Sunday, May 31, 2009

Is the Tipping Point Cyclical, Secular or Both?

How does this Influence the place of Real Estate in the Wealth Portfolio?

According to folklore, the Rothschilds divided their wealth one-third in securities, one-third in art, and one-third in real estate. A recent poll of US millionaires put their real estate investment at one-quarter. Which is the optimum choice? The answer may be found in the analysis of whether we are entering a cyclical or a secular tipping point. In modern usage, a tipping point is that point when change is unlikely to be reversed. The trends of the stock market and those in real estate are not perfectly attuned, because of the liquidity preference, securities prices move faster than real estate prices.

Now that we have completed three consecutive months of stock market gains, many believe (or at least hope) we have passed a turning point that is also a tipping point, as we enter a cyclical market recovery. In my recent series of interviews with mutual fund and hedge fund managers, I have found there is a dichotomy about this belief. Some managers, mostly mutual fund managers, see the market upturn as part of a normal cyclical recovery. For the most part, these are managers that have not changed their portfolios significantly since last summer, if not longer. They believe that the stocks that hurt them on the decline will lead them off the bottom. Led by the financials, stocks have risen. However, a more careful analysis shows the leaders in this recovery are the high momentum or high beta stocks, which suggests that the buyers are more traders than long term investors, perhaps not predictive of a sound long term increase in investment values of high quality stocks and bonds. A number of hedge fund managers are not buying the cyclical recovery story. Some see themselves as asset managers, not more narrowly defined “growth” or “value” stock managers. In numerous cases the asset managers have elected to add high yield debt, bank loans and selective mortgage debt “credits” to their portfolio. The more extreme of these managers are involved in distressed companies’ debt. Along with Moody’s * they expect a sharp increase in defaults well into 2010. Thus, as is common at various turning points, there is considerable debate as to whether what we have seen over the last three months is merely a trading opportunity or not.

The case for a secular tipping point is more difficult to recognize, and if there is one, our focus may be premature. The first place to look is the structures of the financial community. The regulated communities of banks were failing the principles of safety and soundness that allowed them to be both independent and to offer the cloak of government backing. As a result, in many cases they became temporary wards of the state (along with others). Predictably, the banks followed the shadow financial system into debt and equity positions that they did not fully understand, but had no problem selling them on to both institutional and retail customers. At the urging of banks, the government initially wanted to regulate the shadow financial system, but is now increasingly dependent upon the expertise and risk assumption capabilities of the unregulated members of the global financial community. Reluctantly, governments around the world have recognized that risk assumption is much better done in the private sector where the risk of financial failure and possible personal bankruptcy supply a much higher level of discipline than the outmoded rules issued by the government. If this change in attitude is happening, then a major tipping point is close by. If not, the three month turn at best is cyclical in nature.

The real estate market is also currently focusing on a cyclical recovery that will eat into the excessively large inventory in the commercial real estate sector. To look for a secular change one needs to look at the new construction plans. Building “green” is becoming fashionable. One can debate whether the fashion is just a politically sensitive fad in terms of global warming or an honest desire to be more fuel efficient*. Nevertheless, this trend is a considerable change to the production of buildings of all sorts of sizes and locations. However, I doubt that going green is a major tipping point. There is one possible point on the far horizon that would be a tipping point if it were to gain momentum. If we are serious about all kinds of energy conservation (from autos, homes, offices and stores), we need to encourage people to return to the cities. To make this return attractive to people, we must rebuild cities into pleasant, safe and healthy places.

What does this ramble mean to asset allocation between securities and real estate? For securities there is a good chance that we have tipped ever so slightly into a cyclical recovery, which is not at all saying that we are heading for new highs. Only if we see a secular turn in the thinking of governments and their people is there a good chance we will soon move toward new highs. Bottom line is to buy and own securities, but be prepared to sell when the cyclical recovery has been completed. In terms of real estate, almost any sale today will be a good sale . If you do not have to buy, it might be best to wait until both the absorption phase is near over and there are signs of a secular change.

* Moody’s is a position in a hedge fund managed by the author. In addition a portion of said fund will be devoted to securities in the energy technology space.

Monday, May 25, 2009

Anticipating Unintended Consequences or The Impact of MPG Efficiency
on Inflation and Taxation

When well-meaning policies override the laws of supply and demand, the shifting of the American economy towards a command economy is likely to have unintended consequences with serious investment implications. The mandated increase in the miles per gallon (MPG) average for US manufactured automobiles is an example of policy which could be more harmful to us than the supposed benefits of reducing man’s impact on global warming.

The unproved supposition is that if Americans get more gas mileage per gallon the environment will be better and perhaps healthier, thus the results will be worth the expected cost increase of $1,600 per car. There is a belief that the cost of fuel savings will amortize the increased cost. One might say that could happen if the price of gasoline rises sharply to the $4.00 or higher level. While at this point I do not argue with the possibility of a sharp increase in the price of oil due to its own supply and demand imbalance, I wonder whether the policy-makers understand their induced inflationary impact. Unless wages go up substantially, not only is inflation the cruelest form of taxation, but is highly retrogressive. The percentage of a poor family’s weekly spending on transportation will rise dramatically at the expense of healthier food, medical attention and education. Because the good people in Washington are smart and caring for people, I assume that they had already thought this out. As Brutus might say under these conditions “They are all honorable men (and women).”

I wonder whether the inhabitants of the Beltway understand the other implications of this mandated mileage efficiency edict. Since the last mandated increase in gas mileage, some “experts” believe the number of incremental deaths occurring in lighter cars is on the order of 2,000 lives per year. If one values these lives, not in human terms, but economic terms at a $100,000 per life (which is very low in terms of lifetime earnings and expenditures), the aggregate cost would be $200 million per year. One of the likely ways to increase mileage efficiency is to produce lighter cars. Since there appears to be a close relation between vehicle weight and auto fatalities, we can assume this trend will produce a larger number of deaths at a larger economic impact. Luckily for all of us, the frequency of collisions is considerably greater than auto fatalities. However, the human and financial impact of collisions is a multiple of whatever turns out to be the costs of death by auto. The lighter the weight of the vehicles, the greater the structural damage to the driver’s cabin in a collision, and therefore more likely will be declared “totaled” for insurance purposes. I suspect the scrap value of these light vehicles will be significantly less than the metal-laden older vehicles. On an underwriting basis, I believe most American auto insurance companies lose money and only stay in business through successful investing of the “float,” (holding the premiums until they need to be paid out in claims).

There are other consequences from the industry -wide mandate, already there are clear lessons from the auto manufacturers’ current dilemma. While the auto industry can probably challenge the motion picture industry for the title of “Most Opaque Accounting,” many believe one of the reasons for a significant portion of the reported losses is due to selling cars below cost. Why would a company sell anything below cost? I would submit to bring the calculation of the company’s average miles per gallon statistic up. In this way they do not have to skinny down their more profitable heavy vehicles. A further consequence is likely to be met with the same strategy: car companies (that will eventually be owned by the American tax payers) could generate even larger losses than those of 2008 and 2009.

There may be more insidious consequences from the mandate. First, there will be increased substitution of plastic for steel and aluminum. Clearly this substitution will hurt the mines, mills, and workers who produce these metals. There are other consequences for this growing level of substitution, e.g. the USA will produce less scrap metal, a key ingredient in steel manufacturing around the world (including the USA). Ironically, one of our major export earners is scrap metal, often sold to companies to lower their cost of the production of steel that they then re-export back to us at lower prices than what we can produce.

The light weight of plastics and the fact that they do not have to be produced close to the auto companies’ plants have led to many forms of plastic becoming favored materials. While I do not know for certain, I believe that the environmental impact of some plastic producers could be worse than metal producers. I am reasonably certain that the lighter materials take substantially less human labor to produce, and my guess is the labor force is far less unionized.

There are undoubtedly other consequences of the government mandate, not the least of which is traveling on the slippery slope to a command economy. I am quite sure I have not identified all of them by any means. The purpose of this blog is not to attack the government policies, but to explore how unintended consequences, some of which can be anticipated, might materially shape the impact of any major change. Astute investors should give themselves a heads-up by listing the identifiable consequences of impending changes. To quote a modern classic song, “The Times They Are a Changin.”

Sunday, May 17, 2009

Supply and Demand for Homes
is Different from Securities

There is a new crop on the lawns at this time of year. This is the crop of homes for sale, homes for rent and the Open House signs of various real estate brokers. Due to the desirability of getting children registered into the preferred schools, the spring is when a lot of homes come on the market in suburbia and elsewhere. In 2009 there appears to be a bumper crop of these signs. The pricing for both the buyers and renters are heavily influenced by the “comparables.” In order not to lose the sale to a competing offer, the comparables list “recent” sales of similar properties within the agents’ target area. Those real estate agents that have access may display other properties that are listed in the local multiple listings, but caution that the prices shown are treated with some suspicion as they are the “offer” price, not the price on the close. Rarely are current prices discussed in terms of the cost to recreate the same property from scratch. Almost never is there any detailed discussion as to future value, other than some generalized view of the rate of price increase in the region. (Never price decline.) What seems to be the price decision is based largely on past, or to some degree current prices, but not future prices.

In the world of stocks and bonds, pricing considerations are quite different. The nearest stock investor approach to the residential real estate buyer is the statistically-oriented “value” investor. This kind of buyer looks at historic book value, perhaps adjusted for accounting and valuation factors. Often the value buyer knows the history of a security’s price/book value. When current price-to-book value levels are near their bottoms, the security is attractive for purchase. There is a special class of value buyer of securities similar to the residential property buyer who is a specialist in tearing down a home and rebuilding on the same space a larger, more expensive property. In the securities’ world these are the so called “net-net” buyers who look to dispose of all elements of the security issuer that has not been turned into cash. (Notice, that I said security, not stock, because distressed fixed income buyers often play a similar role.) Like the “tear down and rebuilder” home buyer, a net-net buyer may perceive that the assets behind a security could be more profitably used by others if the property was no longer being used in its present activity. Many so called “value” buyers are largely looking backwards for their purchase guidance, believing that the current prices represent an arbitrage opportunity versus the historic prices, while the real estate redeveloper and the net-net buyers have a very specific future orientation.

There is another larger, and often much larger, group of stock buyers. These are the “growth” stock buyers. Originally as practiced by Mr. T. Rowe Price and a few others, this meant investing in stocks of companies that had earnings per share that were growing faster than the growth of earnings in the market in general. This definition of “growth” has been diluted over the years to mean growth of capital. While I disapprove of this dilution, I can understand it. As the number of growth stock investors grew exponentially and the economy began to grow more slowly, the number of true, continuous growth stocks on a secular basis shrank just as the competition for them increased; therefore assembling a true growth stock became very difficult. Interestingly, a past record of growth was not an absolute requirement, but a future of rising earnings was expected. Mr. Price, who I had the privilege of meeting, anticipated this problem by naming his growth fund the T. Rowe Price Growth Stock Outlook Fund. The term “outlook” itself shows a future orientation that most value investors and home buyers don’t have.

There is, however, a great similarity on the part of the sellers of both homes and securities. At the time of sale, particularly in the case of actual or pressing needs to sell, it is one’s neighbors and co-ventures in the stock that dictates the price for an impatient seller. Too often most institutional investors do not pay sufficient attention to the motivations of their current co-ventures in the stock, so they tend to move at the same time to their disadvantage. Thus the lesson for the seller of homes is to wait until the various real estate placards come down or lead the market down with a quick sale at a bargain price. For the securities investor, as Sir John Templeton, another old and valued client, would say, only sell when there is a better bargain available and try to avoid selling when others are selling.

Particularly at this time in our economy, I will be happier if I see fewer real estate signs.

Sunday, May 10, 2009

Does Wealth Equal Freedom or Independence?

In my book MONEYWISE, I equate wealth to freedom. Freedom to do what you want to do (within the laws of the land), and freedom to make active decisions. This weekend a more mature series of thoughts became clear to me. My good wife, Ruth, had surgery on her left hand and wrist, temporarily reducing her ability to dress herself, prepare meals and drive. She is a very dynamic person who is highly independent by nature. She will be partially constrained for a period of up to eight weeks and will be dependent on her sisters, various friends, some of our office staff and her klutz of a husband. Her life over the next several weeks however, will be much easier than most others that have limited support available to them. Nevertheless, she will involuntarily give up some of her prized independence for dependence on others.

Whether we like it or not we are all aging, some fighting it along the way. What is clear by observation is that all of us will be giving up some independence over time. As an investment animal, the need for significant resources to pay for dependence is becoming graphically clear. The kind of temporary, or more frightening, permanent help with life’s functions and some remaining pleasures, will be expensive in both monetary and perhaps family terms. Those with limited means may become dependent on various government transfer payments to senior citizen aid programs. However, these will be limited by budgets, the availability of trained and compassionate home health care aides, and the baby boom population echo. Bottom line, the public funds will be inadequate to meet the personal needs of those without any resources. But it is the larger middle class who will be in the worst shape. They don’t have the resources to independently fund all of their needs and will have too many resources to fully qualify for forms of government aid without disposing of most of their tangible assets.

Well, smart guy investment animal, what are you going to do about it? My book, MONEYWISE, does start to answer the problem. In the book, I advocate the drawing up of a personal balance sheet that recognizes the reserve, or if you prefer the debt, for one’s own retirement. Hopefully the debt includes looking after one’s spouse or significant other. After my experience this weekend, as well as the observations of others, a commercially purchased or self-funded long-term care medical plan is likely to be insufficient to cover all of the needs of incapacitated people. I am not to the point of identifying the need for round-the-clock nursing, however, I recognize the need for a daily visitor to minister to the non-medical needs. Depending on the length of the visit, from one or more hours to a full day’s tour of duty, today’s cost would be well into five figures and perhaps into six figures, multiplied by the number of remaining years. Most people have not set aside money for this need in addition to their long term medical needs. Each person, perhaps aided by their trusted lawyer, accountant, and/or investment adviser or other elder care expert, should determine the amount of capital needed to be assigned to the retirement reserve.

The investment of the retirement reserve puts the investor in a very uncomfortable position. We are led to believe that the higher the potential return from investing the likelier the risk of permanent loss of capital. By adding this uncertainty to the uncertainties of quality of life (as well as length of life), leads to difficult decisions for each of us. Despite the difficulty in making these decisions, we have no choice. Not making a choice is no choice, and losses the benefits of compound interest rates to grow capital.

The realization of the need to add to our own retirement capital base is going to force us to invest more and to spend less. On a worldwide basis, retirement capital is way below the level needed to produce the retirement spending that we may feel is essential. The problem won’t go away and just gets bigger every day. This recognition is why I believe that more and more money will go into the investment channels on a secular basis around the world. Thus, I am long term bullish on security prices.

As these thoughts are being written on Mother’s Day in the US, we should start to help our Mothers and the Mothers of our children and grandchildren.

p.s. Ruth is getting better if for no other reason than self defense.

Sunday, May 3, 2009

Could the “Stress Test” be a Big Trap?

Beginning Monday and perhaps lasting for a week, savers and investors will look forward to the publication of the results of a series of stress tests on the 19 largest domestic financial institutions as to their safety and soundness of their capital. While I do not know the details of the measurement of these tests, the absolute reliance on them seems to me like a dance at the “Mad Hatter’s Tea Party.” In my book MONEYWISE, I identify one of the causes of risk of loss of permanent capital is unanticipated events. These warnings were written in 2007 before both the recognition of the sub-prime mortgage collapse and the recognition of various Ponzi schemes, most of all Bernie Madoff’s. In these cases there were numbers trending in the expected direction and the future was expected to follow predicted patterns.

I hope that I am wrong about the statistical stress tests being applied by the government and that in the near term future, all of the financial institutions tested with their present or augmented capital prove to be safe and sound. As humans, as well as many animals, are conscious (or more likely unconscious) odds makers, the odds on the outcome of the tests are somewhat less than completely perfect.

The intent of the tests is to supposedly give us comfort in continuing to leave our capital with these institutions and perhaps more importantly be willing to advance additional capital in the form of deposits, loans, various forms of equity, and counter-party risk assumptions. This exercise is similar to, but not identical, with an acquisition study. In one way or another I have participated on both sides of the acquisition mating dance. Only at the first level of these discussions are the various numbers significant. Additional scenarios are often produced as variants of the original data. These are similar to the stress tests we are all awaiting. However, in an acquisition exercise there are many other analyses performed. Perhaps the single most important analysis is to evaluate management, to determine how much of the past was created by the leadership rather than the environment, and what is management’s expected roles in the future. The 19 financial institutions are all in competitive businesses among themselves as well as other domestic and global competitors. As an odds-maker, I put the probability of significant changes of price and other terms of trade as almost a certainty. (Unless the government will attempt to put into place monopolistic pricing discipline, under some other name, to protect its investment in these financial institutions.) There are many other elements to a good acquisition analysis. There remains one more critical screen and that is trust.

Both financial and intellectual frauds often start as business in the late stages of expansion to make up for earlier, smaller losses. The frauds are expected to be short lived by the perpetrators until assets are returned in full with interest, or when various market share or sales targets are met. Most frauds are begun by previously honest individuals or organizations. I am not suggesting any of the 19 institutions are doing anything fraudulent. However, I wonder if the stress test is leaving enough of a cushion to keep each of the 19 in a safe and sound condition if there has been undiscovered fraud committed by employees or customers/counter-parties. The odds of such occurrences are favorable; the frauds have not been discovered yet, and the people committing the fraud in some aspects may have superior data systems knowledge and capabilities than each of the 19.

The bottom line as a manager of a financial services fund: I look forward to the coming week and the enthusiasm generated by the expected results. However, I am willing to bet a year to three years from now that we will discover that the stress test failed to identify the specific stress that one or more of the financial institutions will go through. For the others that are addicted to investing in stocks and bonds of financial service companies, they may wish to widen their selections and include both large and smaller companies.

Let the games begin this week.