Value Investing – Page 69

Debt and Sweat

Posted on 14 October 2008 by David Merkel

Ordinarily, when I sit down top blog, I know what I want to write.? That’s not true now.? Yes, I could do a few book reviews.? I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.? If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.? Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).? As jck noted yesterday, this has led to a selloff in Treasuries.? (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.? The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.? Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.? But watch for the discussion of yields and prices (if there is any).? It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.? Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.? This is good for the nation, and we won’t be around for a decade.? You want to be a survivor, right?? You want friendly regulators when we review the levels at which you are marking your illiquid assets?? We thought so.? Sign here.”? (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.? State regulation, particularly when you are a local champion, is much more flexible.? Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.? It’s one thing to bolster their balance sheets.? It is another to get them to lend, particularly in the bear phase of the credit cycle.? Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.? Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.? In the UK, it pushes the national debt to GDP ratio to 100%.? As it gets closer to 150%, the international debt markets usually start to choke.? We have traded bank credit risk for national solvency risk at the margin.? Maybe that will be different here, if only government creditworthiness is perceived to be safe.? It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.? Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.? Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.? The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.? That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.? Also remember that LIBOR has become somewhat of a fiction at present.? There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

TAF expanded to $900 billion.
New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.? Terms here.? FAQ here.? This is big, and it is much easier to start such a program than to end it.? It is difficult to end any program where credit is granted on less than commercial terms.? My guess is that it will be extended past its April 30th, 2009 planned expiry date.
Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.? In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.? No, we have to delever, and the US Gowernment is included in the list of those that need to delever.? There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.? I would not get overly excited about the rally yesterday.? As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.? The question is whether it will persist.? I was a net seller into the rally toward the end of the day.? I think we have more troubles ahead.? Two things to watch:

LIBOR, CP yields and the TED spread. (The short end)
Overall yields of medium-to-long Treasuries and other long-dated debt.? (The long end.)

I expect yields to rise, even if some spread relationships fall.? The added financing needed by the US government is large.? Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.? Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.? We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”? As it is, I am looking for companies with blaance sheets strong enough to survive the worst.? That is my task for the next few days.

Recession or Depression?

Posted on 11 October 200812 October 2008 by David Merkel

Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

The Treasury has shifted the TARP plan in order to recapitalize banks.? Good move, if late.
Similar things are afoot in the UK and Germany.
Many European banks are in trouble.

This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

IFRS: Incomparable Flexible Reporting Standards.

Posted on 11 October 200812 October 2008 by David Merkel

One housekeeping note before I start.? I made a small enhancement to the blog today.? I added a little link on the upper right, just below the banner that reads “Aleph Blog.”? If you click it, it brings you back to the home page.? I know that is how my banner is supposed to work, but I have not been able to get it to do that.

My first topic this evening is the SEC’s move to IFRS.? If you would like to protest this, the form is here.? Here is what I am submitting to the SEC:

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Sirs,

I strongly oppose adopting IFRS in place of US GAAP.? I am not an accountant, but something more important, a user of financial statements.? I am a life actuary and a financial analyst.? I have been on both the preparation and use sides of accounting statements over the last 20+ years.

My first critique is that there is nothing that is that big of an improvement over US GAAP in IFRS, and many areas that seem less accurate.? I will handle those later.? My point here is that in order to justify the costs of retraining accountants and financial analysts, what ever is put into place needs to be a large improvement over GAAP.? IFRS is not that.? It will impose big costs on US corporations to re-tool their accounting, and the small corporations will be disproportionately affected.? In the end, I don’t think we will have materially better financial statements.

Perhaps accounting consulting fees will rise in the short run from the conversion, but that it not a reason to put the rest of us through the wringer.? Just as laws are too important to be left to lawyers only, in the same way, accounting standards are too important to be left to accountants only.

Second, there have been a number of studies done that show that US GAAP confers an advantage of lower capital costs on companies that use it versus IFRS.? Why raise capital costs on US corporations?

Third, IFRS will not unify accounting standards around the world, because the national implementations of IFRS are significantly different.? Here’s an idea, though:? Call US GAAP an implementation of IFRS.? WHo knows, it might become the preferred IFRS because of its relative strictness.

Fourth, IFRS is more squishy than GAAP because it is “principles-based.”? We use rules-based systems in the US because they offer legal protection regarding fraud in securities laws.? I would argue that IFRS is actually rules-based also, but with a less-tested set of rules.? The rules of US GAAP are large because they have grown to meet the complexities of accounting in the modern economy.? More below.

Fifth, the additional squishiness/flexibility will make it more difficult to compare results across companies, making the job of securities analysts more difficult.

Sixth, US GAAP is more investor-focused than IFRS. That’s why it lowers capital costs.

Seventh, value investors will benefit from IFRS because the income statements and balance sheets will be less reliable, which will force more investors to the cash flow statement, which is harder to fuddle.? Average investors will have a harder time investing, to the extent that they look at financial statements.

Eighth, does Congress really want to give up its sovereignty over US accounting rules?? I think not; all it will take is one significant scandal, and Congress will move away from IFRS.? The pressure toward globalization is weaker than most think.

Ninth, IFRS is weaker when it comes to revenue recognition, joint ventures, and accounting for fixed assets and intangibles.? In general, the ability to revise asset valuations up should be limited or nonexistent.? The ability to be flexible in recognizing revenue should be similarly limited.

In the American context, where we have dispersed ownership, we need conservative accounting rules that are comparable across companies.? The proposed move from US GAAP to IFRS is a step backward.? Please do not sacrifice our relatively good accounting standards for something less accurate and applicable to the needs of our nation and its securities markets.

Sincerely,

David J. Merkel, CFA, FSA

Industry Ranks for the Reshaping

Posted on 9 October 2008 by David Merkel

There has been only one other time in my life where I felt so skittish about my methods: June-September 2002.? I got whacked hard by the market then, harder than at present, but I bounced back October 2002 – January 2004, making it up and then some.

I don’t count on that now, but I will give you may industry ranks as of this week:

Running my usual screens, I get a bunch of new tickers to consider:

ABD ??? ABG ??? ACE??? ACGL??? ADCT??? AEG??? AEL??? AFG??? AFSI??? AGII??? AHL AIG??? ?AIZ??? ALL??? ALU??? AMPH??? AMSF??? AN??? ANEN??? ARRS??? ASI??? AWH??? AXA??? AXS??? AZ??? CB??? CBG??? CHEUY??? CIEN??? CINF??? CMVT??? CNA??? ?CNO CPHL??? CPII??? CRMT??? CRNT??? CTV??? DFG??? DSITY??? EBF??? EIHI??? EJ??? ENH??? ENTG??? FFG??? FMR??? FNSR??? FSR??? GBE??? GCOM??? GILT??? GLRE??? GLW??? GNW??? GPI??? GSIG??? HALL??? HCC??? HIG??? HMC??? HMN??? HYSNY IHC INDM ING IPCR IRS JDSU JLL KGFHY L LGGNY LNC LTXC MET MHLD MIG MIGP MRH MRVC MXGL NDVLY NSANY NVTL OB OPLK OPXT PAG PEUGY PFG PL PMACA PNX PRE PRU PTP PUK PWAV RE RFMD RGA/A RNR RTEC RUSHA RUSHB SAFT SAH SAIA SEAB SUR SWCEY SYMM TER THG TLAB TM TMK TRH TRV TTM UAM UFCS UNM UTR VOD VR VTIV WRB XL YRCW ZFSVY

Some of these are on the last list, and some of them I own.? Personally, my “green zone” methods are making me queasy at present because in a credit crisis, trends tend to persist a lot longer, so I will be more likely to look at names that are stalwarts in this crisis.? My investment methods are not purely quantitative.? I use quantitative methods to assist my qualitative reasoning.

As such, I have a few more tickers to toss into the hopper, many of which are safe names, or, names in the red zone that seem cheap:

AA??? ABX??? ALL??? ALOG??? BGP??? BHI??? BKS??? BRNC??? CAG??? CNI??? CP??? DD??? DLX??? DOW??? DPS??? EOG??? FCX??? HAR??? HCC??? HOLX??? HPQ??? IBM??? ITW??? ITW??? MCF??? MET??? MMM??? MSFT??? NBR??? NYX??? ORCL??? PBR??? PFG??? POT??? PRU??? RDC??? REXI??? RTI??? SII??? TAP??? TEL??? TIE??? TM??? VEIC??? WMT??? XTO

Together with my last post, these are the tickers that I will compare against my existing portfolio to choose new names for my portfolio.? As for where I got the batch of tickers for my last post on this topic, my method is to take every idea that I hear over a quarter that I think is interesting, and I note it down, or print it out.? It is eclectic in that sense, but when I analyze the ideas at the end of the quarter, I try to forget where I got the ideas, so that I can analyze them fresh.? I am the main analyst here, and I try to avoid believing the arguments of others when I do my final analysis.

Entering the Endgame for Monetary Policy, Part II

Posted on 8 October 2008 by David Merkel

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

Inflation when the Fed monetizes the debt,
Depression from vastly increased taxes,
Debt repudiation (whether internal, external, or both), or
Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

Begin the Fourth Quarter Reshaping

Posted on 4 October 2008 by David Merkel

Here we go again.? Once a quarter, I gether together the ideas that I have gathered from the last three months, so that I can consider them as replacements for companies in my current portfolio.? Here are the initial candidates:

AAUK??? ABC??? AE??? AGNC??? AHS??? AIB??? AIMC??? AIQ??? AKLE??? AKO.B??? ALJ??? ALV??? AMAT??? AMN??? AMOT??? AMX??? APA??? APD??? ARG??? ATPG??? AUO??? AXP??? AZZ??? BBSI??? BHE??? BRNC??? BTM??? BWS??? CIG??? CNH??? CNMD??? COMS??? COP??? CPOG??? CPX??? CRESY??? CTGX??? CVI??? DAC??? DAI??? DAN??? DCM??? DDS??? DE??? DIT??? DPS??? DVR??? EROC??? ETH??? EXH??? FCS??? FLR??? FRZ??? FWLT??? GD??? GIB??? GIGM??? GIII??? GLT??? GNW??? GRMN??? GSK??? GT??? GVA??? HANS??? HAWK??? HD??? HDNG??? HES??? HOC??? HRZ??? HURC??? IAR??? IP??? IPAS??? ISYS??? JAH??? JMHLY??? JOS\B??? JOYG??? KHD??? KLAYN??? LCRY??? LII??? LINC??? LINE??? LOGI??? LONG??? LOW??? LSR??? LWSN??? LYTS??? MC??? MDR??? MF??? MIDD??? MLM??? MOV??? MRO??? MRX??? MWA??? N??? NCS??? NFX??? NGLS??? NLC??? NOK??? NOV??? NSRGY??? NTGR??? NTL??? NTT??? NUE??? NYX??? OME??? OMI??? ORBK??? OTEX??? PARL??? PBR??? PCP??? PCR??? PDLI??? PHG??? PII??? PKX??? PLCM??? PLUS??? PNX??? PQ??? PRDT??? PRE??? PRU??? PTP??? PWR??? PX??? RAME??? RDS.A??? RE??? RHD??? RIG??? RIO??? SB??? SCHN??? SCL??? SCX??? SDXC??? SGY??? SHLO??? SHS??? SM??? SMCI??? SNX??? SNY??? STX??? SU??? SUN??? SYNL??? TAR??? TEL??? TEO??? TEVA??? TEX??? TFCO??? THRX??? TKTM??? TMB??? TNE??? TOT??? TRID??? TRMA??? TRS??? TRV??? TSO??? TTM??? UFCS??? UFS??? UPL??? USAK??? VMC??? VMW??? VQ??? VRS??? WERN??? WES??? WEYS??? WINN??? WMW??? WNI??? WRB??? WST??? WTS??? ZNT??? ZZ

Now, what have I done in the recent past, aside from losing more money than the S&P 500?? The following transactions:

Rebalancing Buys: ESV DVN IBA KPPC MGA VLO HIG (twice) LNC XEC SFD AVT NTE YRCW CHIC GMK HMC (twice) SBS OMX TNP

Rebalancing Sales: RGA/A YRCW GPI NTE CHIC

Complete Sales: GPI SFD MET RGA/A IRF

New Buy: RGA/B

I sold International Rectifier because of the bid from Vishay.? I would buy more Vishay, except that I fear their bid could succeed, and financing a cash deal in this environment, so large for them, would be a disaster.? I sold Group One and Smithfield for balance sheet reasons.? Metlife I sold because I needed to lighten up in asset sensitive life insurance; I sold the one that I felt could get hurt the worst in a prolonged slump.? FInally, I swapped RGA/A for RGA/B, getting the lesser voting shares at a decent discount.?? It is possible that the two classes will be unified at some point, or, that RGA could be bought out, and the B shares would do better than the A shares in such a situation.

THe next article n this series will be on my industry model and ideas for there, but if you have ideas that I should consider, add a comment, and I will throw the idea into the hopper.

What A Fine Mess You Have Gotten Us Into

Posted on 27 September 200828 September 2008 by David Merkel

One week ago, I posted Oppose The Treasury?s Bailout Plan.? Since then, most criticisms of Henry Paulson’s original proposal supposedly have been incorporated into the new compromise bill, including my criticisms.

But my concern at present is whether the bailout will work at all. I think the complexities of the reverse auctions on small illiquid distressed securitized assets will prove difficult.? Further, the talk that the baioout won’t cost anything is highly unlikely.? Of all of the US Government’s bailouts, only the Chrysler bailout made money.? So long as you are in a fiat money system, in a bailout, the job of the government is to prevent contagion and minimize loss, in that order.? Bailouts don’t make money, and that should not be expected.

But hey, if they are going to play for profit, let them play big.? I was joking around when I wrote my article 2300 Smackers, and I am joking a little here as well.? Why not use the $700 billion to capitalize 10 new banks with $70 billion of capital each?? Let them lever up 10:1 — you have $7 trillion of buying power.? Let the public participate along side the government and the power expands further.? With a profit motive, they will buy and finance what makes sense, and five years from now, the government would sell its stakes, and pay down debt.

The rough part is that they have a non-profit-oriented main shareholder, looking to bail out dodgy institutions.? Also, if the risk is smaller than $7 trillion, these institutions won’t do well.? Also, what of the financials who don’t have government sponsorship?? Couldn’t the government just take super-senior convertible bond stakes in institutions that are under duress?? (Oh, that sounds like one-off bailouts?? Could be a lot cheaper than the current plan…)

And what of the borrowing?? Can this be funded at reasonable yields, and with the dollar at current purchasing power levels?? I have my doubts, though the markets have been benign over the last few days.

Consider the actions of the Federal Reserve in concert with the Treasury.? As I pointed out in Entering the Endgame for Monetary Policy,there is a panic quality to the Fed’s actions.? This concept is endorsed by Brad Setser, Randall Forsyth, and Michael Panzner, among others.? With the short term money markets in disarray, we have Asian Central Banks cutting rates, which aids the West, but increases inflationary risk.

Three notes to close:

I don’t know what Monday will bring in entire, but a failure of Fortis seems likely.?? Note that the ECB is not on the hook here but the Belgian central bank (which probably feeds into their Treasury).
What the FDIC did with WaMu affects other banks like Wachovia.? Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.? Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.? If one of them fails, the game is over.? Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.? Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

All “solutions” to the crisis at this point in time are bad solutions.? The time to act was 10-15 years ago, where we could have implemented contra-cyclical policies in bank regulation, as well as enforcing a strict separation between regulated and nonregulated financial intermediaries.? (No ownership, no lending, no derivative agreements.)

I don’t know what next week will bring us.? Last week was bad for me on a relative performance basis.? My inclination is to look at companies that have good global demand, and not much debt.? As for bonds, keep them short, unless you are buying long TIPS.

Two Updates

Posted on 21 September 2008 by David Merkel

I want to update my two Thursday evening pieces.? First with respect to Liquidity for the Government and no Liquidity for Anyone Else, the degree of financial stress in the short-term part of the market is worse.? Here’s the graph:

Much as the government wants to eliminate stress in the lending markets, I don’t think they are succeeding.? The little bounce still leaves the indicator below Thursday’s close.

One reader brought up the timing mismatch in this indicator, because I have a 2-year Treasury versus a 90-day commercial paper series.? I use the 2-year Treasury, because it is very sensitive to changes in expectations for short-term interest rates.? I suppose I could use 3-month T-bills to match, but this indicator arose out of comparing two different series that change in opposite directions when the economy strengthens or weakens.

Part 2

Now for my article Now We?re Talking Volatility.? Okay, so we had three 4% moves in a five business day period, well, now you have four of them.? Now how do the statistics look?

Oddly, after four 4% events in five days the average return is lower than that for three 4% days.? Most of the history here comes from the Great Depression, and we are dealing with the “Law of Small Numbers” here, so I am not inclined to offer definitive analysis here.? I will give you my guess, though.? Extreme volatility often begets an opportunity for profit, but also sometimes begets significant future losses.? I lean toward the profit side here in the short run, but I also realize that the actions of the US Government might not be the best for the markets, even if the markets have interpreted it positively in the short run.

I would be neutral-to-positive on the US equity market here.? The presidential cycle is a positive, as is the current market volatility.? Given the difficulties with financials, I can’t get very positive, though.? Play defense, wherever you are.

Now We’re Talking Volatility

Posted on 19 September 2008 by David Merkel

If the gyrations of the equity market today were not enough, we are in a historically unusual situation where 3 of the last five business days have had moves on the S&P 500 of over 4% in absolute terms.? Since 1928, how many times has that happened?? 69 times.? Dig this:

So, on average, you make money investing during volatile times, but the possibility of moderate-to-severe loss is significant.? Those losses came in the Great Depression era (as did the huge gains), but for those that have read me a long time, you know that I believe that a second Great Depression is not impossible.? I don’t care how much policymakers say that they have learned, the system has an odd way of mutating to create the same result through a new process.? The market always has a new way to make a fool out of you.

Aside from the crash in 1987, only the depression era has had similar volatility, and they had it for a long time.? Even 1973-74 did not rate under that measure (though it resembled the Chinese water torture).

Take this with a grain of salt.? A salt shaker even.? Eddy Elfenbein and Bespoke often do analyses like these, and they have a certain wisdom most of the time.? But data-mining is always dangerous.? The question that must be asked is whether there is a mechanism to explain the results.? In this case, there is.? Volatile markets scare investors away, and drive prices down, in general.? This causes stock to move from weaker to stronger hands, i.e., from the weakly capitalized to the strongly capitalized (now I get to send my electricity check to Mr. Buffett).

So, ask yourself this: are we heading into a depression?? If not, buy some stock.? Personally, I’m not certain about whether we aren’t heading into a depression.? I view it as a 25% chance now.? Perhaps my next article will help explain.? As for me, I am continuing my normal policy of having 70% of my net worth in risk assets.

Investing in Financial Stocks is Tough

Posted on 13 September 2008 by David Merkel

At RealMoney, I wrote an article in 2005 called, Buyers Beware: Financials are Different.? In addition to many other things I mentioned there, I gave six ways that financials were different:

Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. Demand is the ultimate limiting factor, but this affects financial, industrial and services businesses alike. But with a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps”), but more often, capital limits growth.

The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed with the business remaining as functional as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.

Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint. This is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims-paying-ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.

Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk or systemic risk; guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.); and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification. In a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence cannot be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
Rapid growth is typically a negative. Financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company. The regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.

In general, accruals are weaker than cash entries in accounting.? Not all accruals are created equal either.? Some are less certain to be collected/paid, and some are further out in the future than others.

Financial stocks are generally bags of accrual entries in an accounting sense, with some more certain than others.? E.g., a short-tail personal lines P&C insurer’s accounting is a lot more certain than that of an investment bank.

This is why management quality matters so much with financial stocks.? The managements of financial companies must be competent and conservative, and all the more so to the degree that the accruals that they post are less certain.? Companies that grow too rapidly, or lack obvious risk control are to be avoided.

Looking at the Present Concerns

I own a bunch of insurance companies, but no banks or other financials.? Why?? Insurers are profitable and cheap, and are not under threat from credit risk to the degree that other financials are.? Consider the threats to AIG, Citi, Lehman, Merrill, GM, Ford, Wamu, etc.? The companies that got into trouble grew too fast, levered up too much, neglected risk control disciplines, and more.

Now their valuations have been crunched, and their financing options are limited.? Fortunately there are the options of last resort:

Have you maxed out trust preferred obligations? Other subordinated debt?
Have you maxed out preferred stock?
Have you issued convertible debt to monetize volatility?
Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
Have you sounded out investors in your corporate bonds about debt-for equity swaps?
And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

Given that Bear got a guarantee, perhaps others could too, though I think the US Government is far less willing now.? I could also add another point: have you sold your most valuable liquid assets?

With the crises being faced by financial companies, there is a rule that separates the survivors from the losers: Losers sell their best assets, and play for time.? Survivors/winners sell their worst assets and hunker down — they have enough financial slack that they don’t have to engage in panic behavior.

In an environment like this, where there is a lot of uncertainty, avoiding suspect financials is prudent.? This applies to those who take on the risks from such institutions when the decisions have to be made quickly on whether to buy them or not.? Thus I would be careful on the equities of any buyers in this environment, and would be a seller of any company that is a rapid buyer during this time of financial stress.

Full disclosure: no positions in companies mentioned.? I own SAFT LNC AIZ MET RGA HIG UAM among insurers, and might buy some more….