Value Investing – Page 72

Discounting Future Prospects

Posted on 5 August 200822 June 2017 by David Merkel

In one sense, among value managers, I’m an agnostic.? I am more than happy to analyze the theories of other value managers, and see how they can help me create an even better method for analyzing stocks.

But in the present environment, many value managers have gotten hit, and hard.? Thus the need for a Value Support Group.? I sympathize with their plight, but value has to be sought considering the likelihood of problems in earnings prospects.

Now, I’m not perfect, and sometimes after underperforming days like today, I wonder if I should be writing at all 🙂 , but part of being a value manager should be looking at the future prospects of the industry one is investing in.? Banks and other credit-sensitive financials are staple investments of value managers, because they are mature businesses, with good returns on equity under normal conditions.? Trouble is, conditions aren’t normal, and I can’t imagine how many times I beat the drum over at RealMoney, explaining from 2004-2007 why financials (away from insurers) would eventually have trouble.

As a value manager, I am doing well this year, because I largely avoided credit-sensitive names, and was more willing to believe that the economy wasn’t doing that badly.? Value investing means looking at both the long and short term prospects for an industry, as well as the valuation.? Industries that have gotten smashed on a price basis, but have reasonable long-term fundamentals can be a fruitful place to invest.? Industries with low P/Es, but have deteriorating fundamentals are usually bad places to invest.? Industries like newspapers, where the long-term fundamentals are bad, are bad places to invest, regardless of valuation, unless there are non-newspaper assets.

Ideally, I invest in industries that have been smashed, but the long term fundamentals are decent; I buy high quality names that can survive.? Less ideally, I buy companies that are relatively cheap, where trends are under-discounted.? This is not a perfect way to invest, but it does tend to yield good results over time, with a decent amount of noise in the results.

In summary, value investors should not be wedded to a few sectors, but should be willing to abandon sectors that were previously regarded as key if the situation is bleak enough, and valuations are too high.

Analyzing Growth in Firm Value

Posted on 2 August 20082 August 2008 by David Merkel

We’re nearing the end of second quarter earnings season, and I have have had my share of hits and misses, compared to the estimates that the sell side publishes.? What is the sell side?? The sell side is the analysts working for broker-dealers who publish research on companies, often estimating what they think they should earn in a quarter or year.? There is a buy side as well, which are analysts working for mutual funds, asset managers, etc., who analyze companies for their employers.

As investors, we are pelted with terms for corporate performance:

Comprehensive income — increase in net worth (approximately)
EBITDA? (Earnings before interest, taxes, depreciation and amortization) — what monies are the assets of the company generating in cash terms
Operating income — Net income, excluding one-time charges.
Net income — An attempt to show the repeatable increase in the value of the business, excluding the adjustments that operating income makes.? It also excludes “temporary differences” that are expected to reverse, which go into Accumulated Other Comprehensive Income on the balance sheet, and not through income.? An example would be unrealized capital losses on unimpaired credit instruments.

Which of these measurements should an investor use?

In takeovers, EBITDA is the most relevant, because it shows the cash generating capacity of the assets.
Operating income is the most relevant each quarter for companies that are going concerns.? It excludes “one time” events.
Over the long haul, accumulated net or comprehensive income is the most relevant, because all of the “one time” adjustments are aggregated.

In the short run, the adjustments that come from one-time events (mostly negative) can be tolerated.? But managements are supposed to try to control the factors that generate one-time events in the long run.? That part of their job.? If you have enough track record on a management team, you can sit down and calculate accumulated operating income less accumulated net income.? For good managements, that number is negative to a small positive.? For bad managements, it is a big positive.? I’ve seen estimates over a long-ish period of time, and the average difference between the two is around +5% — +10%.? That much typically goes up in smoke from operating earnings, never to reappear.

Now, some have toyed with adjusted dividend yield formulas, where they add back buybacks, and they use that as a type of true earnings yield.? After all, that reflects cash out the door for the benefit of shareholders.? True as far as it goes, but other uses of retained earnings aside from buybacks are valuable as well.

Buy/create a new technology, plant or equipment
Buy/create a new product line
Buy a competitor, or, a new firm that offers synergies
Buy/create a new marketing channel

In the hands of a good management team, these actions have value.? In the hands of bad management teams, little value to negative value.? So, I prefer earnings to these new measures based off dividends and buybacks for good management teams.? With a bad management team you want them to not have much spare capital for bad decisions, but would you trust the safety of the dividend and commitment to the buyback to a bad management team?? So, in general I prefer earnings, or, if calculable, free cash flow, to dividend/buyback metrics.

What is free cash flow?? The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.

Ideally, free cash flow generation is what we shoot for, but it is difficult to estimate in practice.? When I took the CFA exams, the accounting text suggested that the goal of earnings was to reflect free cash flow to the greatest extent possible.? I’m not holding my breath here; I don’t think that goal is achieved or achievable.? To do that, we would have to have managers expense maintenance capex, and we would have to reflect the capital requirements of financial regulators as a cost of doing business for financial companies, and there are many more adjustments like those.

So, I like accumulated net income in the long run and operating earnings in the short run for measuring financial performance.? I’ll give you one more measure to consider which might be better.? From a not-so-recent CC post (point 2, rest snipped for relevance sake):


		David Merkel
		Notes Before I Leave for ANother Series of Conferences
		11/9/04 5:44 PM?ET
1. Be sure and read Howard’s piece “Hurricanes and the Limits of Rebuilding .” He comments more extensively on something I touched on when Frances was threatening Florida. Recovery from disasters often makes GDP look better afterward, because the destruction is not captured in the GDP statistics as a loss, save for the reduction in insurance profits, whereas the work of rebuilding does get fully captured. 2. The same idea can be applied to equity investing. This is why I pay attention to growth in book value per share, ex accumulated other comprehensive income, plus dividends, rather than earnings. Nonrecurring writedowns, charges for changes in accounting principles, and other adjustments, if they happen often enough, it makes a statement about the way a company handles accounting. Companies that are liberal in their accounting may have good looking earnings, but growth in book value per share can be quite poor. I trust the latter measure.

Growth in fully diluted tangible book value (ex-AOCI) is a good measure of firm performance, if you add back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price. Why the current market price?? Some managements buy back stock indiscriminately, not caring about the price at purchase.? That’s rarely a good idea.? Good management teams wait until their shares are near or below their estimate of fair value before they buy back.

Good management teams are also sparing/judicious with share and option grants.? Measuring the cost of the issuance/grants/dilution at the current market price penalizes the financial performance appropriately for what they have given away from shareholders equity per share all too cheaply.

So, that’s my preferred measure for how much has the underlying value of the firm increased: growth in fully diluted tangible book value (ex-AOCI), adding back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price.

There are things that this measure does not capture, though.? Look for places where assets are misstated on the balance sheet. E.g., property may be worth more or less than the carrying value.? Plant and equipment may be worth more or less than the carrying value.? Having a feel for the appreciation/depreciation in value, however slow, can be an aid to estimating the true change in value for a firm.

Estimating the true value of a firm’s earnings is challenging.? There is no one good measure; it depends on the question that you are trying to answer.? But knowing the outlines of of the problem helps in analyzing the earnings releases as they pelt us each quarter.

PS — I know I have excluded EVA, NOPAT, and other measures here.? Perhaps another day…

The Fundamentals of Market Bottoms, Part 1

Posted on 25 July 2008 by David Merkel

A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored 🙂 .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don’t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion? — yes, residential real estate was near its top.? My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write “The Fundamentals of Market Bottoms.”? Believe me, I have wanted to do so, but some of my pieces at RealMoney were “labor of love” pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Whew!? For an introduction to an article, that’s a long introduction.? Tomorrow, I will pick up on the topic and explain how one sees market bottoms from a fundamental perspective.

Not All Financials are Poision

Posted on 22 July 2008 by David Merkel

I am overweight financials, but I don’t own any banks, or entities where the primary business is credit risk.? I own a bunch of insurers, because they are cheap.? The first one to report came Monday after the close, Reinsurance Group of America.? They beat handily on both earnings and revenues.? They are the only pure play life reinsurer remaining.? Competition is reduced because Scottish Re is for all practical purposes dead.? They make their money primarily off of mortality, charging more to reinsure lives than they expect to pay in death claims.

This is a nice niche business, and a quality competitor in the space — well-respected by all.? And, you can buy it for less than book value.? Well, at least you could prior to the close on Monday.

Here are the financial stocks in my portfolio at present:

Safety Insurance? (Massachusetts personal lines)
Lincoln National (Life, Annuities, Investments)
Assurant (Niche lines — best run insurer in the US)
Hartford (Life, Annuities, Investments, Personal lines, Commercial Lines, Specialty Lines)
RGA (Life reinsurance)
Universal American Holdings (Senior Health Insurance — HMO, Medicare, etc.)
MetLife (Life, Annuities, Investments, Personal lines)
National Atlantic (waiting for the deal to close)

Now, I do have my worries here:

Even though asset portfolios are relatively high quality, they still take a decent amount of investment-grade credit risk, and even squeaky-clean portfolios like the one Safety has are exposed to Fannie and Freddie, unlikely as they are to default on senior obligations.
Those that are in the variable annuity and variable life businesses might have to take some writedowns if the market falls another 10% or so.? For those in investment businesses, fees from assets under management will decline.
Pricing is weak in most P&C lines.

Away from that, though, the companies are cheap, and I have a reasonable expectation of significant book value growth at all of them.? Also, a number of the names benefit from the drop in the dollar — Assurant, MetLife, Hartford, and RGA.

One final note before I close: diversification is important.? I have Charlotte Russe in the portfolio, and it got whacked 20%+ yesterday.? Yet, my portfolio was ahead of the S&P 500 in spite of it.? If Charlotte Russe falls another 5% or so, i will buy some more.? There is no debt, earnings are unlikely to drop much (young women will likely continue to buy trendy clothes), and there are significant assets here.? I don’t expect a quick snapback, but as with all of my assets, I expect to have something better 3 years from now, at least relative to the market.

Full disclosure: long SAFT LNC AIZ HIG RGA UAM MET NAHC CHIC

Thinking About Dividends

Posted on 20 July 200820 July 2008 by David Merkel

Dividends can be controversial.? Are they tax-efficient?? Not as good as compounding capital gains over a long period, and it will be worse when the Bush tax cuts expire.? There is no tax on buying back shares, but individuals get taxed on dividend payments.

Are they the best way to tilt value portfolios?? My guess is no.? There are many factors that drive the calculation of value, and dividends are one of them.? A multifactor model including dividends will probably beat a dividend yield only model.? It will definitely allow for a more diverse portfolio, rather than being just utilities, financials, LPs, etc.

Do dividend-yield tilted portfolios always do better than the indexes?? No, they don’t always do better.? Take the current period as an example.? These two notes from Bespoke are dated, but still instructive.? The total returns off of stocks with above average dividend yields has been poor recently.? Part of that is the current trouble in financials.? Part of it is the financial stress that is leading to cuts in dividends (again, mainly at financials).

Dividend paying stocks tend to lag when bond yields rise, also.? I remember an absolute yield manager who floundered in the early-to-mid ’90s when rates rose dramatically and bonds proved to be greater competition for the previously relatively high-yielding stocks.? They had a great time in the ’80s as yields fell but 1994 proved to be their undoing.

That said, dividends are an important part of total returns, probably one-third of all the money a diversified portfolio earns.? Also, on average, companies that pay dividends also tend to do better in the long run than companies that don’t pay dividends.? Why?

DIvidends have a signaling effect.? They teach management teams a number of salutary things:

Equity capital has a cash cost.
Be prudent risk takers, because we want to raise the dividend if possible, and avoid lowering it, except as a last resort.
Focus on free cash flow generation.? Be wary of projects that promise amazing returns, but will require continual investment.
Be efficient at using capital generated from free cash flow.? The dividend forces management teams to do only the most productive capital projects.? Increasing the dividend is alternative use of capital that must be considered.
Dividends keep management team honest in ways that buybacks don’t.? Buybacks can quietly be suspended, but in the American context, a dividend is a commitment.

Now, if you are going to use dividend yields as a part of your strategy, you need to pay attention to two things:

Payout ratios, and
Growth of the dividend is more important than its size

Is the company earning the dividend?? Do they have enough left over to pay for capital expenditures for maintenance and growth??? Be careful with companies that have high dividends.? My belief is that companies with middling dividends tend to offer value, but the really high dividends portend trouble.? High dividends tend to be cut during periods of financial stress, as we are seeing today.? This article on newspaper stock yields does not convince me.? I have been a bear on the industry for the last ten years.? You can’t maintain high dividends in a industry with significant competition from new entrants (Internet destroying ad revenue, classified ad revenue, and sales revenue).

REITs have decent dividend yields, but the companies with the best total returns had low dividend yields, but they grew them more rapidly.? In general, growing dividend yields where payout ratios are not deteriorating are usually good stocks to own.? Think of it this way, the dividend yield plus its growth rate will approximate the total return of the stock in the long run (for dividend paying stocks).

Two more notes before I end.? FIrst, special dividends usually not a good idea; they signal reduced prospects for the company to deploy capital productively; better to do a dutch tender and buy back shares.? When Microsoft did their special dividend four years ago, I made the following comment at RealMoney:

		David Merkel
		Note From Fed Chairman: Don’t Worry, Be Happy
		7/21/04 12:46 PM?ET
Alan Greenspan completed his testimony slightly after noon today. The Q&A went quicker than usual. No real news from the affair; Dr. Greenspan tells us that inflation is not a problem, growth is not a problem, there is no systemic risk, the carry trade is reduced, a measured pace of tightening won’t hurt anyone, etc.Very optimistic; I just don’t go for the Panglossian thesis that everything can be fine after holding the fed funds target so low for so long. Bubbles develop when credit is too easy.And as an aside, I’d like to toss out a dissenting question on Microsoft (MSFT:Nasdaq). I know that the software business is not capital intensive, but if Microsoft disgorges a large amount of its cash, doesn’t it imply that they don’t see a lot of profitable opportunities to invest in it? Buying back $30 billion of Microsoft stock is a statement that they see no better opportunities (that the government will allow them to do), than to concentrate on current organic opportunities. It implies that additional organic growth opportunities are limited, no? No positions in stocks mentioned

TSCM quoted me in two articles at the time of the special dividend.? I was ambivalent about the buyback, and Microsoft stock has done nothing since then.

I also wrote this article to talk about the value of excess cash flow to management teams.? My view continues to be that excellent management teams should be given free rein to add value, while poor management teams should pay out excess cash to shareholders.

Also, there is a rule in the reinsurance business: buy back shares when the price-to-book ratio is under 1.3; issue special dividends when the price-to-book is higher, and you have slack capital.? But be careful.? Slack capital can be valuable.? I remember Montpelier’s special dividend before the 2005 hurricanes.? Ill-advised in hindsight.? The stock was a disaster, and is the only time in my career that I have flipped from long to short on a stock, post-Katrina.

Finally, I don’t look for dividends.? It is a factor in my models, but not a big one.? That said, 20 of 36 of the stocks in my portfolio pay dividends, and I receive a 2% yield or so on the portfolio as a whole.? I would rather focus on free cash flow, but dividends follow along behind free cash flow.

Bringing this back to the present, be wary.? High dividend yields, particularly on financial stocks, may be cut.? Analyze the payout ratios on stocks you own.? In general, dividends are good, but analyze the situation to determine the sustainability of the dividend.

Musing Over Current Performance

Posted on 18 July 2008 by David Merkel

June was a good month for me, but in the middle of June, it felt like something was shifting in the markets, and it was showing up in my portfolio.? Then, July hit me like a ton of bricks.? The market was down, but I was way down.

Now, I have a number of disciplines that help me on average and over time as I manage equity money.? That doesn’t eliminate the “pit in the stomach” when nothing seems to be working.? It does give me something to do about it, though.? Evaluate poor performers (“what, down so much on no news!”), do some rebalancing trades (“ugh, cash is shrinking… will I have to move into concentration mode as I did in 2002?), and search for errors in my macro views (“why do I have so much cyclicality in the portfolio?”).

My performance versus the market as a whole tends to streak.? There are several reasons for that:

The portfolio has a value tilt.
Market capitalizations are smaller than the S&P 500.
I concentrate the industries that I invest in.
I turn over my portfolio more slowly than most investors.

But, as of Wednesday, as the market bounced back, my portfolio did even better.? I’m behind the S&P 500 by less than a percent now.? But this is what puzzles me here: ordinarily, I expect to outperform more in bear markets than in bull markets, but it seems to be flipped here.

I am overweighted in financials — though all of them are insurers, and none in the financial guarantee business.? Given all of the basket and ETF trading that goes on today, maybe my insurance names are getting dragged along with the banks.? In the short run, that can persist, but eventually industry performance emerges in stock prices.? That’s my best explanation for now.

Away from that, I did a rebalancing sale on YRC Worldwide today.? First rebalancing sale in a while.? Trucking is a volatile industry.? Then again, in cyclical industries, it is always a question of value over the cycle.? The stocks move more than the industry prospects do, so if you resist trends with companies strong enough to survive the cycle, you will make money in the long run.

Full disclosure: long YRCW, and many insurers? (full portfolio available at Stockpickr.com)

Recent Portfolio Moves

Posted on 17 July 2008 by David Merkel

Over the last few trading days, I did rebalancing buys of Lincoln National, Gehl, Charlotte Russe, Group 1 Automotive and Anadarko Petroleum.? As the market has declined, so has my cash position, from 18% to 8%.

One reader has asked my opinion on stop loss orders, and I must admit, I have never used one.? I use the “economic sell rule,” which tries to look forward at the value of companies, rather than analyzing past price movements.? I sell when companies no longer offer me a good return on my money versus other investments.? I sell a little in rebalancing trades, because there is value in redeploying fundsafter quick moves up.

Do I take some losses from not having an automatic sell rule when prices fall?? Yes, but it is more than made up for from the gains on companies that I would have sold , but didn’t.

Don’t blindly adopt a sell rule, but use your head, and estimate the future value of the company, rather than agonizing over the paper loss.

Full disclosure: long LNC GEHL CHIC GPI APC

Fifteen Notes on the Current Market Stress

Posted on 16 July 2008 by David Merkel

1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.? Tonight’s poster child is GM.? How to get cash?? Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.? Not a promising strategy.? As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

2) So where does GM cut expense?? White collar retiree medical care.? This is rarely guaranteed, except to unions, so it is legal to cancel it.? A word to those whose corporations or state/municipal employers presently have retiree medical care.? It is worth your while to find out whether there are guarantees of coverage or not.? If there aren’t, I can assure you that it will be terminated in the next ten years.? If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.

One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.? That will include Chapter 9 of the bankruptcy code.

3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.? Shorts are not the problem.? Failure to properly locate and borrow shares is a problem.? Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.? (Ironic, huh, ‘cuz they are the ones complaining…)

4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.? b) Close down those lines.? Possible areas include GIC-MTN programs, and life insurance generally.? c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.? (I can see American General re-emerging, with SunAmerica in tow!)

5) File this under Sick Sigma, or Six Stigma — GE is finally getting closer to breaking up the enterprise.? It has always been my opinion that conglomerates don’t work because of diseconomies of scale.? As I wrote at RealMoney:

		David Merkel
		GE — Geriatric Elephant
		4/27/2007 1:16 PM EDT

First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.

Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…

But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)

Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.

Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.

Position: none, and I have never understood the attraction to GE as a stock

6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?? I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).? The pressure on marginal financial institutions bearing credit risk is huge.

7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.? With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.? The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.? Budget for the worst case scenario.

8) Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.? Leverage is reduced and a market panic is avoided.

9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.? Shades of GM.? What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.

10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?? Yes.? The dollar is weak, and default swaps on US government debt are rising in yield.? (Thought: how do swaps on US government debt pay off?? Hopefully not in dollars…? Also, what qualifies as an event of default?? Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.

11) Socialism!? Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.? But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.

12) More on preferred stocks.? They have been crushed.? This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.

13) Let me get this straight.? You trusted Wall Street on an implicit guarantee?? You didn’t get a formal guarantee in writing?? Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.? “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”? “Portfolio insurance will protect you; you don’t have to buy puts.”? Never trust implicit promises of Wall Street, because in a real crisis, they go away.

14) Looking over some of my indicators, it looks like we are close to a bounce.? It feels a lot like January of 2008.? So, is it time to buy??? I’m not sure, but I am adding little by little to my stockholdings.? I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).

15) Not that I am likely to liquidate 401(k) assets, or anything like it.? That some are doing so is a sign of the stress that we are under.? Don’t do it, if you can avoid it.? Better, perhaps, to take in a boarder.? It increases cash flow on an underused asset, and optimally, increases community relations.

Watching the Leverage Collapse

Posted on 12 July 200813 July 2008 by David Merkel

Four notes for the evening: first, on Lehman Brothers: Deal Journal wrote a piece earlier this week on Lehman potentially selling their subsidiary Neuberger & Berman.? I generally agreed with the piece, and wrote the following response:

Be wary when managements sell their best/safest assets to stay alive. It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.

Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times. Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.

So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.

The same applies to Merrill regarding their stakes in Blackrock and Bloomberg.? Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market.? I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort.? Merrill Lynch has more running room, but even they could face the same fate.

Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits.? It failed when loan underwriting ceased to be done in any prudent way.? Alt-A lending will return, but it is less likely that Indymac will see the light of day again.? Whether in insurance or lending, underwriting is the key to long-term profits.? Foolish lenders/insurers economize on expenses at the cost of losses.

Third, we have a possible deal that the US government may buy a convertible preferred equity stake in Fannie and Freddie.? This comes on the heels of news that no access would be granted to the discount window, but this deal would include discount window access.? (Ugh.? Is it going to take a Dollar crisis to make the Fed realize that only the highest quality assets should be on the balance sheet of the Fed?)

Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer.? My question is whether $15 billion is enough.? It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?

Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.

As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety.? I write this not to sneer at those who have messed this up, because I have done it as well.? Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion.? (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)

I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability.? Many value managers have been hurt from an overallocation to credit-sensitive financials.? They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?

Well, I have made that bet.? Maybe I should not have owned as many insurers, but they should be fine in the long run.? There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here.? Look at companies that can survive moderate-to-severe downturns.? If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.

Halftime for 2008

Posted on 9 July 2008 by David Merkel

Well, June was nothing great.? I was ahead of the indexes, but that doesn’t mean much in absolute terms.? For the year, I ended June ever so slightly negative.? Good in relative terms, but I aim for better.

July has been ugly for me — I am down considerably more than the market, but these things happen… energy is off, and though I am market weight, the names I own have considerable operating leverage.

While I was on vacation, I did the following trades: bought some International Rectifier, Smithfield Foods, and Officemax.? I enjoyed my time off, and disciplined my computer use to half and hour around lunch, and some time after the kids went to bed.

I am still working on my portfolios reshaping, and should have some trades by early next week.

Full disclosure: long IRF SFD OMX