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 17, 2009
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.
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.
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.
Sunday, April 26, 2009
Schooling vs. Education
Charity Auctions vs. TARP and PPIP
For some of us, as repayment for our multiple sins, this is the season for the benefit parties and auctions of many worthwhile charities. When meeting people at these events for the first time, often one of the opening conversational gambits is “Where did you go to school?” (meaning college), or what they think is the same question, “where were you educated?” As an unrecovered analyst I try to be precise in my answers. To the first question, I state somewhat sheepishly, Columbia College in Columbia University. (The proceeding comment has to do their left-leaning or perhaps left-falling inclinations, which we can discuss another time.) On the other hand, when asked where I got my education, I reply proudly the racetrack and the U.S. Marine Corps. The distinction that I make is one is exposure to other people’s thinking as compared to education, the practical lessons that can be applied to life. Actually what I should have said was that I graduated from college in 1957, but my education continues everyday. Lessons from this weekend are an example.
Ruth and I have just returned from a very successful “Auction by George” at Mount Vernon the home of our first and greatest President, George Washington. In these very troubled economic times, a near record amount of money was raised to be used to continue to restore the property and to benefit future generations of school children. We are particularly pleased that a special fund raising effort was initiated at the party to place, I should say replace, a portrait of our first President in I believe, 40,000 class rooms, along with appropriate learning materials. But I am getting ahead of my lesson plan for this blog.
My good wife commented to me that the items that got the most spirited bidding were not various elements of historic merchandise, but offers of unique experiences. Some of these were lunch with the “talking heads” of the leading news channel, a live back stage visit during another news broadcast, and the ability to have a character named in a forthcoming historical novel. These were special experiences that were being offered, perhaps never to be repeated in one’s lifetime. One particular “unique experience” item attracted such spirited bidding that a second session was awarded to the very close under bidder. We also noted that some merchandise did not sell at the expected prices and were bid back by their owners.
The value of education as mentioned already, is the lessons that one learns in one sphere of activity that can be applied to another. Much of the conversation these days at gatherings in DC is about the economy. In NYC and environs it is about “the market.” The presumed link between the two topics is the various government intervention programs. If one applies the lessons from the Saturday night charitable auction to Monday morning investment positions, one could well postulate that the ability to borrow from the government to buy troubled assets on a nonrecourse basis is a unique experience which may raise the value and possibly the price for these mortgages and other loans. The concept of only being at risk for my investment, not the 5-6 times leverage utilized, is unique and has an appeal similar to highly leveraged fixed income oriented hedge funds. If the prices to be paid for troubled assets are too low, they will be withdrawn. On the other hand if demand is so strong as to raise prices high, additional supply will be forthcoming.
In these cases the raising of capital for such worthy causes as Mount Vernon, American school children and the over-leveraged banking system are worthwhile. As the bidding Saturday night produced near record results, let us Republicans, Independents and Democrats become pleased with the results of the government sponsored auction. Remember in earlier days governments raised money through lotteries (as many do today).
Perhaps most importantly, I hope to increase my education every day and wish my readers the same good fortune.
Ruth and I have just returned from a very successful “Auction by George” at Mount Vernon the home of our first and greatest President, George Washington. In these very troubled economic times, a near record amount of money was raised to be used to continue to restore the property and to benefit future generations of school children. We are particularly pleased that a special fund raising effort was initiated at the party to place, I should say replace, a portrait of our first President in I believe, 40,000 class rooms, along with appropriate learning materials. But I am getting ahead of my lesson plan for this blog.
My good wife commented to me that the items that got the most spirited bidding were not various elements of historic merchandise, but offers of unique experiences. Some of these were lunch with the “talking heads” of the leading news channel, a live back stage visit during another news broadcast, and the ability to have a character named in a forthcoming historical novel. These were special experiences that were being offered, perhaps never to be repeated in one’s lifetime. One particular “unique experience” item attracted such spirited bidding that a second session was awarded to the very close under bidder. We also noted that some merchandise did not sell at the expected prices and were bid back by their owners.
The value of education as mentioned already, is the lessons that one learns in one sphere of activity that can be applied to another. Much of the conversation these days at gatherings in DC is about the economy. In NYC and environs it is about “the market.” The presumed link between the two topics is the various government intervention programs. If one applies the lessons from the Saturday night charitable auction to Monday morning investment positions, one could well postulate that the ability to borrow from the government to buy troubled assets on a nonrecourse basis is a unique experience which may raise the value and possibly the price for these mortgages and other loans. The concept of only being at risk for my investment, not the 5-6 times leverage utilized, is unique and has an appeal similar to highly leveraged fixed income oriented hedge funds. If the prices to be paid for troubled assets are too low, they will be withdrawn. On the other hand if demand is so strong as to raise prices high, additional supply will be forthcoming.
In these cases the raising of capital for such worthy causes as Mount Vernon, American school children and the over-leveraged banking system are worthwhile. As the bidding Saturday night produced near record results, let us Republicans, Independents and Democrats become pleased with the results of the government sponsored auction. Remember in earlier days governments raised money through lotteries (as many do today).
Perhaps most importantly, I hope to increase my education every day and wish my readers the same good fortune.
Sunday, April 19, 2009
Should We Appreciate Bonds? Part II
Cocktail parties for charities often reveal more investment concerns than those expressed in an organization’s formal meetings with investment advisers or investment committee members. In this age of unusually high fixed income yields and low total returns from common stocks, taking advantage of spreads for capital appreciation, not primarily income and capital preservation, can be unnerving. The question of whether this new approach is a sound one for a fiduciary has been expressed by members of several charity boards and committees.
As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.
Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.
A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.
Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.
While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.
At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)
The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.
(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)
As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.
Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.
A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.
Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.
While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.
At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)
The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.
(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)
Sunday, April 12, 2009
Relations and Correlations
At this time of year people of many faiths hold family gatherings. At the same time, those who are not physically near their biological families often group together for a meal. In the current era, some of us define our families through various types of electronic media. All of these relationships bring people together that have some common directions that keep these individuals glued together, at least for awhile. In a similar fashion, at times security prices moves in the same direction, and often in similar magnitude. The year 2008 saw almost all stocks, bonds, commodities, and even currencies and interest rates drop. There were very, very, few price series that rose. A number of observers commented that the only thing that went up was the correlations of prices to one another. This being the case, there were very few price trends that were reliably going up. Thus, with the exception of successful short selling, most natural hedges did not work at all or did not work well enough to totally offset declining prices.
Even before last Thursday’s price spike (April 9), we started to see various commentators issuing views as to what investors should do when, not if, the next upward phase begins. These pundits are savvy enough not to issue a declarative statement that they had seen the bottom point, (even though I believe many common stocks have seen their bottom prices). Few, if any commentators see an immediate sustained rise in prices, and almost none are firmly predicting new record prices. Also, they are not predicting when the upsurge will begin. Nevertheless, they believe that there will be a meaningful rise.
The interesting, and much more difficult job is to define a winning strategy to take advantage of the force of the animal spirits which will drive the market higher. Some investors rely on the historical patterns of certain types of stocks, bonds and commodities leading the way, e.g. large cap growth stocks, high yield bonds, commodities in short supply, etc. A second group focuses on the expected human reactions to the drubbing that portfolios have sustained in a very rapid manner. They also hold the knowledge that the last ten years have yielded little or no positive results, particularly on an after-inflation basis, and where needed, on an after-tax basis. The third and much smaller group, to which I am a member, believes that the future will be shaped more by the future structure of the players and events, rather than by dogma.
The U.S. Congress and other political organizations are currently in the “blame and punishment” mode, trying to ensure that the problems that have been created will never happen again. This is an impossible task for several reasons. The first is that they have forgotten that it takes “two to tango” (or to do other dangerous and competitive contact sports). None of the imprudent paper would have been sold if it were not for the greed and ignorance of buyers of all sizes and sophistication levels. The second barrier to ensuring a solution is that we are in the process of creating new and different investment organizations, with talent freed from the government-mandated bureaucracies of today’s large financial institutions. The third barrier is that the globalization of the world’s commerce is keeping some of the world’s brightest students from studying and eventually settling in the United States.
I am convinced that new types of investment organizations have been and will be formed. I hope that new and refined financial contracts and instruments will be created. As both natural resources and technology will find more immediate payoffs overseas, the financial community and many of us as customers will follow with our dollars. Increasingly it will become clear that national governments are important part of the problem. But even a larger part of the problem is a lack of awareness; we must teach people of all levels of economic knowledge that they are primarily responsible for what happens to them.
How does this translate into a portfolio selection process? First one should deal with a multiplicity of forward looking managers who combine “beyond- the-horizon” awareness with an intimate knowledge of the details of the tactical exploitation of events. Second, in order to be able to avoid the liquidity problems of rapid purchases, an “opportunity reserve” is a good idea. The opportunity reserve should be made up of two elements, short term cash or money market funds, as well as the most liquid index funds. The mix should be dictated by a general market view. Note that this reserve is quite low cost. Opportunistic investments should be few in number. Even for the ultra high net worth individual/family or a large institution, no more than ten probes into the future should be undertaken.
I have a personal bias toward specialist managers whose skills are more focused on future developments. I also suggest that portfolio components should not be well correlated to each other in terms of performance. If and when they become too correlated, it may be time to rebuild the opportunity reserve with particular emphasis on the cash side.
This Easter Sunday finds me pro families however they are related, but I am anti correlations in the long run.
Even before last Thursday’s price spike (April 9), we started to see various commentators issuing views as to what investors should do when, not if, the next upward phase begins. These pundits are savvy enough not to issue a declarative statement that they had seen the bottom point, (even though I believe many common stocks have seen their bottom prices). Few, if any commentators see an immediate sustained rise in prices, and almost none are firmly predicting new record prices. Also, they are not predicting when the upsurge will begin. Nevertheless, they believe that there will be a meaningful rise.
The interesting, and much more difficult job is to define a winning strategy to take advantage of the force of the animal spirits which will drive the market higher. Some investors rely on the historical patterns of certain types of stocks, bonds and commodities leading the way, e.g. large cap growth stocks, high yield bonds, commodities in short supply, etc. A second group focuses on the expected human reactions to the drubbing that portfolios have sustained in a very rapid manner. They also hold the knowledge that the last ten years have yielded little or no positive results, particularly on an after-inflation basis, and where needed, on an after-tax basis. The third and much smaller group, to which I am a member, believes that the future will be shaped more by the future structure of the players and events, rather than by dogma.
The U.S. Congress and other political organizations are currently in the “blame and punishment” mode, trying to ensure that the problems that have been created will never happen again. This is an impossible task for several reasons. The first is that they have forgotten that it takes “two to tango” (or to do other dangerous and competitive contact sports). None of the imprudent paper would have been sold if it were not for the greed and ignorance of buyers of all sizes and sophistication levels. The second barrier to ensuring a solution is that we are in the process of creating new and different investment organizations, with talent freed from the government-mandated bureaucracies of today’s large financial institutions. The third barrier is that the globalization of the world’s commerce is keeping some of the world’s brightest students from studying and eventually settling in the United States.
I am convinced that new types of investment organizations have been and will be formed. I hope that new and refined financial contracts and instruments will be created. As both natural resources and technology will find more immediate payoffs overseas, the financial community and many of us as customers will follow with our dollars. Increasingly it will become clear that national governments are important part of the problem. But even a larger part of the problem is a lack of awareness; we must teach people of all levels of economic knowledge that they are primarily responsible for what happens to them.
How does this translate into a portfolio selection process? First one should deal with a multiplicity of forward looking managers who combine “beyond- the-horizon” awareness with an intimate knowledge of the details of the tactical exploitation of events. Second, in order to be able to avoid the liquidity problems of rapid purchases, an “opportunity reserve” is a good idea. The opportunity reserve should be made up of two elements, short term cash or money market funds, as well as the most liquid index funds. The mix should be dictated by a general market view. Note that this reserve is quite low cost. Opportunistic investments should be few in number. Even for the ultra high net worth individual/family or a large institution, no more than ten probes into the future should be undertaken.
I have a personal bias toward specialist managers whose skills are more focused on future developments. I also suggest that portfolio components should not be well correlated to each other in terms of performance. If and when they become too correlated, it may be time to rebuild the opportunity reserve with particular emphasis on the cash side.
This Easter Sunday finds me pro families however they are related, but I am anti correlations in the long run.
Sunday, April 5, 2009
Shrinking Discipline and Its Consequences
What common characteristic, increasingly in short supply today, was shared among the Roman Legions, Goldman Sachs and the US Marine Corps? Aggressive Discipline.
Aggressive Discipline is based on an immutable moral system that establishes a bright line border on what is acceptable and what is not. Discipline is not just compliance with prohibitive laws and regulations, but a feeling as to what is right to do. The aggressive application of discipline is often found in the heat of battle/competition in the gray areas not covered by established precedents, laws or regulation. From time to time the three generally victorious champions mentioned above, make or made mistakes, but usually corrected them by internal actions. The heart of discipline is accepting not only the rules of the game, but also the principles behind the rules.
The most basic of financial dealing principles is that all trades will be honored on time and completely. In other words buy only what we can afford out of our present resources. These resources include our cash and our borrowing capacity. The disciplined approach to borrowing is not what we can borrow, which is determined by others, but what we can repay from our own activities. We have been attempting to escape discipline throughout our society. Financial leverage and deficit spending are really the same act, but one is in the private sector and the other in the public sector. I find it ironic that our cure for the excessive borrowing by individual “home owners” and finance “houses” is being shifted initially to the public sector by deficit spending, or if you prefer the term used inside the “Beltway,” stimulus. This illogical pattern unfolds as some individuals and corporations borrow money that cannot be repaid in time, resulting in the government paying these debts by the creation of more debt. While this may be straight line thinking for some, for me it is just passing the problem along temporarily.
What makes this behavior worse is that the diagram is not a flat circle but a rising cone of adding interest cost to the debt assumed. Eventually as citizens, whether income and estate tax payers or not, we will have to repay the society’s debt nominally in full. When the government resorts to inflation it is electing for the cruelest form of taxation, because inflation impacts all who use dollars. The greatest impact is on the poor, who just have expenses and little in the way of assets. All of these consequences trace back to the decision to purchase goods and services above our reasonable ability to repay the borrowed funds. We were attempting to escape the discipline of our current resources. What we were doing, in most cases, was perfectly legal, just not smart enough to accept the discipline of avoiding trouble.
Another example of our declining use of discipline is shrinking disclosure. Politicians and some banks are attempting to hide the current valuation of assets and liabilities because they are difficult to measure. This is the whole “mark-to-market” controversy. Any comparison to the Mad-Hatter’s Tea Party is purely coincidental. What is being missed is the real function of financial commerce, in particular banks. What do banks really do? They accept our cash, which we freely give to them believing that they will return it to us on demand. In order for a bank to earn enough for it to operate, it makes loans to others and makes investments. If on any given day all of the bank’s depositors (or even a significant portion) wanted their money back, we would quickly be dealing with an insolvent institution that owed more to its depositors than it had cash on hand. Sounds like potential trouble. However, on any given day each of us has less available cash than the total of all of our debts. Banks take protection by portraying themselves as conservative institutions with lots of reserves of their own, backed by some government money (FDIC).
There are many users of bank financial statements, including (1) depositors who are looking for safety, (2) borrowers in some cases looking for the individual bank’s capacity to make a single loan, (3) government agencies seeing whether the bank is in compliance with various national and international capital requirements, and (4) during this difficult time, a Bank’s Credit Management team, determining how much more they can lend, and to what type of borrower.
A significant number of bank loans and some investments have become more difficult than usual to measure as fixed income markets are no longer functioning in their traditional ways. There is a growing amount of loans and investments that are labeled “Level 3” on the books of banks, insurance companies, brokerage firms, and various types of funds. The government is concerned that the bank community is reluctant to make loans of any type, as banks’ lending capacity is being limited by the written-down value of previous loans, and investments are now significantly below cost. In this case, financial discipline is playing its proper role of limiting the actions of a prudent lender. Because this limitation is inconvenient for the government, our leaders are advocating that certain assets which are difficult to measure, be carried at cost (which has nothing to do with value). Furthermore, the contemplated new accounting rules may prevent a reasonable assessment of value to be included in the financial statement footnotes. Some carefully determined “normalization” of prices might be useful, but we should be suspicious.
A difference in accounting treatments can lead to very different investment decisions. A number of years ago I was hired as a consultant to review the performance of an SEC registered closed end fund. The numbers shown in the SEC report included write downs of various Chinese private investments. The performance was so bad relative to other SEC registered funds, locally managed funds and various securities indexes, that the directors wanted to fire the manager. The local external portfolio manager could not understand what the complaint was about. He managed a clone of the SEC fund and not only was there no complaints, but the cloned fund was regarded as a winner in the local community. When I examined the two portfolios of identical names, I noted the prices were different for a number of holdings of private companies. The local fund carried prices at cost and would only change the price upon sale. The SEC registered fund used our accounting rules as applied by a sophisticated US auditor, who changed the price of the private companies whenever there was information as to the price of a private sale or the public announcement of some trouble with a private company. The directors used my report to force a number of changes in the investment adviser and the subsequent removal of the portfolio manager. The bottom line is the fund that hired me is still in business today and both the clone fund and the investment adviser have disappeared.
The lesson is that the most realistic numbers help in making the correct decision. From my old performance analysis days comes the slogan “bad data leads to bad decisions.” In the end the admission of an error in thinking is the best way to prevent future mistakes in judgments.
How to apply this recognition to an investment world of shrinking discipline and purposely less disclosure? The impetus is to diversify. Diversify types of investments in terms of both types of investments and within different types of investments. Also diversify your sources of information and agents to be used. During these difficult periods, simpler companies with managements that have a lot at stake in the company’s reputation and capital structure make sense and have more appeal than my old stomping ground of financial conglomerates, multi-industry/multi-product and other diversified corporations. Not that these are bad investments, but they suffer in comparison with the simpler organizations at today’s prices, discipline and disclosure levels.
Aggressive Discipline is based on an immutable moral system that establishes a bright line border on what is acceptable and what is not. Discipline is not just compliance with prohibitive laws and regulations, but a feeling as to what is right to do. The aggressive application of discipline is often found in the heat of battle/competition in the gray areas not covered by established precedents, laws or regulation. From time to time the three generally victorious champions mentioned above, make or made mistakes, but usually corrected them by internal actions. The heart of discipline is accepting not only the rules of the game, but also the principles behind the rules.
The most basic of financial dealing principles is that all trades will be honored on time and completely. In other words buy only what we can afford out of our present resources. These resources include our cash and our borrowing capacity. The disciplined approach to borrowing is not what we can borrow, which is determined by others, but what we can repay from our own activities. We have been attempting to escape discipline throughout our society. Financial leverage and deficit spending are really the same act, but one is in the private sector and the other in the public sector. I find it ironic that our cure for the excessive borrowing by individual “home owners” and finance “houses” is being shifted initially to the public sector by deficit spending, or if you prefer the term used inside the “Beltway,” stimulus. This illogical pattern unfolds as some individuals and corporations borrow money that cannot be repaid in time, resulting in the government paying these debts by the creation of more debt. While this may be straight line thinking for some, for me it is just passing the problem along temporarily.
What makes this behavior worse is that the diagram is not a flat circle but a rising cone of adding interest cost to the debt assumed. Eventually as citizens, whether income and estate tax payers or not, we will have to repay the society’s debt nominally in full. When the government resorts to inflation it is electing for the cruelest form of taxation, because inflation impacts all who use dollars. The greatest impact is on the poor, who just have expenses and little in the way of assets. All of these consequences trace back to the decision to purchase goods and services above our reasonable ability to repay the borrowed funds. We were attempting to escape the discipline of our current resources. What we were doing, in most cases, was perfectly legal, just not smart enough to accept the discipline of avoiding trouble.
Another example of our declining use of discipline is shrinking disclosure. Politicians and some banks are attempting to hide the current valuation of assets and liabilities because they are difficult to measure. This is the whole “mark-to-market” controversy. Any comparison to the Mad-Hatter’s Tea Party is purely coincidental. What is being missed is the real function of financial commerce, in particular banks. What do banks really do? They accept our cash, which we freely give to them believing that they will return it to us on demand. In order for a bank to earn enough for it to operate, it makes loans to others and makes investments. If on any given day all of the bank’s depositors (or even a significant portion) wanted their money back, we would quickly be dealing with an insolvent institution that owed more to its depositors than it had cash on hand. Sounds like potential trouble. However, on any given day each of us has less available cash than the total of all of our debts. Banks take protection by portraying themselves as conservative institutions with lots of reserves of their own, backed by some government money (FDIC).
There are many users of bank financial statements, including (1) depositors who are looking for safety, (2) borrowers in some cases looking for the individual bank’s capacity to make a single loan, (3) government agencies seeing whether the bank is in compliance with various national and international capital requirements, and (4) during this difficult time, a Bank’s Credit Management team, determining how much more they can lend, and to what type of borrower.
A significant number of bank loans and some investments have become more difficult than usual to measure as fixed income markets are no longer functioning in their traditional ways. There is a growing amount of loans and investments that are labeled “Level 3” on the books of banks, insurance companies, brokerage firms, and various types of funds. The government is concerned that the bank community is reluctant to make loans of any type, as banks’ lending capacity is being limited by the written-down value of previous loans, and investments are now significantly below cost. In this case, financial discipline is playing its proper role of limiting the actions of a prudent lender. Because this limitation is inconvenient for the government, our leaders are advocating that certain assets which are difficult to measure, be carried at cost (which has nothing to do with value). Furthermore, the contemplated new accounting rules may prevent a reasonable assessment of value to be included in the financial statement footnotes. Some carefully determined “normalization” of prices might be useful, but we should be suspicious.
A difference in accounting treatments can lead to very different investment decisions. A number of years ago I was hired as a consultant to review the performance of an SEC registered closed end fund. The numbers shown in the SEC report included write downs of various Chinese private investments. The performance was so bad relative to other SEC registered funds, locally managed funds and various securities indexes, that the directors wanted to fire the manager. The local external portfolio manager could not understand what the complaint was about. He managed a clone of the SEC fund and not only was there no complaints, but the cloned fund was regarded as a winner in the local community. When I examined the two portfolios of identical names, I noted the prices were different for a number of holdings of private companies. The local fund carried prices at cost and would only change the price upon sale. The SEC registered fund used our accounting rules as applied by a sophisticated US auditor, who changed the price of the private companies whenever there was information as to the price of a private sale or the public announcement of some trouble with a private company. The directors used my report to force a number of changes in the investment adviser and the subsequent removal of the portfolio manager. The bottom line is the fund that hired me is still in business today and both the clone fund and the investment adviser have disappeared.
The lesson is that the most realistic numbers help in making the correct decision. From my old performance analysis days comes the slogan “bad data leads to bad decisions.” In the end the admission of an error in thinking is the best way to prevent future mistakes in judgments.
How to apply this recognition to an investment world of shrinking discipline and purposely less disclosure? The impetus is to diversify. Diversify types of investments in terms of both types of investments and within different types of investments. Also diversify your sources of information and agents to be used. During these difficult periods, simpler companies with managements that have a lot at stake in the company’s reputation and capital structure make sense and have more appeal than my old stomping ground of financial conglomerates, multi-industry/multi-product and other diversified corporations. Not that these are bad investments, but they suffer in comparison with the simpler organizations at today’s prices, discipline and disclosure levels.
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