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
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:
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?
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.
What did I do last week while the market was being whacked? I bought some Reinsurance Group of America, Shoe Carnival, YRC Worldwide, SABESP, and Universal American. I reduced cash in the portfolio from 11% to 8%. It may have hurt me in the short run, but should be good in the long run.
I have modest concerns about the current profitability of Smithfield Foods, but no concern about their long-term profitability. They have an intelligent management team. I may buy some more soon.
Now, as to my comments yesterday regarding quantitative risk measures: yes, I am highly skeptical. Economics is not Physics. The relationships are not stable enough for the quantitative statistics to be valuable. I go back to what Buffett said, “I’d rather have a noisy 15% than a stable 12%.” If you have a long time horizon, why do you care about standard deviation or beta? If you have a short time horizon, why are you investing in risk assets?
Risk is not short-term variation, unless your time horizon is short. Consider my article on longevity risk.? All good risk management considers when the money will be needed. Risk is unique for each person, and can’t be summarized through a “one size fits all” statistic. What are the odds of not meeting the goals of the investor? How severe will the shortfall be? That is risk.
Personally, I am annoyed at the consultant community. They employ statistics that have little relation to future performance in an effort to earn fees. They get away with it because clients don’t get investing. They buy the concept of randomness, and ignore the managers with good processes that have been hit by bad short-run performance.
Eventually value investing wins. Do value investors calculate the Modern Portfolio Theory [MPT] statistics before investing? Of course not. They know that their job is to find undervalued businesses. They don’t care about market trends.
As you consider investments, ignore MPT. It is better (if you have a long horizon) to focus on overall investment processes, with a review of the names in the portfolio over time, to get a feel for the methods of the manager.
On Friday, toward the end of the day, I added to my position in Cemex, just to rebalance the portfolio and take advantage of undue weakness in the Mexican stock market.
Earlier in the day, though my timing was good, it could have been better, I swapped my exposure inJapan Smaller Capitalization Fund [JOF] for the SPDR Russell/Nomura Small Cap Japan ETF [JSC]. Given that I like JOF, why did I trade? The premium to NAV got too high — it was 10% on an intraday basis by my calculations, so, I traded. Eventually it will go back to a discount of -5% or so, and I will reverse the trade. I still like Japanese Small caps, but I have my limits when it comes to NAV premiums.
Away from that, I am still considering trading away some/all of my RGA for some MetLife, since I think it will be a cheap way to acquire more RGA. I’m glad the separation has finally come for MetLife and RGA; it was only a question of when. RGA is a unique company; unless Swiss Re, or Munich Re, or Aegon wants to spin out their Life Re business, there are no other pure play life reinsurers out there. Reinsurance of mortality in the present environment is a cozy oligopoly, with one former main player, Scottish Re (spit, spit), badly damaged. (Though I lost badly on Scottish Re, I am still grateful that when I figured out what was going on, I was able to sell at $6+/sh. Current quote: 14 cents/sh, and I hope that MassMutual and Cerberus are enjoying themselves. I took enough lumps for my patronage of Scottish Re, so anyone who sold when I did is at least that much better off.)
Pricing power isn’t anything amazing here, because the life insurers in general have enough capital, and are not ceding as much business to the reinsurers. But it is a steady business, and one with barriers to entry — ACE and XL will try to get into the business, and Scor will try to improve its position, but RGA, Swiss Re and Munich Re will be tough to dislodge.
I am looking forward to the next reshaping, and considering industry trends… I’m really not sure which way the portfolio will go, but I am gathering tickers and industry data, and preparing for the next change.
One last note: did you know that I am overweight financials? Yes, but only insurance companies, and Alliance Data Systems. (I still don’t trust the banks, and particularly not the investment banks.) The insurers that I own are cheap to the point where earnings don’t need to grow much to give me good value over the long run, and are largely insulated from any hurricane activity this year. Now, if the winds blow, you can expect that I will do a few trades to take advantage of mispricing among reinsurance companies. That said, Endurance, Aspen, Flagstone, and PartnerRe look cheap to me at present. Endurance looks very cheap… I have owned all four in the past, and will probably own some of them again in the future. But, no major commitments until the wind starts blowing (hurricanes), or if we get to the middle of the hurricane season (say, mid-September), and nothing has happened. Then it would be time to buy. Damage from windstorm tends to be correlated within years — bad years start early, and are very bad. Good years are quiet, and continue quiet with a few storms doing low levels of damage.
Anyway, that’s what I am up to. Got other ideas? Share them with my readers!
Of the 35 stocks in my portfolio, only 4 lost money for me in May: Magna International, Group 1 Automotive, Reinsurance Group of America, and Hartford Insurance.? My largest gainer, OfficeMax, paid for all of the losses and then some.
I am only market-weight in energy, so that was not what drove my month.? Almost everything worked in May: company selection, industry selection, etc.? My other big gainers were: Charlotte Russe, Helmerich & Payne, Japan Smaller Capitalization Fund, and Ensco International.? I have often said that I am a singles hitter in investing — this month is a perfect example of that.
Now, looking at the year to date, I am not in double digits yet, but I am getting close — I am only 3.6% below my peak unit value on 7/19/07.? My win/loss ratio is messier: 15 losses against 32 wins.? It takes the top 5 wins to wipe out all of the losses.? The top 5: National Atlantic, Cimarex, Helmerich & Payne, Arkansas Best, and Ensco International.? Energy, Trucking, and a lousy insurance company that undershot late in 2007.
The main losers: Deerfield Triarc (ouch), Valero, Royal Bank of Scotland, Avnet, and Deutsche Bank.
I much prefer talking about my portfolio than individual stock ideas, because I think people are easily misled if you offer a lot of single stock ideas.? I have usually refused to do that here; I am not in the business of touting stocks.? I do like my management methods, though, and I like writing about those ideas.? If I can make my readers to be erudite thinkers about investing; I have done my job.
So, with that, onto the rest of 2007.? I don’t believe in sitting on a lead — I am always trying to do better, so let’s see how I fail or succeed at that in the remainder of 2007.
PS — When I have audited figures, I will be more precise.? You can see my portfolio, for now, at Stockpickr.com.
Full disclosure: long VLO AVT NAHC XEC HP ESV MGA GPI RGA HIG OMX CHIC JOF
1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.
Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG? I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn?t it cheap? It might be; who can tell? There?s a lot buried on AIG?s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I?m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.
You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)
AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.
So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:
If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I?ll keep you apprised as I make moves here.
What can I say? I like the industry?s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.
Position: long LNC HIG AIZ
3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!
Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets ? he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.
4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn?t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn?t figure out what the real exposure was and we questioned whether THEY could.
Nothing gets a management more angry than being told that they don?t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn?t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren?t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today ? the Binomial Expansion Technique ? was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn?t be quantified by science and certainly couldn?t be certain about.
Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.
5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I?m not sure, but this is looking more interesting by the day.
6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:
Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.
The Florida legislature can determine how the pain is shared, but they can?t legislate that the pain go away. No free lunch.
P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who?s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won?t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)
I don?t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker?s Comp, but now we have a new state on the top of the heap: Florida.
The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don?t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)
In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional ?taking? by the state of Florida. No one should be forced to do business that they don?t want to do. Fine to set up the regulatory rules (maybe), but it?s another thing to compel parties to transact.
Okay, here?s a possible future for Florida:
1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don?t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.
Farfetched? No, it?s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it?s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn?t bet that way.
Position: long one microcap insurer that will remain nameless
While I don?t pretend to be the insurance maven that you are, I don?t believe it?s quite as black and white as you portray.
First, let me preface my comments by saying that I believe in free markets and don?t agree with the Governor?s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I?d like are not too bad compared to others in the state.
That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.
One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy ? and that was before all of the storms.
I?m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there?s another bad storm.
Maybe that?s an argument that we shouldn?t be building major population centers right on the coast, but that?s another story.
I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won?t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.
We don?t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That?s why many Florida legislators are calling for a national catastrophe fund.
They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.
The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I?m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.
I?m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.
I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.
Position: long a small amount of one microcap insurer with significant business in Florida
Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!
7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.
8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.
9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: ?Trading in CDOs Slows to a Trickle.?? The basic premise is that CDOs are going away because trading in CDOs is declining.? Well, the same is true of houses, or any debt-financed instrument.? Volumes always slow as prices begin to fall, because momentum buyers stop buying.
Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.? That would shrink the market, but not destroy it.? Securitization when used in a moderate way is a good thing, and will not completely disappear.? Buyers will also become smarter (read risk-averse) at least for a little while.? This isn’t our first CDO blowup.? The cash CDO vintages 1997-1999 had horrible performance.? Now we have horrible performance.? Can we schedule the next crisis for the mid-teens?
10) On Chavez, he is a dictator and not an oil executive.? Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?? As MarketBeat points out, take him with with a grain of salt.? Venezuelan crude oil needs special processing, much of which is done in the US.? If he diverts the crude elsewhere, who will refine it for sale?
11) I am really ambivalent about Bill Gross.? He’s a bright guy, and has built a great firm.? Some of the things he writes for the media make my head spin.? Take this comment in the FT:
That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world?s sixth-largest economy? How could an investor in California?s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation?s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years ? subprimes and CDOs in the trillions of dollars ? and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television?s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.
Most municipal defaults are short term in nature, even those of states, of which there have been precious few.? Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.? It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.? In exchange for guarantee fees the municipalities get lower yields to pay.
The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.? That’s the issue.
12) I try to be open-minded, though I often fail.? (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.? Good judgment triumphs over openness.)? I have an article coming soon on the concept of the PEG ratio.? This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.? The math is done, but the article remains to be written.? I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.? (At least, it will be a good first stab.)
One month down, eleven to go?? Can we stick our heads out of the foxhole yet?
Personally, I was off just a little in January.? Comparing myself against a bunch of value indexes, which did better than growth indexes in January, I did better than all of them.? We’ll see what the future brings, though, these things can turn on a dime.
So what worked for me?? Arkansas Best, National Atlantic (not out of the woods yet), Charlotte Russe, Gehl, YRC Worldwide, Alliance Data Systems, Reinsurance Group of America, and Honda.
What hurt?? Nam Tai, Gruma, Valero, Deutsche Bank, Royal Bank of Scotland, and Anadarko Petroleum.
Common factors:
Financials with complexity got hurt
Energy was lackluster at best
Industrials, Retail, and Trucking did well
Value took less pain
What got whacked before went up
One final note here.? Look at this graph from Bespoke.? The “sea change” there mirrors my own turn in performance.? What does that tell me?? Perhaps it tells me that in late 2007 there were a lot of hedge funds liquidating positions that value managers liked to own.? After the end of the year, the selling pressure ebbed, and value seekers came in.? At RealMoney today, both Cramer and Marcin were commenting on they could find stuff to buy when the market was down in the morning.? I agreed; I haven’t seen this many good values since 2002.? I’m not counting on anything here, but I think my portfolio has attractive valuations and prospects.? Much as I am not crazy about the macro environment in many ways, I have some confidence that my portfolio should do better than the S&P 500 in 2008.
Full disclosure: long NTE GMK VLO DB APC RBS ABFS NAHC CHIC GEHL YRCW ADS RGA HMC
Two more news bits. I don’t buy for takeovers, but today Bronco Drilling got bought out by Allis-Chalmers Energy. (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of RGA, I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re. So, today’s good earnings are a surprise, but the quality of RGA is not.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Position: long RGA BRNC
2)? There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them.? For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism.? I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book).? Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year.? If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE.? No one would pay that.? So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist.? (Well, the Bible warns us of the dangers of being a third-party guarantor…)
Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable.? The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.
3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come.? No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier.? But Bill Gross leaves me cold here.? He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%.? These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.
I also think that David Wessel and many others let the Fed off too easily on their misforecasting. ? Who has more Ph.D. economists than they do?? I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming.? Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.
One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed.? I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought).? Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview.? That’s difficult to do without overseeing the capital markets, post Glass-Steagall.? Unfortunately, that is what creates at least the appearance of the “Greenspan Put.”? And now the market relies on its existence.
4)? But maybe the Fed overreacted to equity markets getting slammed by SocGen exiting a bunch of rogue trades.? Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the US equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm.? Risk control begins with personnel control, starting with separating the profit and accounting functions.? Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management.? I have experienced these audits in my life, and it is a normal part of good business.
Because of that, I fault SocGen management most of all.? For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign.? There is no excuse for not having proper controls in place for an error that large.
That’s all for the evening.? I am way behind on my e-mail, so if you are waiting on me, I have not given up on responding to you.
I didn’t feel well today, but my broad market portfolio did better than me. I probably could not have picked a worse day to do my reshaping, but here are the results:
Sales:
Aspen Holdings
Flagstone Reinsurance
Redwood Trust
Mylan Labs
Lafarge SA
Purchases:
Reinsurance Group of America (old friend, cheap price)
Honda Motors
Rebalancing Buys:
Valero
ConocoPhillips
Vishay Intertechnology
Rebalancing Sale:
Deerfield Capital
I’m not done. My moves today raised cash from 5% to 10%, and trimmed positions from 36 to 33. I have room for two more ideas, and am working on where to place cash. My timing of buys and sells today was good — not that that is a key competency of mine by any means.
Aside from the sale of the reinsurers, which were just cheap placeholders, the other positions were not as relatively cheap as they once were. RGA and Honda are quality companies selling at bargain prices. If I had more names like those, I would buy them all day long.
Away from my broad market portfolio, I raised my equity exposure in my mutual funds fractionally today. Time to rebalance.
PS — I can’t remember another day quite like this, where the late negative to positive move was so pronounced.
1) Let’s start on a positive note: Doug Kass says it is time to buy the financials.? I may never be as successful or clever as Mr. Kass, but I think he is early by one year or so.? And this is from someone who is technically overweight financials — I own six insurers, two high-quality mortgage REITs, and two European banks.? When it comes time to own financials, I may have a portfolio with 50% financial stocks, and I will pare back the insurers.
2) What of the Financial Guarantors?? Forget that I said I would flip the 14% MBIA surplus note, I did not expect that it would do so badly so quickly.?? The rating agencies are all concerned to potentially downgrade MBIA, Ambac, and others.? Downgrades are death, and rating agencies would only consider such measures if they knew that other companies would step in to continue their AAA franchise if they kick the losers over the edge.? Berky, by entering the financial guarantee space, has signed a death warrant for at least one of MBIA and Ambac, and who knows, Berky might buy the loser.
3)? Away from that, PartnerRe, one of my favorite companies, has written off its entire stake in Channel Re, which provided reinsurance to MBIA.? Leave it to that classy company to write off the whole thing, which implies bad things for MBIA as it relies on reinsurance from Channel Re, which it also partially owns.
4) Though this is a test of the financial guarantors, it is also a test of the rating agencies, which are in damage control mode now.? My view is the Moody’s and S&P will survive the ordeal, and come back fighting.
6) Now, a lot of the subprime crisis is really a stated income crisis.? Think about it: income is such a standard metric for loan repayment.? If one lets borrowers or agents fuddle with income, should we be surprised that loan quality declines?
7)? Even the black humor of the credit crunch in residential real estate points out how much more residential real estate might fall in price, and with it the values of companies that rely on residential real estate.
8) The boom/bust nature of Capitalism can not be repealed.? As an example, at the very time that you want banks to want to lend more to support the real estate market, they insist on larger down payments.
9) At my last employer, and at RealMoney, I would often say that the biggest crater to come in residential housing was in home equity loans.? JP Morgan is a good example of this.? Should this be surprising?? I noted from 2004-2007 how much of the ABS market had gone to home equity loans, and felt it was unsustainable.? Now we are facing the music.
10) Now consider credit cards.? Even cards on the high end are reporting deteriorating loan statistics.? Unlike past history, many people are paying on their cards to maintain access to credit, and letting their home loans slide.? Worrisome to me, and to the real estate markets as well.
13) Now for long term worries, consider what will happen to the real estate market as the baby boomers age.? Houses in colder areas will get sold, and houses in warmer areas will be bought.? This article does not take into account reverse mortgages, which will also be prominent.? Aside from that, the idea that baby boomers will be able to cash out of their homes to fund retirement will be hooey, unless we let wealthy foreigners buy into the US.? There will not be enough buyers for all of the houses to be sold without immigrants buying them.
