Yes, Break Up AIG!

Yes, Break Up AIG!

Posted on by David Merkel
Photo Credit: Insider Monkey || Carl never looked so good.
Picture?Credit: Insider Monkey || Carl never looked so good.

I’ve written about this topic twice before:

 

Those were back in 2008, before the financial crisis. ?I made similar comments at RealMoney earlier than that, but those are lost and gone forever, and I am dreadful sorry.

I’ve written a lot about AIG over the years, including my article that was cited by the Special Inspector General of the TARP in his report on AIG. ?I’ve also written a lot about insurance investing. ?I’d like to quote from the final part of my 7-part series summarizing the topic:

1) The first thing to realize is that diversification across insurance subindustries usually does not work.

Do not mix:

  • Life & P&C
  • Financial & Anything
  • Health & Anything

Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.? The main point is this.? Insurance is not uniform.? Coverages are sold and underwritten differently.? Generally, higher valuations will be obtained on ?pure play? companies? Diversification is swamped by management inability.? These are reasons for AIG and Allstate to spin off their life operations.

2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.? With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.

Both of these concepts augur in favor of a breakup of AIG — even without the additional capital needed for being a SIFI (which no insurance firm should be, they don’t collapse together, like banks do), large firms get a valuation discount, because they can’t grow quickly.

Synergies and diversification benefits between differing types of insurance tend to be limited as well. ?Focus is worth a lot more in insurance than diversity, because managements are typically not good at multiple types of insurance. ?They have different profit models, distribution systems, capital needs, and mindsets. ?Think of it this way: if you can’t get personal lines agents to sell life insurance and annuities, why do you ever think there might be synergies? ?They are very different businesses.

Now Carl Icahn is arguing the same thing — size and diversification are harming value at?AIG, as well as a high cost structure. ?I think his first argument is right, and a breakup should be pursued, but let me mention four complicating factors that he ought to consider:

1) Costs aren’t overly high at AIG, and there may not be a lot to cut. ?Greenberg ran a tight ship, and I suspect those who followed tried to imitate that. ?I would try to double-check cost levels.

2) ROEs are low at AIG likely because many life insurers have low?embedded margins and those?can’t be changed rapidly because of the long duration nature of the contracts. ?The accounting for DAC [deferred acquisition cost]?assets can be liberal at times — writedowns are not required until you are deferring losses. ?I would analyze all intangible assets, and try to estimate what they returning. ?I would also try to look at the valuation of life insurers?comparable to those at AIG, which are high complexity beasties. ?You might find that a breakup won’t release as much value as you think, at least initially.

3) Pure play mortgage insurers are fodder for the next financial crisis. ?If one of those gets spun off, it won’t come at a high valuation, particularly if you give it enough capital to maintain its credit ratings.

4) There are a variety of cross-guarantees across AIG’s subsidiaries. ?I’m assuming Icahn read about those when he looked through the statutory books of AIG. ?That is, if he did do that. ?They are mentioned in the 10K, but not in as much detail. ?Those would probably be the most difficult part of a breakup of AIG, because you would have to replace guarantees with additional capital, which reduces the benefit of breaking the companies up.

Summary

Breaking up AIG would be difficult, but I believe that focused insurance companies with specialist management teams would eventually outperform AIG as it is currently configured. ?Just don’t expect a quick or massive initial benefit from?breaking AIG up.

One final note: it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise. ?Insurance is a set of complex businesses, and few understand most of them, much less all of them. ?It would be easy to naively overestimate the ability to improve profitability at AIG if you don’t know the business,? the accounting, and how free cash flow emerges, if it ever does.

They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings. ?Icahn and his friends might be surprised at how little value could initially be released, if any.

 

Full disclosure: long ALL

 

Redacted Version of the October 2015 FOMC Statement

Redacted Version of the October 2015 FOMC Statement

Posted on by David Merkel
Photo Credit: Day Donaldson
Photo Credit: Day Donaldson

 

September 2015 October 2015 Comments
Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace. Information received since the Federal Open Market Committee met in September suggests that economic activity has been expanding at a moderate pace. Shows less certainty about current GDP.
Household spending and business fixed investment have been increasing moderately, and the housing sector has improved further; however, net exports have been soft. Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft. Shades up household spending.
The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilization of labor resources has diminished since early this year. The pace of job gains slowed and the unemployment rate held steady. Nonetheless, labor market indicators, on balance, show that underutilization of labor resources has diminished since early this year. Shades labor employment down a little.
Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. No change.
Market-based measures of inflation compensation moved lower; survey-based measures of longer-term inflation expectations have remained stable. Market-based measures of inflation compensation moved slightly lower; survey-based measures of longer-term inflation expectations have remained stable. No change.? TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.79%, down 0.11% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.   Well, that sentence lasted for one meeting.? Would that more got chopped out of the statement.
Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely. CPI is at +0.0% now, yoy.? States that they have a global view of what they need to watch.? Good luck with that.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Gives the impression that a change might be coming at the next meeting, but the way the FOMC thinks about monetary policy is currently scattered, to say the least.

I wouldn?t make too much of this change.? The FOMC is big on their newfound flexibility, and isn?t going to be very predictable for some time.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. No change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. No Change.

?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Still a majority of doves.

We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.
Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting. Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting. No change.? Lacker dissents, arguing policy has been too loose for too long.

Comments

  • This FOMC statement was yet another great big nothing. Only notable changes were shading household spending up, and employment and GDP down.
  • Don?t expect tightening in December. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? The FOMC says that any future change to policy is contingent on almost everything.
  • On the new phrase, ?whether it will be appropriate to raise the target range at its next meeting,? I would not make much of it. It gives the impression that a change might be coming at the next meeting, but the way the FOMC thinks about monetary policy is currently scattered, to say the least.? I wouldn?t make too much of this change.? The FOMC is big on their newfound flexibility, and isn?t going to be very predictable for some time.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
  • Equities fall and bonds rise. Commodity prices fall and the dollar rises.? This is a sign that the markets anticipate more economic weakness.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.
Commissions Matter

Commissions Matter

Posted on by David Merkel
Photo Credit: GotCredit
Photo Credit: GotCredit

Before I start on this tonight, let me say that I never begrudge any salesman a fair commission. ?When I was a bond manager, I made a point of never letting my brokers “cross bonds” to me, i.e., at no commission. ?I would raise my purchase price a little to compensate them. ?Had my client known that I did that, he might have objected, but it was in his best interests that I did it. ?As a result of that and other things that I did, my brokers were very loyal to me, and worked to give my client excellent executions whether buying or selling. ?They were also more frank with me about bonds they thought I should sell. ?Fairness begets fairness under most conditions, and suspicion and tightness also have their way of breeding as well. ?Consider that in all of your dealings.

My main reason for writing tonight is to remind investors to think about how the parties you transact with are compensated.

  • If they are compensated on?transactions, expect to see a lot of buying and selling.
  • If they are compensated on asset-based fees, expect them to try to get business, and then retain it.
  • If they are compensated on profits, they will try to get profits. ?Be wary of how much control they might have over the accounting, they will be incented to be liberal if they have any control. ?They will also be incented toward volatility, because volatile assets offer the best possibility of a big score, even if the probability is moderate at best.

The greater the potential compensation, the greater the tendency to act along the incentives offered. ?As a result, if a life insurance salesman has a product offering a high commission, and one offering a low commission, he may act in the following way:

  • Figure out if you are price-sensitive or not.
  • Figure out if you are willing to accept a product that has a long surrender charge. ?Long surrender charges lock in business, and allow for high commissions to be paid.
  • Also analyze how much complexity you are willing to accept — more complex permanent policies and especially ancillary riders are far more profitable because even external actuaries would have a tough time analyzing them.
  • If you are price-sensitive, bring out the low commission policy that is more competitive.
  • If you are price-insensitive, bring out the high?commission policy that is less?competitive.

(Note: there are state laws in every state that constrain this behavior for life insurance agents, but it can never be eliminated in entire.)

Now, many agents will act in your interests in spite of their own interests, but some won’t, so be aware. ?Always ask a question like, “This seems expensive. ?Don’t you have another policy that is less expensive that accomplishes only the main goal that I am shooting for?”

You could always ask them what commission is that they will earn. ?Most won’t answer that. ?First, it’s kind of offensive, and second, they will argue that it is not material to your decision.

But it is material to your decision. ?Here’s why:

  • The size of the commission directly affects the size of the premium that you pay.
  • It also directly affects?the length and size of the surrender charge that you would pay if you terminate the policy early.
  • After all, the actuaries or other mathematical businessmen are trying to avoid the risk of paying a commission that they can’t recover under ALL circumstances. ?They will get their fees from you to recoup the commission cost. ?They will either get it from you coming or going, but they WILL?get it from you, at least on average.

If the?salesmen?disagree with you after mentioning this (or showing them this), you can say to them that every actuary knows this is true, don’t argue with the actuaries, they know the math. ?(And its why we tend to buy term and other simple policies. ?Shhh.)

I’ve seen more than my share of ugly products in my time. ?I’m happy I never designed any. ?I did kill a few of them. ?That said, one of the most unpleasant duties I ever had as a life actuary was about 18 years ago when I inherited a department to clean up, and I got the responsibility of talking to the clients that were the most irate, demanding to talk to the man in charge. ?I never created those products, but I was nominally in charge of the division as I cleaned up the pricing, reinsurance, reserving, accounting, and asset-liability management.

I’ll tell you, it is no fun talking to people who conclude that they have been had. ?It is even less fun to be the one who has been had. ?Thus I would tell you to view all salesmen of financial with skepticism. ?It is hard to assure a good result with intangible products that are hard to compare. ?Thus aim for simplicity and lower surrender charge and commission products.

Now, I used life insurance as my example here because I know it best, and it excels in complexity. ?But this applies to all financial products, especially illiquid ones. ?Be wary of:

  • Brokers who make money off of commissions
  • Those who sell private REITs and structured notes
  • Any product where you have a limited ability to liquidate or sell it.
  • Any product that you can’t understand how the company and salesman are making money off it.
  • Any product where you can’t understand what the legal form of the investment is (Stock, bond, mutual fund, partnership, derivative, insurance, etc.)

Here are some final bits of advice:

  • Look for advisers who are fiduciaries, and are responsible to look out for your interests (but still be wary)
  • Look at the fee structures, and look for lower cost alternatives.
  • Seek competing products,?salesmen and companies.
  • Negotiate lower compensation where possible.
  • Remember that higher yields are almost never free… what yields more typically has more risk. ?Yield is the oldest scam in the books.

Remember, regardless of what laws exist, you are your own best defender when it comes to your own economic interests. ?Be aware of the economic incentives of those who seek your business with financial products, and be reasonably skeptical.

Book Review: Financial Tales

Book Review: Financial Tales

Posted on by David Merkel

financial tales

This financial book is different from the 250+ other financial books that I have reviewed, and the hundreds of others I have read. ?It tells real life stories that the author has personally experienced, and the financial ramifications that happened as a result. ?Each?of the 60+ stories illustrates a significant topic in financial planning for individuals and families. ?Some end happy, some end sad. ?There are examples from each of the possible outcomes?that can result from people interacting with financial advice (in my rough large to small probability order):

  • Followed bad advice, or ignored good advice, and lost.
  • Followed good advice, and won.
  • A mixed outcome from mixed behavior
  • Followed bad advice, or ignored good advice, and won anyway.
  • Followed good advice, and lost anyway.

The thing is, there is a “luck” component to finance. ?People don’t know the future behavior of markets, and may accidentally get it right or wrong. ?With good advice, the odds can be tipped in their favor, at least to the point where they aren’t as badly hurt when markets get volatile.

The stories in the book mostly stem from the author’s experience as a financial advisor/planner in Maryland. ?The stories are 3-6 pages long, and can be read one at a time with little loss of flow. ?The stories don’t depend on each other. ?It is a book you can pick up and put down, and the value will be the same as for the person who reads it straight through.

In general, I thought the author advocated good advice for his clients, family and friends. ?Most people could benefit from reading this book. ?It’s pretty basic, and maybe, _maybe_, one of your friends who isn’t so good with financial matters could benefit from it as a gift if you don’t need it yourself. ?The reason I say this is that some people will learn reading about the failures of others rather than being advised by well-meaning family, friends, and professionals. ?They may admit to themselves that they?have been wrong when they be unwilling to do it with others.

I recommend this book for readers who need motivation and knowledge to guide themselves in their financial dealings, including how to find a good advisor, and how to avoid bad advisors.

Quibbles

The book lacks generality because of its?focus on telling stories. ?It would have been a much better book if it had one final chapter or appendix where the author would take all of the lessons, and weave them into a coherent whole. ?If nothing else, such a chapter would be an excellent review of the lessons of the book, and could even footnote back to the stories in the book for where people could read more on a given point.

I know this is a bias of mine regarding books with a lot of unrelated stories, but I think it is incumbent on the one telling the stories to flesh out the common themes, because many will miss those themes otherwise. ?In all writing, specifics support generalities, and generalities support specifics. ?They are always stronger together.

An Aside

I benefited from the book in one unusual way: it gave me a lot of article ideas, which you will be reading about at Aleph Blog in the near term. ?I’ve never gotten so many from a single book — that is a strength of reading the ideas in story form. ?It can catch your imagination.

Summary / Who Would Benefit from this Book

You don’t need this book if you are an expert or professional in finance. ?You could benefit from this book?if you want to improve what you do financially, improve your dealings with your financial advisor, or get a good financial advisor. ?if you want to buy it, you can buy it here: Financial Tales.

Full disclosure:?The author sent a free copy?to me directly. ?Though we must live somewhat near to one another, and we both hold CFA charters, I do not know him.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.

On Writing Critical Book Reviews at Amazon

On Writing Critical Book Reviews at Amazon

Posted on by David Merkel
Photo credit: Luke Dorny
Photo credit: Luke Dorny

I love books. ?I read a lot of them, especially those on investing, finance, and economics. ?I could argue that the genre is tired, but there are a lot of people trying to jazz it up, sometimes with more success, and sometimes with less. ?Those who do it different have a strong probability of bombing it, but occasionally a new approach is brilliant.

If you’re new to Aleph Blog, you might not know that about one in ten posts is a book review. ?That wasn’t what?I intended when I started this project 8.6 years ago. ?Actually, I’m not sure what I intended, this has ended up bigger and more involved than I ever imagined.

If you have read my book reviews, you might note several things that are different:

  • I read in full almost all of the books that I review. ?When I don’t, I disclose it.
  • I don’t just review new books. ?I review older books when it makes sense to me.
  • I don’t just review books that I like, but those that I don’t like also.
  • I also try to identify who might be the right sort of person for a given book — some people don’t like math, some books are too simple, some are too hard, etc.

I usually cross-post my reviews at Amazon.com. ?For the types of the books that I review, I think I have a pretty good reviewer ranking at Amazon. ?That said, I know it would be a lot higher if I did four?things.

  • Stop mixing in my own experiences or knowledge on a given topic, which sometimes is equal to that of the author, and occasionally, exceeds the knowledge of the author. ?Book reviews aren’t supposed to be about me. ?I get it, and I am trying to reduce that.
  • Review only new books, and get them done as close?as possible to the release date of the book. ?There are many book reviews that are in my opinion lousy, but they got done first, and people voted them up, giving a review that is the equivalent of a “smiley face” button a parasitic life off of the book.
  • Write shorter reviews.
  • Stop doing critical reviews. ?Only post happy stuff — these authors hail from Lake Wobegon, and are all above average.

I want to amplify that last point. ?Books have natural defenders — certainly the author and his friends, but also?if it is a book on a cultic topic, such as gold, Bitcoin, various schools of economic prejudice thought, doomsday economics,?THE ONE WAY TO INVEST, etc., etc., etc., you get the mindless zombies partisans defending the cult. ?They will vote you down, and it doesn’t take many reviews where you have 20% helpful votes, even if it is the best critical review, before your rating sinks dramatically.

I’m not going to stop writing critical reviews. ?I’d rather be less popular and known, than sacrifice credibility, even if I look like a fool at times. ? (Yes, that is somewhat contradictory.) ?That’s just a price of cross-posting at Amazon, and I will keep doing it to benefit readers generally, whether they like it or not.

And Now For Something Completely Different

On an unrelated note, one interesting thing that has developed over time are all of the independent authors and small publishers sending me books in the mail.??Some are preceded by an email for permission, others show up like lost puppies.

They are interesting books, and I don’t review all of them, because many of them don’t work — they are just too quirky, and probably needed a better editor, or, a publisher who would do the author a favor and tell him, “No.”

Second unrelated note: the hardest books for me are those where I know the author, and I end up not being crazy about the book. ?Usually, I quietly spike those reviews, and send a note to my friend/acquaintance as to why he won’t see a review out of me. ?I do have a heart, after all, and value my relationships more than “telling it like it is,” unless it is egregious.

All for now, as always thanks for reading.

Too Many Vultures, Too Little Carrion, Redux

Too Many Vultures, Too Little Carrion, Redux

Posted on by David Merkel
Photo Credit: TexasEagle || A: Do you see any prey? B: No, I don't. Do *you* see any prey?
Photo Credit: TexasEagle || A: Do you see any prey? B: No, I don’t. Do *you* see any prey?

I was surprised to find that I wrote another piece with the same title — 8.5 years ago, before the housing bubble crashed. ?It was a short piece (with dead links). ?Here it is:

I had a cc post over at RealMoney called Too Many Vultures, Too Little Carrion . The idea was that there?s too much money ready to rescue dud assets at present. Yesterday, Cramer had his own blog entry suggesting that the absorption of subprime assets at relatively high prices implied that the depositary financial sector is a sound place to invest. I disagree. In the early phases of any secular change, there are market players who snap up distressed assets, and later they find out that they could have gotten a better bargain had they waited.

The good sale prices for subprime portfolios is not a sign of strength, but a sign that there is a lot of vulture capital looking for deals. The true problems will surface when the vulture capital gets burned through or scared away.

That last paragraph is the “money shot.” ?When there is too much vulture capital waiting to invest in distressed securities, marginal business concepts don’t get destroyed, clearing the way for a reduction in capacity, and healthy firms pick up the pieces. ?At such a time, you have to wait until the distressed players get hosed, or get smart.

Today’s topic is the debt and equity of companies producing energy, or providing services to them, all of which get hurt by a lower oil price. ?In the recent past, you have had marginal energy companies able to get financing amid decreasing opportunities for decent profits. ?Thus the article at the Wall Street Journal talking about hedge funds losing money on recently placed bets on energy.

Aiding the financing of marginal companies can pay off if the companies will be profitable within a reasonable window of time, or, if you are trying to buy assets cheap for a reorganization. ?But if there is too much capacity, and thus low prices for products, the profits after financing may never emerge, and the value of the assets may sag.

Let me talk about another group of oil companies on the global scene. ?They are relatively high cost players with large-ish balance sheets that are presently pushing to recover market share. ?Yes, I am talking about OPEC countries. ?Not the national oil companies of those countries, but the countries themselves.

Think of the countries as the companies, because the companies themselves fund the government of these countries. ?Consider this quotation from the Bloomberg article to which I linked, regarding one of the stronger OPEC countries, Saudi Arabia:

Saudi Arabia, the main architect of OPEC?s new strategy, will have a budget deficit of 20 percent of gross domestic product this year,?the International Monetary Fund estimates. While the kingdom has been able to tap foreign currency reserves and curb spending to cope with the slump, financial assets may run out within five years if the government maintains current policies and prices stay low, the IMF said Wednesday.

Less wealthy OPEC members have even fewer options. The threat of political unrest is mounting in the ?Fragile Five? of Algeria, Iraq, Libya, Nigeria and Venezuela, according to RBC Capital Markets LLC.

Think of the budget deficits that the OPEC countries have to fund in the same way you think about the debt service of a US E&P company. ?The deposits of oil being produced may be low cost in and of themselves, but any profits go to cover debt service of the greater enterprise, and whatever is not covered, more will be borrowed, should the markets allow it.

What’s the longest that this game could be played? ?Never say never, but I would be shocked if this could continue ?to 2020. ?That said, there are a lot of OPEC countries that won’t make it that far, and a lot of E&P and services businesses that won’t make it that far either. ?Now, the countries could face severe political turbulence, but eventually, they will have to reduce what they borrow and spend. ?That doesn’t mean the oil stops flowing, though a new government could decide to cut spending further, and save the patrimony (crude oil) for a better day.

The free market oil producers are another matter… they can go under, and production would likely stop. ?The question is what side of the solvency line you end up on when enough production capacity is eliminated. ?If you are still solvent, you will reap some reward for your fiscal rectitude as prices rise again, and the Saudis breathe a sigh of relief, congratulating themselves for winning a very expensive game of “chicken,” or, a Pyrrhic economic war.

As such, be careful playing in heavily indebted companies that benefit from higher energy prices. ?That they are limping along should be no comfort, because those that they presently rely on for financing will eventually have to give up, much as those snatching up bargains in subprime?had to give up when the financial crisis hit.

And for those watching the price of crude oil, this is yet another reason why Brent crude should remain near $50/bbl, for a few years. ?It is the uneasy equilibrium where producers are both entering the market and giving up. ?The Saudis don’t want it much lower — there are limits to the pain that they want to take, as well as impose on the rest of OPEC.

Return to the PEG Ratio

Return to the PEG Ratio

Posted on by David Merkel
Photo Credit: Tony & Wayne || Do we PEG the growth of pretty flowers?
Photo Credit: Tony & Wayne || Do we PEG the growth of pretty flowers?

I was looking through an article to see if it had any decent stock ideas, and noted that most of the companies featured were growth stocks. ?As such, my first pass for analysis is the PEG ratio, which is the ratio of the Price-Earnings ratio divided by the growth rate expressed as a percentage (e.g. 8% => 8 for this calculation.).

I’ve written about the PEG ratio a long time ago, and it is a classic article of mine. ?The PEG ratio is a valid concept for “growth at a reasonable” price investors. ?It does not work well for value investors or aggressive growth investors. ?My rule for implementation comes to this: if the current P/E ratio is 12 or higher?and the PEG ratio is lower than 1.5, that stock might be worth a look. ?Better to find the PEG ratio below one, though.

I went through the article and concluded that maybe Becton Dickinson and Hanesbrands might be worth a look. ?But then I thought, “What if I applied the formula to propose overvalued stocks?”

I set my screener for a 2016 PE higher than 12 and a PEG higher than 2.0x, with failing momentum, where the stock was down more than 20% in the nine months prior to the current month. ?Here were the 50 stocks that resulted:

What I find fascinating here is the mix of hot companies, basic materials and energy names, and limited partnerships.

This is only a start for analysis, so don’t run out and short these. ?Not that I am big on shorting, but high earnings valuations, and failing price momentum could be a good place to start. ?I have no positions in any of these companies, and I rarely if ever short. ?I just thought this would be an interesting exercise.

Why Companies SHOULD Offer Earnings Guidance

Why Companies SHOULD Offer Earnings Guidance

Posted on by David Merkel
Picture Credit: Insider Monkey
Picture Credit: Insider Monkey || Isn’t Jamie Dimon handsome?

Recently Jamie Dimon was interviewed by Bloomberg, and commented that companies should stop giving earnings guidance. This is out of character for me, but I will explain why companies should offer earnings guidance. (Why is it out of character? Previously I have said that I don’t personally care whether firms that I own give earnings guidance or not… that still remains true.)

From the interview:

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said corporate leaders shouldn?t give earnings guidance because they can?t predict the future and should focus instead on long-term performance.

Some CEOs ?start making promises they shouldn?t make,? Dimon, 59, said Monday in a Bloomberg Television interview with Stephanie Ruhle. ?Don?t make earnings forecasts. You don?t know what?s going to happen every quarter. I don?t even care about quarterly earnings.?

<snip>

While many JPMorgan shareholders ?completely appreciate? long-term investing, other market participants overreact to short-term results, Dimon said. The New York-based firm last week reported third-quarter profit that missed analysts? estimates as a slump in trading and mortgage banking drove revenue lower from a year earlier.

Dimon is mostly right, as far as he goes, particularly when you think about a complex bank, where the accounting for profits over a short period is less than an exact science.

I’ve written at least two articles on earnings estimates:

In general, I think you have to have something like [adjusted non-GAAP (ANG)] earnings estimates in order for shareholders to have some measure of how corporations are tracking in their goals of building value. ?That doesn’t mean that corporations have to facilitate that, because the sell side?will do it themselves if the company is big enough, the shares trade enough, or?it raises capital often enough.

Dimon and other CEOs can sit back and let the earnings estimates be their own little sideshow. ?Still, there is a reason to give forward guidance. ?It lowers your cost of capital on average.

Forward guidance gives investors (and sell side analysts comfort that there is a business model there that is predictable in building value. ?I’m not talking about GAAP earnings, but ANG?earnings because in principle they should reflect the true increase in the per share value of the firm after eliminating accounting entries that distort that effort.

Now don’t get me wrong. ?Not all companies craft their?ANG earnings so honestly — they may even adjust differently period to period to make things look good. ?As with all things in the market, buyer beware.

But if companies can show that they have adequate control over their financial results such that they forecast future earnings and they honestly come to pass, investors will think the place is better managed than most, and reward it with a higher P/E multiple.

That is my simple argument.

A Bigger Brick in the Wall of Worries

A Bigger Brick in the Wall of Worries

Posted on by David Merkel
Photo Credit: takomabibelot
Photo Credit: takomabibelot

I have my list of concerns for the economy and the markets:

  1. Unexpected Global Macroeconomic Surprises, including more from China
  2. Student Loans, Agricultural Loans, Auto Loans — too much
  3. Exchange Traded Products — the tail is wagging the dog in some places, and ETPs are very liquid, but at a cost of reducing liquidity to the rest of the market
  4. Low risk margins — valuations for equity and debt are high-ish
  5. Demographics — mostly negative as populations across the globe age
  6. Wages in the “developed world” are getting pushed to the levels of the “developing world,” largely due to the influence of information technology. ?Also, technology is temporarily displacing people from current careers.

But now I have one more:

7) ?Nonfinancial corporations, once the best part of the debt markets, are beginning to get overlevered.

This is worth watching. ?It seems like there isn’t that much advantage to corporate borrowing now — the arbitrage of borrowing to buy back stock seems thin, as does borrowing to buy up competitors. ?That doesn’t mean it is not being done –?people imitate the recent past as a useful shortcut to avoid thinking. ?Momentum carries markets beyond equilibrium as a result.

If the Federal Reserve stimulates by duping getting economic actors to accelerate current growth by taking on more debt, it has worked here. ?Now where is leverage low? ?Across the board, debt levels aren’t far from where they were in 2008:

Graph credit: Evergreen GaveKal

As such, I’m not sure where we go from here, but I would suggest the following:

  • Start lightening up on bonds and stocks that would concern you if it were difficult to get financing. ?How well would they do if they had to self-finance for three years?
  • With so much debt, monetary policy should remain ineffective. ?Don’t expect them to move soon or aggressively.
  • Fiscal policy will remain riven by disagreements, and hamstrung by rising entitlement spending.
  • Long Treasuries don’t look bad with inflation so low.
  • Leave a little liquidity on the side in case of a negative surprise. ?When everyone else has high debt levels, it is time to reduce leverage.

Better safe than sorry. ?This isn’t saying that the equity markets can’t go higher from here, that corporate issuance can’t grow, or that corporate spreads can’t tighten. ?This is saying that in 2004-2006, a lot of the troubles that were going to come were already baked into the cake. ?Consider your current positions carefully, and develop your plan for your future portfolio defense.

Book Review: 100 to 1 in the Stock Market

Book Review: 100 to 1 in the Stock Market

Posted on by David Merkel
100 to 1 in the Stock Market
100 to 1 in the Stock Market

 

How can a book be largely true, but not be a good book? ?By offering people a way to make a lot of money that is hard to do, but portraying it as easy. ?It can be done, and a tiny number succeed at it, but most of the rest lose money or don’t make much in the process. ?This is such a book.

Let me illustrate my point with an example. ?Toward the end of every real estate bull market, books come out on how easy it is to make money flipping homes. ?The books must sell to some degree or the publishers wouldn’t publish them. ?Few actually succeed at it because:

  • It’s a lot of work
  • It’s competitive
  • It only works well when you have a bunch of people who are uneducated about the value of their homes and are willing to sell them to you cheap, and/or offer you cheap financing while you reposition it.
  • Transaction costs are significant, and improvements don’t always pay back what you put in.

You could make a lot of money at it, but it is unlikely. ?Now with this book, “100 to 1 in the Stock Market,” the value proposition is a little different:

  • Find one company that will experience stunning compound growth over 20-30+ years.
  • Invest heavily in it, and don’t diversify into a lot of other stocks, because that will dilute your returns.
  • Hold onto it, and don’t sell any ever, ever, ever! ?(Forget Lord Rothschild, who said the secret to his wealth was that he always sold too soon.)
  • Learn to mention the company name idly in passing, and happily live off of the dividends, should there be any. 😉

Here are the problems. ?First, identifying the stock will be tough. ?Less than 1% of all stocks do that. ?Are you feeling lucky? ?How lucky? ?That lucky? ?Wow.

Second, most people will pick a dog of a stock, and lose a lot of money. ?If you aren’t aware, more than half of all stocks lose money if held for a long time. ?Most of the rest perform meh. ?Even if you pick a stock you think has a lot of growth potential, there is often a lot of competition. ?Will this be the one to survive? ?Will some new technology obsolete this? ?Will financing be adequate to let the plan get to fruition without a lot of dilution of value to stockholders.

Third, most people can’t buy and hold a single stock, even if it is doing really well. ?Most succumb to the temptation to take profits, especially when the company hits a rough patch, and all companies hit rough patches, non excepted.

Fourth, when you do tell friends about how smart you are, they will try to dissuade you from your position. ?So will the financial media, even me sometimes. ?As Cramer says, “the bear case always sounds more intelligent.” ?Beyond that, never underestimate envy. 🙁

But suppose even after reading this, you still want to be a home run hitter, and will settle for nothing less. ?Is this the book for you? ?Yes. ?it will tell you what sorts of stocks appreciate by 100 times or more, even if finding them will still be rough.

This book was written in 1972, so it did not have the benefit of Charlie Munger’s insights into the “Lollapalooza” effect. ?What does it take for a stock to compound so much?

  • It needs a sustainable competitive advantage. ?The company has to have something critical that would be almost impossible for another firm to replicate or obsolete.
  • It needs a very competent management team that is honest, and shareholder oriented, not self-oriented.
  • They have to have a balance sheet capable of funding growth, and avoiding crashing in downturns, while rarely issuing additional shares.
  • It has to earn a high return on capital deployed.
  • It has to be able to reinvest earnings such that they earn a high return in the business over a long period of time.
  • That means the opportunity has to be big, and can spread like wildfire.
  • Finally, it implies that not a lot of cash flow needs to be used to maintain the investments that the company makes, leaving more money to invest in new assets.

You would need most if not all of these in order to compound capital 100 times. ?That’s hard. ?Very hard.

Now if you want a lighter version of this, a reasonable alternative, look at some of the books that Peter Lynch wrote, where he looked to compound investments 10 times or more. ?Ten-baggers, he called them. ?Same principles apply, but he did it in the context of a diversified portfolio. ?That is still very tough to do, but something that mere mortals could try, and even if you don’t succeed, you won’t lose a ton in the process.

Quibbles

Already given.

Summary / Who Would Benefit from this Book

You can buy this book to enjoy the good writing, and learn about past investments that did incredibly well. ?You can buy it to try to hit a home run against a major league pitcher, and you only get one trip to the plate. ?(Good luck, you will need it.)

But otherwise don’t buy the book, it is not realistic for the average person to apply in investing. ?if you still want to buy it, you can buy it here: 100 to 1 in the Stock Market.

Full disclosure:?I bought it with my own money. ?May all my losses be so small.

If you enter Amazon through my site, and you buy anything, including books,?I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

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