends on how long the float exists.

10) On page 70, Buffett admits that Workers Comp and other casualty have not done well, which is rare among the lines that have done well.

11)? On page 71, he admits that terms are not generally attractive for life business.? Also oddly, there are no life premiums earned in 2008 and 2009, but losses in both years.? I don’t get this.

12) On page 74, the allocations to junk debt seems too high, though I might make that bet as well.? Where else do you go in this environment?? The high allocations to foreign debt I suspect are there to immunize Berky on foreign liabilities it has written.

13) Page 76 contains what I think is the core strategy for Berky — Inflation-protected investments in regulated industries funded by the short-term float generated from writing P&C insurance.

14) Page 78 shows how economically sensitive “other manufacturing” can be for Berky, in that profits doubled over 2009.

15) Page 79 — The change in NetJets was the decisive factor as far as changes in the profitability of Berky’s service businesses.? Score a big one for David Sokol.

16) Page 81 — the discussion on impairment of equity stakes is fascinating, but I think it would all be easier if Buffett just valued everything at market.? Who cares at what level you bought it?? The important question is for what can you sell it?

17) The Contractual Obligations exhibit on page 84 made me edgy, because total obligations are large relative to assets.? Then I took a step back and said, “But that’s the nature of liabilities, and the difference between that and the value of liabilities is not large.”? All that said, review my second risk factor at the end of this article.

18) On page 94, it reveals that Berky is mismatched short, assets versus liabilities.? That is a bet that I would take as well, but it is a bet.?? In a depressionary scenario, it would get pinched.

19) On page 97, he lists his “owner related business principles.”? I am an admirer here — the ethics are excellent, relative to the rest of our financial markets.? If I wee summarizing much of it I would say:

Ignore the accounting if it doesn?t represent the economic reality.
Act like an owner.
Lumpiness is normal for good investments.? Don’t look for smooth results.

20) I appreciate the humility that Buffett displays on point 9 of his principles. He didn’t phrase it right, and now he has corrected it.

But now for what should be at the top of what Warren writes:

The Two Real Risks for Berky

From the 10-K on page 19:

Insurance subsidiaries? investments are unusually concentrated and fair values are subject to loss in value.

Compared to other insurers, our insurance subsidiaries invest an unusually high percentage of their assets in common stocks and diversify their portfolios far less than is conventional. A significant decline in the general stock market or in the price of major investments may produce a large decrease in our consolidated shareholders? equity and under certain circumstances may require the recognition of losses in the statement of earnings. Decreases in values of equity investments can have a material adverse effect on our consolidated book value per share.

If I were Buffett, I would put this on page one of his shareholder letter, because this is the biggest risk.? No other insurance company in the US takes as much equity risk as Berky.? Buffett is a great investor, but in a Great Depression scenario, Berky could be a zonk.

The second risk is more quiet and insidious.? Debt has grown where the Berky parent company is on the hook, whether directly, or by guarantee, as at the finance subsidiary.? This was AIG ten to fifteen years ago.? The initial increase in debt was innocuous, but it led to more increases in debt.? After 20 years, AIG was overindebted both in cash terms and synthetically.

What I am saying is that once the discipline against debt is breached, it becomes easy to justify more debt.? I think we are seeing that now, and Buffett is compromising his principles.

Hey, Greenberg eschewed debt for two decades, and then piled it on for two decades.? Is Buffett doing the same thing?? Personally, I think he is, though I don’t think he has thought it through.? Warren, if you are reading me, pull back on the debt.? It killed Hank.