Value Investing – Page 76

Assurant and Intelligent Acquistions

Posted on 2 May 2008 by David Merkel

Those who have read me for a long time know that my favorite insurance company is Assurant.? I’m not writing tonight about how they had great first quarter earnings, or how their investment portfolio suffered less than their competitors.? Rather, it springs from a Bloomberg article that is not available on the web.? It seems Assurant is talking to Countrywide about purchasing their Balboa Insurance Group.

What makes for an intelligent acquisition?? Two things: don’t overpay, or flub the integration.

On overpaying, it helps if you are buying:

part of a business rather than the whole company
a noncore asset of the target
and offering noneconomic benefits (e.g. joining Berkshire Hathaway, because Warren doesn’t change the culture…)
through a negotiation, not an auction (think of MetLife buying Traveler’s Life)
something where you can get significant expense savings
and you are known to be prudent and fair as an acquirer

On integrating, it helps if:

you are integrating a business that differs from your business in at most one or two ways
corporate cultures are similar
the differences in technology are small
you gain new markets or technologies that you can use in the rest of your business

Assurant has done very well through small in-fill acquisitions where they pick up a new line of business that they can grow organically.? They also have done well in occasionally buying scale in areas where they are already strong, for example, when they bought the pre-need (funeral) insurance business of Service Corp International (a very concentrated niche business line).

With Balboa Insurance Group, Assurant would deepen its penetration into lender placed homeowners insurance.? Assurant is #1, and Balboa I think is #2 because of its business with Countrywide.? Assurant has efficient systems — they will be able to take out costs, and deliver even better service to Countrywide / Bank of America.

Now, if Countrywide is interested in selling, it is likely that the best bid would come from Assurant, not because they will overpay, but because they can offer the best service, and take out the most in expenses.? Bank of America would likely find Balboa to be a small noncore asset, so their interest in retaining it would be low.

Here’s small excerpt from the Bloomberg piece:

“Certainly that is a business we would be interested in,” Assurant Chief Executive Officer Robert Pollock said today in a conference call with investors. “Until things between Bank of
America and Countrywide close, I don’t think that’s going to be a focus” for Bank of America.

Countrywide, based in Calabasas, California, reported a first-quarter loss of $893 million earlier this month, its third straight quarterly loss, as late mortgage payments and home
foreclosures rose. Bank of America said April 21 that its purchase, which would make the Charlotte, North Carolina-based bank the largest U.S. mortgage lender, remained on course forcompletion in the third quarter.

“Even in that case though, we still have to evaluate what we would have to pay for that business versus our ability to win” Balboa, Gene Mergelmeyer, president of Assurant’s specialty
property business, said in the call.

So, I look at this as a possible plus for both Bank of America and Assurant.? Balboa will be most valuable in Assurant’s hands.? Put it this way, why would another insurer want to buy Balboa when it is up against much superior competition?

PS — From the “don’t give a sucker an even break” file, Bank of America may not guarantee the debt of Countrywide.? This should not be a surprise.? They aren’t required to guarantee the debt, and Countrywide bondholders should just be grateful for the equity infusion.? If things get bad, though, Bank of America could walk away from Countrywide, and give it to the bondholders.

Full disclosure: long AIZ

Book Review: The Fundamental Index

Posted on 1 May 200820 May 2008 by David Merkel

The books keep rolling in; I keep reviewing. Given that I am a generalist, perhaps this is a good task for me. Before I start for the evening, though, because I know the material relatively well, I skimmed the book, and read the parts that I thought were the most critical.

The Religious War Over Indexing

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

The market is efficient!
Keep expenses low!
Don’t trade fund positions!
Fundholders buy and hold!
Tax efficiency!
Weight by market cap or float!

For fundamental indexers:

The market is inefficient (in specific gameable ways).
Keep expenses relatively low.
Adjust internal fund positions as valuations change!
Fundholders buy and hold!
Relative tax efficiency!
Weight by fundamental value!

Some of the arguments in Journals like the Financial Analysts Jounrnal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I’m going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: “How can I get the average return out of a class of publicly buyable assets?” The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: “What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let’s set up a portfolio that weights the positions by the estimated future values.” Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value — dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That’s worth the fuss. Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin’s Q — it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can’t do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

Asset Allocation — best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn’t work.. but everyone doesn’t do it. Ask Jeremy Grantham…)
The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors… in general, the more volatile, the more fund investors lose from bad market timing.)
A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal…)
And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That’s not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint… but I could be wrong.)

Who should buy this book? Academics interested in the debate, and buyers of indexed equity products should buy the book. It is well-written, and ably sets forth the case for fundamental indexing.

Full disclosure: If you buy anything from Amazon after entering Amazon through any link on my leftbar, I get a small commission. It is my version of the tip jar, and it does not increase your costs at all.

Financial Literacy for Children

Posted on 30 April 2008 by David Merkel

As we were driving down the highway Monday evening, back from our oldest daughter’s symphony concert at U-MD, my wife and I began talking about teaching children about money.? We homeschool, so we have to consider a lot in training our children for the real world.

Some of my children have an interest in the market, some don’t. Personalities differ, but you want to give them some core knowledge that everyone can use. There have been people in our home school get-togethers who when they find out I am an investor, they ask “Do you know of any good books on the stock market for kids?” Lamely, I suggest the out-of-print book by Ken Fisher’s son, Clayton, which is pretty good, but I didn’t think it was definitive.? One has complained to me about the Stock Market Game, which seems to teach speculation, not investment.

That’s true of most stock market contests — the only exception I can think of was the Value Line contest back in 1984 . I managed to place in the top 1%, but not high enough to win. That contest forced you to pick 10 stocks from ten different groups for six months. The stocks were sorted by price volatility deciles, so you had to pick some volatile stocks and tame stocks. The stocks were equal weighted, and there was no trading. Great contest — I would love to run something like that. I have suggested it to The Street.com, but no dice. Hey, maybe Seeking Alpha would like to try it! Nominal prize money, but there would be bragging rights!? (Abnormal Returns, this could work for you as well…)

My wife tells me to think about it. Well, today, as I’m going through my personal e-mail, I run across a note from the Home School Legal Defense Association promoting the National Financial Literacy Challenge. Timely, I think. They are having a competition based off of the national standards published in 2007 by the Jump$tart Coalition for Personal Finance.

So I look at the standards, and I think, “These are pretty detailed… how can you turn this into a usable curriculum?”? I print them out and read a little bit of them to my wife Ruth, who says, “Typical for those that set standards, and aren’t teachers; you can’t work with that stuff.”? My wife was a high school teacher, and despite that hindrance, she still homeschools well.? But she knows the troubles that come to public school teachers as mandates come down from on high.

She asked me, “What would you recommend, then?”? I thought about it and said that the personal finance book that I reviewed recently, Easy Money, would be a good book for high school seniors to read.? It’s not a complex book at all.? Afterward I would discuss it with them.? She asked me why I hadn’t done that for our older two children and I said, “It was published after they went to college.? I’ll ask them to read it this summer.”

For investing, I still think that Buffett’s Annual Reports are understandable to most teens.? Marty Whitman is easy to read as well.? But I always liked Ben Graham, and I think The Intelligent Investor is accessible to the average teenager.? Good investing is not complex… but often we make it so.

Full disclosure: if you enter Amazon from my links and buy anything, I get a small commission.? It is my substitute for the tip jar, and it doesn’t increase your costs at all.

I Don’t Get It

Posted on 23 April 2008 by David Merkel

1) Liberty Mutual buys Safeco?? Pays 1.75x book, and 11x estimated earnings?? Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal.? They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead?? This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions.? There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present.? There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer.? Off of Safeco, he likes Chubb.? Okay, I like Chubb too.? Great company, and cheap.?? I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative.? Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds.? With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold.? With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings.? With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool.? I wouldn’t go there.

3) I don’t get Bill Miller.? I’m a value investor.? I like companies that trade at modest multiples of book and earnings.? I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies.? Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis.? At this rate next year, he might be behind the S&P over ten years.? Quite a flameout for one who was so lionized.? Could he be fired?? Yes, but not by Chip Mason.? They are too close.? If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade.? Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility.? I’m a professional, and I think humility is a key virtue in handling money.? As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net.? Hey, I’ve paid market tuition, and it is painful.? But boy, I learned a lot, and I don’t repeat mistakes often.? (Repeating mistakes sometimes is bad enough… 😉 )

Full disclosure: long SAFT (not SAF)

National Atlantic Notes, Part II

Posted on 22 April 200822 April 2008 by David Merkel

National Atlantic has filed its Preliminary Proxy Statement. I’m only going to tackle one part of it here tonight — the section starting on page 24, “Opinion of the Financial Advisor.” Those who have read me for a long time know that I am neither biased for or against any “fairness opinion.” For those who want to go back to my early days on RealMoney, you can view what I wrote on the MONY acquisition by AXA. The fairness opinion was correct, and the contesting value investors were dead wrong. Part of the problem was not understanding the insurance accounting.

With National Atlantic, I think the fairness opinion does not truly represent the value of the company. Let me go through a few critical bits of the fairness opinion:

(Page 26)

     Selected Publicly Traded Companies Analysis. Banc of America Securities
reviewed publicly available financial and stock market information for National
Atlantic and the following seven publicly traded personal lines property and
casualty insurance companies with a market capitalization below $2.5 billion:

        o   Mercury General Corporation
        o   State Auto Financial Corporation
        o   Horace Mann Educators Corporation
        o   Infinity Property & Casualty Corporation
        o   Safety Insurance Group, Inc.
        o   Donegal Group, Inc.
        o   Affirmative Insurance Holdings, Inc.

Banc of America Securities reviewed, among other things, per share equity
values, based on closing stock prices on March 7, 2008, of the selected publicly
traded companies as a multiple of calendar years 2008 and 2009 estimated
earnings per share, commonly referred to as EPS, and as a multiple of book value
per share as of December 31, 2007 (in the case of Safety Insurance Group and
Affirmative Insurance Holdings, as of September 30, 2007).

Affirmative and Infinity do not belong in this group, because they are both nonstandard auto writers, which get lower valuations than standard writers. Donegal is mainly a commercial writer when last I looked… the rest are fine. I might have included Gainsco, Commerce Group, or Universal Insurance Holdings. In any case, it biases the calculation of the estimated price low.

     Implied Per Share Equity Value Reference Ranges for National Atlantic         Consideration
     ---------------------------------------------------------------------         -------------

          2008E EPS                                    2007 Book Value
       ---------------                               -------------------

        $3.27 - $4.20                                   $5.24 - $7.85                   $6.25

It also would have been better to do a scatterplot of Price-to-book versus expected ROE on compared companies. I will have to perform that analysis eventually.

(Page 27)

Selected Precedent Transactions Analysis. Banc of America Securities
reviewed, to the extent publicly available, financial information relating to
the following twenty selected transactions involving property and casualty
insurance companies with a transaction value below $500 million:

Announcement
Date Acquiror Target
- --------------- -------------------------------------------------- -----------------------------------------

2/20/08 o Meadowbrook Insurance Group, Inc. o ProCentury Corp.
1/3/08 o QBE Insurance Group Ltd. o North Pointe Holdings Corp.
4/4/07 o Fortress Investment Group LLC o Alea Group Holdings Ltd.
3/14/07 o Argonaut Group, Inc. o PXRE Group Ltd.
12/4/06 o Elara Holdings Inc. o Direct General Corp.
11/22/06 o Clal Insurance Enterprises Holdings Ltd. o GUARD Financial Group Inc.
11/13/06 o Tower Group Inc. o Preserver Group Inc.
10/31/06 o American European Group, Inc. o Merchant's Group Inc.
10/6/06 o Affordable Residential Communities Inc. o NLASCO, Inc.
10/3/06 o Affirmative Insurance Holdings, Inc. o USAgencies, L.L.C.
9/28/06 o Arrowpoint Capital Corp. o Royal & Sun Alliance Insurance
8/16/06 o QBE Insurance Group Ltd. o One Beacon Insurance Group, Ltd.
8/4/06 o Delek Group, Ltd. o Republic Companies Group, Inc.
7/19/06 o Inverness Management L.L.C. o Omni Insurance Group Inc.
11/4/05 o General Motors Acceptance Corp. o MEEMIC Insurance Company
5/22/03 o Liberty Mutual Holding Company Inc. o Prudential Financial Inc.
5/22/03 o The Palisades Group o Prudential Financial Inc.
3/26/03 o Nationwide Mutual Insurance Co. o Prudential Financial Inc.
11/1/00 o American National Insurance Company o Farm Family Holdings, Inc.
10/25/00 o State Automobile Mutual Insurance Company o Meridian Insurance Group, Inc.

The only deal here that would truly be a “comparable” might be Republic Companies. It was a company that was mainly a personal lines company, unlike many of the rest of these deals which are for commercial insurers and reinsurers (I am not familiar with all of them). Republic was sold significantly over its book value. And, where is Commerce Group? I know it is too big to meet the cutoff, but there is a sale of a single state insurer. I would think that valuation would be relevant.

                 Implied Per Share Equity Value
              Reference Ranges for National Atlantic            Consideration
            ------------------------------------------        ------------------
               2008E EPS             2007 Book Value
            ----------------       -------------------

             $5.36 - $6.30             $8.51 - $9.82                $6.25

So, I think these values are low as well. There is far more certainty to the valuation of the reserves of a short-tailed insurer, which usually deserves a higher valuation.

(Page 28)

     Discounted Cash Flow Analysis. Banc of America Securities performed a
discounted cash flow analysis of National Atlantic to calculate the estimated
present value of the standalone unlevered, after-tax free cash flows that
National Atlantic could generate during National Atlantic's fiscal years 2008
through 2012 based on the National Atlantic management forecasts. Banc of
America Securities calculated terminal values for National Atlantic by applying
terminal forward multiples of 7.0x to 9.0x to National Atlantic's fiscal year
2013 estimated GAAP earnings and of 0.40x to 0.70x to National Atlantic's
estimated 2012 year-end book value. The cash flows and terminal values were then
discounted to present value as of March 7, 2008 using discount rates ranging
from 15% to 17%. This analysis indicated the following implied per share equity
value reference ranges for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                       $5.42 - $7.42                            $6.25

I’d like to see them spill the guts of the calculation, and the other calculations above as well. Using “0.40x to 0.70x to National Atlantic’s estimated 2012 year-end book value” and “discount rates ranging from 15% to 17%” is too severe. This is a company with no debt. It’s marginal cost of capital, using the “pecking order” theory is low. Also, short-tail P&C companies under competent management teams don’t retain valuations below 0.8x book.

     Run-off Analysis. Banc of America Securities also performed a run-off
analysis of National Atlantic to calculate the net present value of dividends
that would be paid to shareholders over the remaining life of the company
assuming that it serviced its existing policies without writing any additional
policies or renewing any existing policies. Based on the assessment of National
Atlantic management that the company would not be permitted to pay annual
dividends by the New Jersey regulators, this analysis calculated the net present
value of the final dividend available for distribution to shareholders after all
payouts on loss reserves and losses on unearned premium reserves, estimated to
be approximately $88.0 million payable in 2016. Banc of America Securities
applied a sensitivity analysis to assess a range of values if the loss reserves
were inadequate by up to 10% or were overstated, showing a redundancy of up to
10%. The range of final dividend distributions were then discounted to present
value as of March 7, 2008 using discount rates ranging from 13% to 17%. This
analysis indicated the following implied per share equity value reference ranges
for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                      $1.36 - $3.60                             $6.25

Again, the discount rate is too high. Beyond that, they make the fatal assumption that the company can’t close its books until 2016. If National Atlantic stopped writing policies today, then, one year from today, it would receive its last premium. The company would operate with a skeleton staff for one more year, after which, the remaining book could easily be sold to a company specializing in run-offs. You wouldn’t get your money in 2016. It would be more like 2010. Six years of interest discount at 13-17% makes a huge difference in the price.

=-=-=-=-=-=-=-=-=–=-==-=–=-==-=-=–=-==–=

I have more work to do here, but my fundamental view is not changed. I will be voting against the deal, and encouraging others to do the same. Should the deal succeed, I will likely file for appraisal rights. As I have noted before, I believe that I have meritorious arguments for a better price.

Full disclosure: long NAHC SAFT

The Source of Most Economic Prediction Errors at Present

Posted on 18 April 2008 by David Merkel

This should be regarded as a small “opinion piece” of mine.? My big gripe with economic predictions over the past five years, is that forecasters use the old closed economy simplifications that worked when the US was a unique capitalist economy, and international trade flows did not affect the total picture much.

Today, I don’t try to analyze the US economy as a whole.? I look at its sectors and try to analyze them in a global context.? Even if the domestic US economy is in a funk, it is possible for sectors that serve other countries that are growing to do well.

So, I don’t make much of those who assume a recession will restrain inflation.? Perhaps a global recession will do so, but a US recession will not.? We need to look more closely at how the US is devaluing its currency versus other countries, and that might give us better clues regarding future inflation.

It is much richer to look at the sectors of the US economy, and look at them separately.? They have varying exposure to the US and Global economies.? That difference is critical now for investment decisions.

Not Concerned About Reinsurance Group of America

Posted on 18 April 200818 April 2008 by David Merkel

So Reinsurance Group of America missed estimates. Big deal; they’ve had good-to-excellent earnings for the last ten quarters; they have a bad quarter now and then when the “law of small numbers” catches up with them. Look at 2Q05 and 4Q01 for examples. The law of small numbers means that every now and then, you get a random gaggle of deaths with high face amounts, and the quarter is bad. This is often a good buying opportunity, because Wall Street, which only understands that the earnings missed, without understanding the underlying model, assumes that the miss will persist into the future. That has not been true of RGA.

I have met the CEO and CFO of RGA, and I think they know what they are doing, more than all of the other companies that do life reinsurance. They are the quality name in the space, including their more complex European competitors.

The stock price is currently way above my lower rebalance point, but I would be a buyer on weakness if I did not have a position. This is one of those stocks that you tuck away for 5-7 years, and you find that it doubles. The current oligopolistic nature of life reinsurance may shorten that timespan.

Full disclosure: long RGA

Second Quarter 2008 Portfolio Changes

Posted on 16 April 2008 by David Merkel

For this quarter, I sold two my two placeholder assets, the Industrial and Technology SPDRs, and Arkansas Best, which had richened enough for me to trade out of it.

I had two rebalancing buys, Charlotte Russe and Avnet.? On Charlotte Russe, the rebalancing buy occurred because I tendered all my stock @ $18 in the Dutch Tender, and 45% of it got bought.? On Avnet, things aren’t as bad as the market thought on 4/15, in my opinion.? I had one rebalancing sell, Helmerich and Payne.? Just taking some off the table for risk reduction purposes.

Here is my final comparison file that was based off of data at the close of business on Monday.? To comply with the Bloomberg data license, all numeric fields remaining are ones that I calculated.? The columns of the file rank the 290 stocks on the following metrics (lower better unless noted):

52-week RSI
Trailing P/E
P/Book (2)
P/Sales (2)
P/2008E
P/2009E
Dividend Yield (higher better)
Net Operating Accruals (2)
Implied Volatility
Neglect (higher better)

The grand rank sums up the ranks giving double weights to P/B, P/S, and NOA.? My current stocks are highlighted in yellow, except for the two middle ones, which are in orange.? Candidates for sale come from the lower half (high grand ranks), candidates to buy from the upper half.

Here were my purchases (P/2008E):

International Rectifier — 9.5x
Group 1 Automotive — 7.1x
OfficeMax — 9.3x
Universal American Financial — 5.8x

Cheap names all (and could get cheaper?).? If you asked me what my concerns might be over this group of names, I would say that credit quality is adequate but not stellar.? I would also confess a little doubt on Universal American.? It looks cheap, and lines of business they are in are stable lines.? They lost money on mezzanine subprime mortgage ABS.? I looked at the writedowns, and they seem adequate.? If you send the security vintages 2006-2007 to zero, this stock is still cheap, in my opinion.?? What I can’t evaluate is whether they could have operational problems in their senior health insurance business.? It’s a good business, if managed properly.

As for International Rectifier and Group 1, I have owned them before.? With IRF, I like industrial technology — stuff that is harder to obsolete.? On Group 1, I looked at all of the small cap auto retailers, and picked this one.? I liked its business mix, and what seemed to be a clean balance sheet, with few immediate needs for liquidity.? The group as a whole has been smashed, and is discounting very unfavorable conditions.? I don’t think things are that bad, and besides, a lot of the revenues come from repairs and sales of used cars.

With OfficeMax, I think prospects are less cyclical than the market seems to believe.? Office supplies get purchased during bad economic times as well, and the current price already discounts? a lot of pain.

Well, those are my purchases.? Let’s see how they fare over the coming years.

Full disclosure: long HP CHIC AVT GPI UAM OMX IRF

Nerds and Barbarians

Posted on 11 April 2008 by David Merkel

There have been a lot of bits and bytes spilled recently over whether hedge funds like volatility or not. Here’s a sampling:

Here’s the truth, the answer isn’t a simple yes or no.? Hedge funds are limited partnerships that do a wide variety of things in the markets.? Some aim for easily modeled consistent gains through arbitrage.? Others aim for maximum advantage, no matter what.? I call the first group the “nerds” and the second group the “barbarians.”? Neither of these terms are meant to be insulting — I consider myself to be a nerdy barbarian.

Nerds are yield-seekers.? They are attempting to achieve high smooth yields well in excess of the nominal risk-free rate on a constant basis.? They tend to get funded by fund-of-funds who attempt to diversify nerds, and maybe a barbarian or two, who have clients looking for smooth yields in excess of their hurdle rates.

When volatility rises, nerds get hurt.? In the same way that junk bond investors get hurt in volatile times, so do hedge fund nerds.? Almost all simple arbitrages rely on calm markets, where there is enough liquidity to finance every project imaginable, and a few that aren’t imaginable.? Volatility alerts investors to the concept that maybe there will not be enough cash flow to complete the transaction at a positive net present value.

Barbarians are another matter.? They swing for the fences, and are looking for maximum advantage.? They look to earn the returns from big bets that could be right or wrong.? They like increased volatility, because it enables them to take positions when they are despised or enraptured.? They play for the mean reversion, something that the nerds can’t do.

To make matters more complex, some hedge fund groups blend the two attitudes.? Good idea, if you can maintain your competitive advantages.

To close this, there is no simple answer to whether hedge funds like volatility or not.? Some benefit,? some get hurt. In my opinion, because of hedge fund-of-funds, which like nerds, volatility tends to hurt hedge funds in aggregate, but not by much.

With credit spreads wide, and disarray among the nerds, it is probably time to favor high yield investing and nerds in hedge funds.??? Don’t jump in with both feet though, I would only allocate 50% of a full position at present.? There is a lot more volatility to be worked out of the system.

Industry Ranks April 2008

Posted on 9 April 200810 April 2008 by David Merkel

Okay, here are my industry ranks for April 2008. Please remember that my model can be used in value mode (the green zone) or in momentum mode (the red zone). I usually just stick to the green zone, but this time I included a few red zone ideas. So, this time I added in technology companies, insurance, industrial and healthcare companies. Yeah, I know that’s a lot, and my results reflected that — usually I have just 20 or so companies from the screen, but this time it is 80+.

Oh, my screen, aside from industry, has only two factors: market cap greater than $100 million, and Price-to-book times Price-to-forward earnings must be less than 10. Ben Graham had a similar criterion, except that he used trailing P/E, and his cutoff was 22.5. Here are the tickers:

ABG ACGL ACMR ACW ADPI AEL AFFM AGYS AHL AIG AMSF ARM AWH AXS BBW BC BRLC BRNC CBR CHUX CLS CMOS CNA CVGI DK EDS ENH ENSG FFG FL FLEX FMR FRPT GPI HMX HOTT HTRN IKN INDM IPCR IRF KEM KG LAD LNY LTR MENT MIG MRH MRT MWA MXGL NCS NNBR NSIT NSTC NYM OCR ODP PCCC PDFS PKOH PLAB PMACA PNX PRE PSS PTP RE RMIX RNR ROCK RTEC SAF SAH SANM SEAB SMP SNX TECUA THG TRS TRW TRX UAM UNM XL XRIT

Lots of insurers — what can I say, the group is cheap… cheaper than the lack of pricing power should make them. Add in two more tickers that crossed my desk today: MRO and AWI, and I think I am ready to put my spreadsheet together and start analyzing promising cheap companies. One nice thing about my methods is that it can accommodate a large number of tickers. When you add up the tickers from yesterday and today, and add in the 32 existing tickers, that’s almost 300 tickers altogether.

Fortunately, my ranking system helps my winnow down the list pretty quickly, as it scores cheapness on a wide number of variables at once, and throws in many of the anomalies that are mispriced in the markets. Then it is up to me to use business judgment to decide what makes sense, because most cheap stocks are cheap for a reason, while the gems are merely overlooked.

Feel free to pitch in more stock ideas. I should come to decisions within a week or so.

PS — Have you checked out Newsflashr.com yet? It looks like a promising way of aggregating financial news, as well as other news.