Monday, March 31, 2008 0 comments ++[ CLICK TO COMMENT ]++

CIFG Asks Fitch To Cease Rating Its Financial Guarantors; Ambac Presentation

CIFG is the latest party to ask Fitch to end the rating of its insurance subsidiaries.

CIFG Holding Ltd said on Monday it asked Fitch Ratings to withdraw ratings for its CIFG Guaranty bond insurance unit and two affiliates, citing a lack of confidence in the credit agency's approach.

The request to withdraw insurer financial strength ratings for CIFG Guaranty, CIFG Assurance North America Inc and CIFG Europe was disclosed hours after Fitch cut CIFG's ratings for a second time this month, amid worries about its capital position and exposure to U.S. subprime mortgage debt.

CIFG said it believed Fitch "is not in a good position to accurately determine the appropriate capital requirements for CIFG's insured portfolio"...

The other major credit rating agencies, Standard & Poor's and Moody's Investors Service, have also taken away CIFG's "triple-A" credit ratings.

MBIA asked Fitch to stop rating it about a month ago so the problems faced by Fitch isn't surprising. I don't think any of these moves by CIFG or MBIA help the bond insurance industry but it probably doesn't hurt it either. Fitch's models have been the weakest of the big three rating agencies (the others being S&P and Moody's). I think a lot of people, including me, lost credibility in Fitch when they almost implied that 'no amount of capital is enough to maintain a AAA financial strength rating.'

As with MBIA, without confidential information from CIFG, it would be difficult to provide an accurate rating in the future. Fitch will try to keep rating the financial guarantors but will have little advantage over other rating agencies that rely on public information alone. They likely won't be able to compete against Egan-Jones and other smaller rating agencies who likely will charge a lot less. This is pretty much the beginning of the end of Fitch's rating of bond insurers.

The unfortunate thing for the bond insurers--and you would know it if you were a shareholder :(--is that there is nothing worse than raising capital at exorbitant cost only to see ratings cut:

Last year, CIFG received a $1.5 billion infusion as part of an agreement to be acquired by Banque Populaire and Caisse d'Epargne, which together controlled CIFG's owner, the French bank Natixis SA. That injection was intended to help CIFG preserve the "triple-A" ratings it had at the time.

Management of many of the bond insurers are rolling the dice right now by diluting their shareholders heavily in order to maintain high financial strength ratings. If ratings are ever cut, as has been the case with CIFG, it would have been a disastrous strategy.

Note on Ambac

On a different note, Ambac is presenting in a couple of conferences and you can find their presentation here. It summarizes the present situation (basically a lot of storm clouds) but I didn't find anything deeply insightful. As I have suggested before, it is crucial for Ambac to avoid eliminating its structured finance side. Not only does it present the best growth opportunity in the future, it is also the backup in case Ambac loses its AAA rating. Practically no one has the expertise to underwrite structured products other than the monolines. Admittedly, the monolines compete against hedge funds, investment banks, etc that write CDS. But my expectation is for those parties to face even bigger problems than the monolines in the not-too-distant future. All it takes is a few big blow-ups for the market to start considering counterparty risk, which will provide an advantage to the mononlines (monolines also have counterparty risk but my guess is that it is much lower than the fly-by-the-night hedge funds or heavily leverage investment banks).

In addition to all that, there is a reluctance by some government entities in using bond insurance. For example, the State of California has asked some pension funds in its state, as well as the Federal government, to provide insurance. I am not sure if any formal offer has been made but so far no one is stepping up to the plate (I suspect a lot of entities have their own looming problems and can't waste money backing some municipality or quasi-government entity). Although I don't think anything will happen any time soon, the possibility of government insurance does exist. For instance, if I'm not mistaken, Florida provides catastrophe insurance. I'm not sure about the details or the extent of the coverage, but that has curbed private insurance (incidentally this is also what causes people to overbuild in risky areas because the government bails them out.) If government encroaches into municipal bond insurance, the monolines' best hope is structured products.

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Inadvertently Investing In Criminal Enterprises

Have you ever wondered if there was a possibility that you might invest in some criminal organization? Without knowing it, that is? Well, one of the Japanese companies I was following, Suruga (TSE: 1880), was recently outed as a business that thrived on corruption. Who knows what the final outcome will be but the CEO, who is also the majority owner of the company, just threw away his company. Crime does indeed not pay!

I was looking at the chart of Suruga and couldn't figure out why the stock dropped so much.

(source: Tokyo Stock Exchange)

There were a few days where the stock didn't trade a few weeks ago. Being in Canada, it's hard to know what was happening but I finally found some news from Google. As a side note, news is one of the problems with investing in foreign stocks (although I will note that a small-cap like Suruga wouldn't generate much news even if it were Canadian.)

It looks like Suruga's explosive growth over the last few years was due to the use of a land-shark:

A real estate company president who was recently arrested on suspicion of conducting unlicensed negotiations aimed at forcing tenants to move out of buildings in Tokyo, received about 15 billion yen from Suruga Corp. as a reward for his work and to cover expenses he incurred carrying out his land-sharking scheme, sources said.

The reward was given to Hiroshi Asaji, 59, president of Koyojitsugyo, an Osaka-based real estate firm, for his work to ensure tenants in five buildings in Tokyo were evicted, the sources said...

The incident revealed that a huge amount of money from the redevelopment in central Tokyo was channeled to Asaji, who is believed to have close ties with gangs...

As the total cost to buy up the five buildings was a little more than 70 billion yen, Suruga made an initial profit of about 27.5 billion yen. Even after paying 15 billion yen to Asaji, Suruga still made a huge profit, the sources said...

Suruga began making good money from redevelopments in central Tokyo about five years ago. At this time the company had begun entering into deals with Asaji, who is believed by the MPD to have close relations with Yamaguchi-gumi, a nationwide criminal gang.

Real estate industry insiders say Suruga's rapid growth was a result of Asaji's land-sharking operations...

Though legal issues regarding buildings in central Tokyo are complicated, resulting in such negotiations often taking a long time, Asaji managed to clear the building of tenants within a year...

In June, a bank that deals with Suruga informed the company that Asaji's company might have ties with Yamaguchi-gumi. But Suruga continued to strike business deals with Koyojitsugyo's affiliates until the end of 2007.

The MPD believes Suruga's decision to severe ties with Asaji was delayed because the two sides' business interests matched.
(source: Suruga paid land-shark 15 bil. yen / Firm grew rich after
hiring alleged gangster to clear buildings of tenants,
March 7 2008, The Yomiuri Shimbun.)

None of the allegations have been proven in a court of law, so everything I say is my opinion.

Needless to say, I'm removing Suruga from my watch list. Good thing I never came close to investing in it. Having done some research on the company, I suspect the allegations are true. The amount that was alleged to have been paid to the land-shark is very large for a company this size so I'm sure Suruga knew what it was doing. Furthermore, Suruga's book value grew by 23%, 42%, and 77% in the last three years. As the old saying goes, if it's too good to be true then...

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Worth Increasing US$ and Yen Exposure

Over the last year I have been wrong--big time--regarding the US$. I paid for my incorrect decision by losing around 10% of my portfolio last year due to the US$ decline against the Canadian dollar. However, I am maintaining my mildly bullish view of the US$. The US$ will likely fall while its economy weakenes and the Federal Reserve cuts rates, but I believe it has declined sufficiently against the Canadian dollar. My feeling is that the US$ will mostly fall against the strong Asian currencies and the Yen.

I am also strongly bullish on the Japanese Yen. The Yen has increased quite a bit in the last few months but I believe it has further to go (but this can take years). I am planning to increase my exposure to the US$ and Yen. Ideally, I would like to hold 50% of my portfolio in Yen-denominated assets (such as Japanese stocks). The Japanese stock market has been selling off like crazy so I'm not sure if I should just convert some money to Yen and wait, or to plunge headfirst while the sell-off continues.

The chart below from Yahoo Finance shows the relationships between the US$, C$, and Yen (note that this is not the same as the US$ index, which is against a basket of currencies).

I annotated the chart with my observations (hope they are not too distracting). To sum up, The US$ and Yen have been coupled together for the last 7 years or so. This is likely due to Japanese government intervention to keep the Yen cheap against the US$ (Japan exports a lot to the US). In the last few months, the US$ has plunged against the Yen (resulting in the unwinding of the Yen carry-trade) but I am not sure if that will continue. It is possible that the US$ may couple with the Yen and strengthen if there is capital flight to US$-denominated assets (typically happens during crises in the developing world, as was the case in 1997). The sell-off in gold lends some credence to the view that the US$ may strengthen. In any case, from my point of view as a Canadian, the C$ has been trading flat against the US$ lately. I think the run-up in the Canadian dollar (mostly due to commodities) is over. I think any risk of US$ weakness relative to the C$ for Canadians is minimal now. This, of course, doesn't mean that the US$ won't fall against, say, the renminbi.

The Canadian dollar, as a quasi-commodity curency, has strengthened significantly against the US$ and Yen in the last 7 years. The question for me is whether it will weaken against either of them in the future. It is possible that it will be flat against the US$, while weakening against the Yen.

Currencies are not my game and I wouldn't make an investment based solely on some vague feelings of where a currency should be. However, I think I can tailor foreign currencies and use them as a diversification tool. I plan on increasing my Yen-denominated investments (basicaly Japanese stocks). What I have suggested is mostly a contrarian view, given that the consensus is for much further weakening of the US$, not to mention bullishness for the Canadian dollar.

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Sunday, March 30, 2008 0 comments ++[ CLICK TO COMMENT ]++

Another Bubble Pops: Hedge Funds

Almost every economic boom results in the rise of certain financial assets to celebrity status. In the late 90's, the dot-com bubble resulted in IPOs (initial public offerings) being all the rage. Recently, the real estate bubble led to a boom in certain derivatives, with disastrous results in ABS of RMBS (asset back securities of residential mortgage backed securities) and CDO of ABS of RMBS (CDO stands for collateralized debt obligation). But this write-up isn't about any of them. Instead, this is about the rise and fall of hedge funds.

Hedge funds--the given label being as foggy and mysterious as the funds themselves--have been around for more than 50 years. Two of the most famous investors of all time, Benjamin Graham and Warren Buffett, ran hedge funds many decades ago. They are nothing new and are not going to completely dissapear. The question, instead, is whether they have grown too big--often on promises of unsustainably high returns--and will shrink. I fall into the camp that thinks there are too many hedge funds and the industry will be much smaller going forward. Do note that I am just some working class guy (which means I can't invest in them) and don't work in their industry. So it's purely an outsider's view. Some might argue this to be an ill-informed view (after all, how can one hold such a strong opinion without actually investing in several hedge funds) but I'm sticking with my view.

No better article to talk about hedge funds' troubles than one from The Telegraph out of Britain (thanks to Naked Capitalism for original mention). The British would surely know given that London is one of the major hubs for hedge funds (the other is the state of Connecticut in USA.) As usual, I will quote items that I find interesting but if you have an interest in hedge funds, read the full articles.

(source: Hedge fund legends hit by financial crisis, 30/03/2008. The Telegraph (UK) )

Hedge funds morphed from being American, secretive and peripheral to becoming one of the most important influences on global markets. Assets grew from about $200m in 1998 to an estimated $1.5 trillion at the end of last year.

You or I may not come into contact with hedge funds, or even know what they really are, but make no mistake about it: they are massive and heavily influence the markets. According to the quote above, they control $1.5 trillion, compared to around $50 trillion of total stock market capitalization for the world, around $50 trillion for the bond market, and $45 trillion (notional) for CDS (credit default swaps, where hedge funds are a major player). Hedge funds also invest in commodities, gold, art, collectibles, and so forth, but those are smaller markets. As a comparison, mutual funds in the US represent around $12 trillion of assets. Given that only the wealthy or institutions are allowed to invest in hedge funds, this $1 trillion figure is quite impressive.

With their dominance came increasingly displays of hubris and extravagance. Two years ago Albourne Partners, a hedge fund adviser, hired Knebworth and staged Hedgestock - the "alternative conference for the alternative investment industry" - one of the most extravagant and bizarre business meetings ever organised.

There were talks and meetings like any normal business conference, except the grounds were decked out as if it were a 1960s music festival, with the additions of a polo field, laser clay pigeon shooting range, hot-air balloon station and remote-controlled duck racing, while 4,000 delegates were dressed as hippies and danced to a live performance by rock giants The Who.

Meanwhile, London's annual Ark dinner, the industry charity night, became the biggest fund-raising night in the world...

Even when the markets turned last year, the hedge funds' high jinks continued. Stephen Partridge-Hicks, the former Citibank debt guru and head of Gordian Knot, one of the big credit hedge funds and so hit first, tackled the crisis by splurging thousands of pounds on a show-stopping party. In October, as his fund tanked, he chartered a plane to fly 150 mates to Morocco where he had hired Marrakech's upmarket Amanjena hotel for a James Bond-themed party. On top of the usual champagne and haute cuisine, Patridge-Hicks staged a James Bond scene - complete with actors, stunts, a real submarine and a fly-by from two Mig jets - starring himself as 007.

Arrogance & hubris are the downfall of any human. Ask George W. Bush and his neoconservatives who marched into Iraq expecting roses for simply being there. Hubris may also have brought down Elliot Spitzer. I personally am not concerned with Spiter's personal actions regarding prostitution but his arrogance against others certainly was sure to bite back. It seems a lot of the hedge fund managers have succumbed to hubris as well. Their almost inevitable fall is probably written on some wall somewhere.

I remarked in a posting a while ago about the fall of Victor Nierderhoffer, who fell victim to Mr. Market last year after losing to the same demon during the Asian Flu financial crisis back in 1997. Well, the latest ones to be struggling are John Meriwether and Eric Rosenfeld of LTCM fame.

Many hedge funds collapse under the sword that led them to glory--the glory of outperforming a superinvestor like Warren Buffett for many years. That shiny sword is none other than debt! Unlike the favoured sword of King Aruthur, the sword of leverage does not work in your favour all the time. Leverage has a nasty habit of swinging back towards you when you least expect it.

Without leverage I suspect many hedge funds would be shown for what they are. Namely, empty machinations that can barely outperform someone off the street. Mind you, they can crush losers like me who invest in questionable entities like Ambac but I'm referring to much saner investors, like the readers of this blog ;). The typical modus operandi of hedge funds is to take a small gain and boost that through leverage. Of course, the possibility of a small loss multiplied by leverage is never considered. I suppose it is beyond some people's arrogance to consider the possibility of themselves actually ending up with a small loss which turns into a big one.

The leverage situation seems to be quite acute for quantitative funds and credit market funds. All of that makes sense to me. For instance, the potential return in many debt instruments is very small so hedge funds tend to use leverage to multiply the return. A 3% return turns into 15% with 5x leverage but a 3% loss results in a -15% return.

When Walter Schloss says to avoid debt at all times, maybe he is not really advising value investors; maybe he is providing some valuable lessons to overleveraged hedge funds ;)

Another problem, even for unleveraged/lowly leveraged funds, is that their investors are very short-term oriented. The hedge funds do have legal tools to block withdrawls but they seem insufficient at times. For instance, some of these funds are in a crisis even though they are only down 8% to 15%. This is in the neighbourhood of the broad markets (or mutual funds) so it isn't the end of hte world. There is also nothing to say the funds won't bounce back in an year.

In some sense I can see why hedge funds face problems even if they are down a moderate amount. Investors pay high fees and I imagine they expect top-notch performance. So why wait around or put in more money when things look shaky? In contrast, investors pay a tiny fee for mutual funds and switching around mutual funds (or withdrawing funds) doesn't really have much impact.

One prime broker said: "Hedge funds have had it easy. Every man in a pink Cadilac has been able to raise money, start a fund and do really well. Frankly, those who have taken the biggest risks have come off best because markets have been so extraordinarily kind."

The biggest risktakers being rewarded the most reminds me of some executives of financial firms. Some of the financial firms that are struggling--some on the verge of bankruptcy--also had many highly compensated executives. In a perverse outcome, the as the risk was ratched up, executives end up with larger and larger pay packages. Some misguided compensation consultants also somehow managed to convince board of directors to raise the floor for the executives so that if something terrible were to happen, it would be laid at the feet of shareholders. If you don't believe anything I'm saying, go and ask any shareholder of Merril Lynch, Citigroup, MBIA, Ambac, CIBC, Washington Mutual, Credit Suisse, or [insert your favourite name here]. Sorry about the rant but I see big similarities between what I perceive as misguided executive compensation and hedge fund management compensation.

One said: "Hedge funds got carried away. Benevolent markets meant that anyone could be a superstar which couldn't be true. The current crisis will quickly show the pretenders and leave behind those that are genuine hedge funds - that can make money whatever the weather."

Unfortunately for hedge funds, I believe there are only a very tiny number who fit the description above. The vast majority of mutual funds underperform passive indexes and it won't be any different for hedge funds.

So, what will the result be from the shrinkage in the hedge fund industry? Well, in the short term, I expect some volatility related to de-leveraging and liquidation sales. No one knows for sure but it seems like hedge funds are heavily invested in thinly traded securities, emerging market stocks, and commodities. I'm in the bear camp when it comes to commodities so it wouldn't surprise me to see them collapse if more hedge funds start unloading their assets. Hedge funds are also big players in the credit default swap market. It would not surprise me to see violent disruptions in some of those markets. I am quite suspicious of the CDS market given that it is unregulated and there is sizeable counterparty risk. Fortunately the CDS market is net-neutral (like all derivatives are) so a loss by one party will result in an equal gain by another.

In the long run, hedge funds will fall out of favour with the wealthy elites and institutional funds--these are basically their only investors. If we are entering a bear market (the stars are starting to align in favour of a bear) then those that can't post positive returns will likely dissapear. One of the advantages of hedge funds is supposedly their low correlation to the broad markets. If they can't prove their lack of correlation to the broad markets, they have no reason for existing...

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Thursday, March 27, 2008 1 comments ++[ CLICK TO COMMENT ]++

Monolines: Historical CDS Chart

I am not too knowledgeable about the CDS (credit default swap) market and I feel that it is too illiquid and irrational at times. However, it is worth looking to see how the players in the CDS market perceive risk. Thanks to the author of the Accrued Interest blog, I was able to obtain the CDS charts for selected monolines and Berkshire Hathaway (as a side note, Accrued Interest is one of the best bond market blogs I have run across. There are good posts that explain the details of difficult-to-understand concepts.)

I wil be showing Berkshire Hathaway CDS spreads as a benchmark; while the monoline insurer spreads are my main interest. For those not familiar, a credit default swap is a derivative contract which allows the buyer of the CDS to swap an underlying credit instrument (say a bond of some company) when the company defaults. Essentially, the buyer of a CDS contract receives protection against default of a bond (or some other credit). In some sense, it is a very crude form of bond insurance without regulatory requirements. My understanding is that a sizeable chunk of the CDS market involves speculators who have no interest in owning the underlying credit instrument. In some cases, the CDS market is far larger than the underlying asset (i.e. more CDS contracts have been written than there are outstanding bonds). This is similar to some futures markets (if I'm not mistaken, the crude oil futures market is like that.)

Berkshire Hathaway is a good benchmark to evaluate the rest of the CDS spreads. Berkshire Hathaway is one of the few AAA-rated companies (note that the monoline insurer holding companies were never able to obtain AAA) and it has a lot of excess capital, which minimizes the probability of default.

(source: Bloomberg)

As you can see, there is clearly a lot of irrational behaviour in the CDS market. The CDS spread for Berkshire Hathaway quadrupled from 0.20% to 0.80% in the last 3 months, even though nothing materially adverse occurred at Berkshire Hathaway (I will note that Berkshire indicated that their future reinsurance earnings, which is a big chunk of their earnings these days, will be much lower. But I personally don't think that justifies the magnitude of the increase in the CDS spread). Investors are clearly bidding up the cost of the CDS, not because Berkshire is 4x more at risk of defaulting, but likely due to economic conditions.

The following chart plots the 5 year CDS spread over the last 6 months for Ambac, MBIA, and Assured Guaranty. Needless to say, it's an ugly chart for anyone long the monolines. The holding company CDS spreads as well as the insurance subsidiary spreads (if available) are shown. Here are some thoughts:

(source: Bloomberg)

The chart shows long-term CDS (5 yr) contracts and this is likely much better than the case for the short-term CDS (Jay Brown, CEO of MBIA, alluded to this a while ago in his letter to shareholders.) That is, the market thinks the monolines have a higher chance of going bankrupt sooner rather than later. If the market signal was correct, then the upside for investors from this is that if the monolines can get through their near-term problems, the long-term looks easier.

As Berkshire's CDS profile indicated, there has clearly been an uptrend in CDS spreads. This is further affirmed by the increasing CDS spreads for Assured Guaranty, which has largely avoided writing mortgage-related insurance since 2004 and is rated AAA (stable). There might also be a shift upwards in monoline insurer spreads since the existence of the whole industry is under threat. There is some attempt by municipal governments to avoid paying higher insurance premiums by pursuing alternatives. There is no way they are going to avoid higher premiums (since risk was somewhat mispriced all of this decade) but they are determined to get insurance using other means. Their alternatives include getting some other government entity to insure them, legislating lower premiums, or trying to improve their ratings by making the rating agencies use a single scale (which can result in some of the bigger "municipals" getting a AAA rating). All these industry threats clearly increase the risk and that is likely one big reason AGO's CDS spreads have increased.

As to be expected, the holding companies have higher spreads than the underlying insurance subsidiaries. The insightful observation is the fact that the insurance company spreads are near their highs whereas the holding company spreads are better than most of this year (except in February when they dipped). The increasing spreads for the insurance subsidiaries is not good news in my opinion. It means that the market is perceiving increasing risk with the core insurance company. As I have alluded to before, one can never be sure what is driving any of this. It is quite possible that the insurance company spreads are increasing because others are hedging their risk by buying CDS on the insurance company. If you are hedging then it is cleaner to buy CDS for the insurance company than the holding company (the reason is because a lot of non-insurance factors impact the holding company whereas the insurance company's risk is almost solely dependent on the insured assets.)

It's interesting to note that Ambac had a significantly higher spread late last year (compared to MBIA) but is very close to MBIA right now. Surprisingly, the stock market thinks the opposite. Ambac's stock price is down much further than MBIA right now. However, one should keep in mind that Ambac's dilutive effects were far worse than MBIA's (MBIA raised capital at better terms than Ambac). But Ambac's stock dropped much further even before any of the dilutive capital funding plans. Anyone following my posts on this blog would have seen how Ambac's and MBIA's fortunes have criss-crossed several times over the last year. Ignoring incompetent management (Ambac's has been far worse lately), the fate of MBIA and Ambac will come down to their exposure to CDO-squareds, HELOCs, and CESes (each monoline has differing profiles).

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Tuesday, March 25, 2008 0 comments ++[ CLICK TO COMMENT ]++

Fairfax Injects $350 million Into Struggling AbitibiBowater

The main contrarian forestry industry stock I'm following is AbitibiBowater (ABH). If you are looking at the forestry industry, you can either go for forestry companies that produce wood products or paper products. I decided to avoid the wood companies due to the housing uncertainty. ABH is a leading paper company which I haven't posted much about lately because I'm waiting to see if the company can stabilize its operations. Abitibi and Bowater merged a few months ago to create the largest paper forestry company.

On top of horrible fundamentals (weakening paper demand, increased costs due to C$ increase, overcapacity in the industry), ABH has high leverage. Lately there have been some concern about ABH's ability to re-finance its debt. There was one big positive move recently, which occurred when Fairfax, run by Prem Watsa, a value investor, decided to pump $350m into the company:

According to the terms outlined in the news release, Fairfax is buying the five-year debentures with an 8 per cent interest rate, which can be paid in the form of additional debentures at a 10 per cent rate. The $350-million (U.S.) in debt is convertible into AbitibiBowater common shares at $10 a share and has a subsidiary guarantee.

If the debentures were fully converted, Fairfax would hold 35 million new shares of AbitibiBowater, which currently has roughly 51.9 million shares outstanding.

The market cheered the news but, as has been the case with struggling companies lately, it involves a lot of share dilution. Overall, I think this is good news for the company since it removes some of the financing problems and provides a stable long-term-oriented investor.

If one waltzes into distress investing, it pays to keep in mind that dilution is a huge risk. Unlike a "normal" share price decline, dilution can involve massive stakes being sold off (up to 40% of the company given away; in the case of Ambac, it was 66%) and it crystallizes the loss. That is, when a share price declines, it an always rise back because of the possibility of irrational market pessimism; but if shares are diluted, you are basically giving away ownership of the company and you won't ever get it back.

Monday, March 24, 2008 4 comments ++[ CLICK TO COMMENT ]++

The Downside of Being an OPMI: The Bear Stearns Case

Bear Stearns provides a good illustration on the shortcomings of being an OPMI (outside passive minority investor). The fact that Bear Stearns is being "saved" is probably good for the markets but the same cannot be said for the shareholders. Who knows what the facts are in this case but here is what has transpired.

Bear Stearns, one of the top 5 independent investment banks, collapsed under the most murky of circumstances in many decades. It has a book value of $84/share but was offered a price of $2/share by JP Morgan Chase & Co. The deal disallowed the board of directors or other key employees from soliciting other bids (this apprently didn't stop James Cayne, one of the biggest holders and current chairperson, from soliciting others).

Imagine if you were a shareholder. What seems like take-under deal was signed by the board of directors (who are supposed to represent the shareholders) at the last minute. Most shareholders would have taken a loss of around 90% so it is highly probable that a shareholder vote would have rejected the deal (I will note that BSC has high employee ownership so some may vote in favour of the deal to save jobs, but given that JPM says it will cut around 50% of the workforce, even this support was never clear.)

Given that the takeover was likely not going to get the shareholder vote, JPM now increased its offer to $10/share. The interesting thing is that the board of directors somehow managed to issue shares and give away 40% of Bear Stearns to JPM without a shareholder vote. Not that too many other parties would have been interested in BSC but this pretty much locks up the deal for JPM. It's quite scary to think about how management and board of directors can issue shares and offer them to a preferred party (JPM in this case) without any shareholder approval. BSC board even side-stepped NYSE rules to offer the shares to JPM. Needless to say, Jamie Dimon of JPM has significantly increased compensation (one analyst called it bribes in a Bloomberg article) to senior executives, who also sit on the board.

The Bear Stearns deal goes to show how a lot of shady deals are done behind closed doors by insiders. The public and the media always criticize board of directors for their questionable compensation packages for executives, but these closed-door "smoky room" deals are even worse. The WSJ Deal Journal blog also shares similar views as me, questioning who the BSC board is representing.

The Bear Stearns situation is important in that it pitted shareholders against other interests (such as government, other banks, and bondholders). Shareholders likely wouldn't care if they get offered 10% or zero (bankruptcy) but it certainly affects bondholers, customers, and others. The fact that the Federal Reserve was also made to guarantee up to $30 billion of questionable assets is a plus for those attempting to profit from the BSC takeover.

The monoline insurers also face a similar situation, where the shareholders have divergent interests from municipalities, politicians, and others. Shareholders of monolines don't care about ratings if the business can't write any new business; but buyers of insurance, as well as some politicians, do care. I really feel that the management of Ambac fleeced their sharehodlers due to pressure from the government. The Ambac situation isn't as bad as BSC because there is some benefit from retaining the AAA rating.

Another deal where insiders favoured select parties, which led to a company being fleeced is Borders (BGP). Borders borrowed money from its main shareholder, William Ackman, at exorbitant interest rate (secured loan at 12.5%--unsecured wouldn't be bad but secured at that rate?) and issued a lot of warrants. Borders was desperate no doubt but couldn't they have made a public offer or attempted to raise funding from other parties?

The key point is that OPMI didn't have a say in any of this. If you are a small investor--or even a large investor in the case of BSC--it's very hard to avoid massive losses due to dilution when the board of directors do something. Warren Buffett says that management is very important but I would say that the board of directors are a far greater importance these days!

(I don't have a position in any company that I discussed except Ambac, a monoline insurer).

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Friday, March 21, 2008 0 comments ++[ CLICK TO COMMENT ]++

Adding Seiko to Watch List; Removing Others

I was searching the Japanese stock market (which still keeps dropping) for well-known brands and came across Seiko (TSE: 8050). I'm sure many of you have heard of Seiko, the Japanese watch company. The Japanese market continues to sell off and valuations keep getting cheaper and cheaper. The Japanese Yen has been strengthening and this is going to hurt exporters. Over the last few years Japan has relied on exports so their economy will take a hit. However, my feeling is that the lower valuations will compensate for any weakening of the economy.

Seiko is one of the dominant players in the watch industry. I don't know anything about watches (I'm not into them at all) so it's not clear if Seiko has a competitive advantage in the marketplace. Apart from the super-luxury brands, it doesn't seem like there is a huge brand loyalty at the low-end to mid-end area. Furthermore, with all the fake watches floating around, the watchmakers will face a continuing threat. Nevertheless, I took a quick look at the financials and looked at the business and it seems worth looking at. (If anyone has any Japanese stock suggestions, leave a comment below. I'm most interested in anything with a P/B <> 10%; established world brand is a plus.)

(all numbers are approximate)

Seiko Holdings
ticker: 8580 (Tokyo Stock Exchange)
market cap: Y56 billion (approx. $500 million)
industry: watches and high-precision devices

P/E (FY07) : 5.4
P/E (forward): 8.6; 8 (management FY08 estimate; analyst)
P/S: 0.24
P/B: 0.89

ROE (forward): 10.8 (mgt FY08)
Debt/Equity (not sure): 1.7 (a big negative)

Seiko is discontinuing some operations so be careful with any numbers. There are some extraordinary items in some of the numbers. The official English company website for investor relations seems quite basic.

Like most Japanese companies, the stock is trading near a 5 year low. The stock is quite attractive based on valuation measures like P/E and P/B. Any non-cyclical company trading with a P/E below 10 and ROE above 10% is good in my books (this is a newbie opinion! :) ). But I wonder if these numbers are at a cyclical high. I'm not sure if the watch industry will head down, now that the US consumer, along with possibly the Japanese consumer, cuts spending.

Seiko's debt is quite high and that poses one of the big risks in my eyes. It has been successful in trying to reduce its debt over the last few years but I wonder what will happen if sales decline due to a weakening economy. The problem I find with Japanese companies is that if you want reasonable ROE then you either have to pay up with valuation (i.e. high P/E) or have to take greater risk with higher debtload. My strategy is to prefer the latter because, although debt is a big threat in most circumstances, Japanese companies' debt is at low interest rates. My hope is that they will be able to service the debt even when the profitability deteriorates. If, on the other hand, I took on higher valuation, I am scared of P/E contraction. You can say a company is good, or is cheap, or whatever else you want, but if investors flee high P/Es for low P/Es elsewhere, you are in trouble. (As a side note, the reason Japanese stocks have high P/E ratios is not because of speculation per se, but because of depressed earnings and poor management of businesses.)

If the stock price hits around 50% of book then it will be very attractive. I'm not sure if it's going to get anywhere near there but we'll see. It'll also be worth waiting and seeing how much the stronger Yen will impact operations. I figure we'll know by fall/autumn of this year when FY2009 first and second quarter numbers will come out.

Re-jigging the Watch List

I'm removing the following from the watch list for the reasons mentioned:

  1. Countrywide (CFC), Pulte Homes Senior Notes due 2046 (PHA), Thornburg Mortgage 7.5% Conv Pref (TMA-PRE): I never realized how much levered Ambac is to the whole housing cycle and given my heavy exposure with Ambac, I'm not going to make any further investments in housing-related businesses (except possibly building materials suppliers or retailers). Additionally, I'm dropping Pulte because the unfolding crisis has made convertible bonds and equity far more attractive than straight bonds.
  2. Global Diversified Trust (TSX: DG.UN): Thank God I didn't invest in this (I was nowhere near investing in this though). If you ever wondered who owned the lower tranches of the subprime mortgage debt, well, it's mostly hedge funds and trusts like this. Canada also had this ABCP (asset-backed commercial paper) crisis and trusts like this were caught up in it. You can probably still make money in these things as a distress investor but it is extremely difficult to analyze these things. Everything is opaque and a mystery. Unless you work in the industry and maybe have access to tools (like Bloomberg data or some other source) where you can look into an MBS and figure out the underlying details, it's hard to say anything one way or another.
  3. Sanyo (TSE: 6764): This company may turn around at some point but I'm not willing to entertain these situations anymore. I guess it's a learning experience or just honing my skills, but I have decided to avoid highly-leveraged or high capex businesses with low margins. I would throw Sanyo into the same pile as some sectors I avoid like 'semiconductors', although Sanyo isn't really in that industry. (Maybe a semiconductor company like Intel may do well but how many AMD shareholders are happy? I would consider best-of-breed semis as a cyclical investment when their P/Es are high but would completely avoid the weaker ones or turnaround situations like Sanyo).
  4. Shoe Pavilion (SHOE): Given that nearly every single retailer is being beaten up, I am concentrating my effort on bigger, better capitalized businesses with stronger brands and stability.

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How Good Is Your Current Investment Knowledge?

No, this is a different kind of knowledge. Paul Krugman has a quite humourous post on his blog about acronymns that have been floating around in the investment world lately:

So, OFHEO got out of line with PCE, leading to a plunge in CDOs backed by RMBS, at least according to ABX. CRE looks similar, according to CMBX, and ABI suggests bad stuff ahead. Meanwhile, both the TED spread and A2P2 are flashing red, not to mention ABCP and ARS, which have just gone away. (Nobody even remembers MLEC.) HELOCs are being cut. Can TAF and TSLF save the day?
(source: Paul Krugman, The Conscience of a Liberal blog, March 19, 2008)

So how well did you understand all that? If you knew the terms, you are probably a bad investor ;) It probably means that you made bad investment decisions and ended up being in the middle of the biggest financial crisis to hit Wall Street in over 25 years.

I know all the terms except ABI and A2P2. If I didn't make my disastrous investment in Ambac, I probably wouldn't know 1/10th of the terms. Believe me, I would have preferred to avoid knowing the terms :)

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Thursday, March 20, 2008 2 comments ++[ CLICK TO COMMENT ]++

BCE Deal Closing Delayed

One of the risks with risk arbitrage is the possiblity of deals taking longer than expected. I don't have a lot of money invested in the BCE deal and I can wait, but it was delayed yet again. It looks like the deal will now close by June 30th. Given the calamity in the debt market, the delay may be a good thing.

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A Whiff of Deflation Wafts Over Commodities


One of the biggest one day corrections in CRB history...

Still too early. We have been here before. Corrections like this are nothing new. The comodity complex is simply back to where it was two months ago..

But is this the beginning of the end of the commodity bull market? Short-term T-bill rate is below the Japanese short-term rate. Yikes! Anyone doubt the forces of deflation?

Stay tuned...

Wednesday, March 19, 2008 0 comments ++[ CLICK TO COMMENT ]++

Bloomberg Interview with Jean-Marie Eveillard

Here is a Bloomberg interview with Jean-Marie Eveillard. The interview is not too insightful except for some of his stock picks so you can skip this one if you wish. As is generally the case, when commentators say they like a stock, you need to be careful with price. It's often not clear if the commentator likes the stock at the current price or if they just like the company in general.

Some quick notes:

  1. Visa/MasterCard vs American Express: He says that the business models of Visa and Mastercard are more uncertain than Amex. I disagree with that. Yes, Amex is more diversified in having a credit card issuing operation (whereas Visa and MC generally just process transactions). But Visa and MC are like tollbooths in that they collect a fee for every transaction. Jean-Marie Eveillard thinks that the fees may go down but I don't think that's a problem. The untapped market is so huge (CC pentration in many developing countries is low) and Visa/MC have such a large barrier to entry that they should do fine. Having said all that, those are hot stocks so I wouldn't go near them unless you are a growth investor who can project growth pretty well. I like the businesses but not at these prices.
  2. Home Depot (HD): One of the reasons he likes HD is because it owns most of the real estate it sits on. He feels that this provides a cushion if things fall apart. One of my watch list stocks, Sears Holdings (SHLD) also owns a huge chunk of the land. The current commercial real estate situation is poor and likely to get worse, but if you are making a long term investment, this real estate can be unlocked at some point in the distant future.
  3. Gold: Jean-Marie Eveillard likes gold. He thinks it is attractive and acts as insurance. I used to dabble in gold stocks a few years ago and am bearish on gold, as well as all commodities, right now. There has been too much euphoria over commodities over the last few years, and a bull market that has been going strong of 8 years (it's actually 10 if you count oil's bottom in 1998) is bound to end. Commodities are far riskier than many people think.
  4. Barnes & Noble: He mentioned this but I'm not sure why some people like booksellers. Recall that William Ackman is also heavily invested in Borders Group.
  5. Japan: As I have talked about many times (in fact, Japan can become one of the big themes of my blog if things work out :) ), Japan looks attractive to Jean-Marie Eveillard. Similar to what Jim Grant was saying, Japan offers world-class industrial companies that are very cheap. Jean-Marie mentioned SMC (TSE: 6273), the world's largest pneumatic tools provider, and Fanuc (TSE: 6954), a robotics supplier that is supposedly #1 in its field. A quick look shows that P/E ratios for these two aren't too low, but their ROE looks to be above 10%. Jean-Marie was saying that even if operating earnings drop 40% for some of the Japanese companies (not sure if he was talking about these two or about others), the companies are still attractive.

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Monoline Insurer Legal Battle: SCA vs Merrill Lynch

I think there may be some solid lawsuits that monoline insurers may launch against mortgage bond issuers accusing them of fraud (I don't know if they will win and it will take many years--monolines' fate will have been settled long before). However, there will be some legal challenges by some in an attempt to win something without any ethics on their side. That is, a lawsuit trying to weasle your way out of your obligations on some technicality. I personally don't view this as ethically sound since you are simply using the letter of the law. However, that's how the legal system works so these cases are to be expected.

The first attempt by a monoline insuer to avoid paying damages is SCA. SCA is trying to void its CDS-type insurance contracts that it underwrote for Merrill Lynch. Today, Merrill Lynch sued SCA in court. Here is some background from Bloomberg:

Hamilton, Bermuda-based SCA, stripped of its AAA bond insurer ratings this year by the three major ratings companies, said last week it was seeking to void the contracts, responsible for $427.4 million of the new reserves for losses set aside last quarter. SCA declined to name the counterparty, which Chief Executive Officer Paul Giordano said on a March 14 conference call failed to meet requirements ``in a fundamental way.''

``We believe that the terminations are appropriate and effective and we expect to defend against any challenge by Merrill,'' Michael Gormley, a spokesman for SCA, said in a telephone interview today.

The debt that Merrill bought protection on from XL last year includes classes of: West Trade Funding II Ltd., Silver Marlin CDO I Ltd., and Jupiter High-Grade CDO VI Ltd. The credit-default swaps offer payments if the securities aren't repaid as expected, in return for regular insurance-like premiums.

Merrill's complaint said that XL this year sought to cancel the contracts by arguing that Merrill isn't ready to exercise the ``voting rights'' as the holder of the insured CDOs classes in ways that reflect XL's written instructions, as agreed upon by Merrill in the contracts.

The complaint says that XL based the assertion on public information from Standard & Poor's that says Armonk, New York- based competitor MBIA has written protection on classes of the CDOs senior to what XL is providing protection on and is the ``sole controlling party'' for the CDOs.

Merrill responded that it hasn't entered into contracts with another party on the CDOs that would preclude it from acting in the way specified in XL's contracts, according to the complaint.

It looks like SCA is trying to get out of the insurance contract by arguing that Merrill Lynch isn't following the contract since it also has taken insurance from MBIA on more more senior tranches. I am neither a lawyer nor an expert on insurance so I have no idea what the courts will say. From a layman perspective, I think SCA should lose this case. If Merrill Lynch committed fraud in presenting its bonds, that's another story; but when SCA is simply trying to get out because of some legality, it seems quite lame.

Even though I am a shareholder in Ambac, I personally don't like to see insurers get out of paying claims unless it is clearly fraudulent. There is nothing worse than a company that you paid money to protect an adverse event backing out precisely when the event occurs.


How Badly Is Sears Holdings Performing?

There have been quite a lot of press in the last year about Sears Holdings' problems. Shareholders, especially that bought shares within the last 2 years, likely aren't a happy bunch. But how badly has it actually been performing relative to the competition?

(source: Yahoo! Finance)

The above 2 year chart plots Sears against some of its competitors such as Macy's, JC Penney, Home Depot, and Target. The S&P Retail Index (^RLX) is also shown on the graph.

As you can tell, Sears Holdings has largely been following the broader retail trend. This does not excuse Sears' performance, for great companies stand out from the competition, but it does mean that it isn't doing any worse than the rest. Practically all the retailers (except possibly the ones catering to lower-income shoppers like Wal-mart (WMT)) have been doing poorly given the weakening US economy.

The pattern will be different from longer periods of time (SHLD actually does better) but my point here is to figure out whether Sears has lost its footing. It doesn't seem like it has...

Tuesday, March 18, 2008 0 comments ++[ CLICK TO COMMENT ]++

The US Dollar...

(source: The Economist)

No doubt George Washington is crying over the fate of the US$...

So Are Foreigners...


The fate of the US$ has always looked grim during crises is it different this time?

The fate of the US$ is likely destined to have a poor outcome... for the basic reason that developed countries have a harder time growing than developing ones. It is likely (just a guess) that the US$ will weaken against whichever country grows its economy in the future (such as China or Russia, or who knows which one). The following chart from the Federal Reserve shows how the US$ has done exceptionally well over the last few decades but I don't think it will repeat that performance...

(source: Federal Reserve Bank of St. Louis)

Monday, March 17, 2008 0 comments ++[ CLICK TO COMMENT ]++

What's Wrong With Investment Banks?

I ran across an excellent opinion piece in Fortune that talked about the problems with investment banks (on a side note, there is also an interview with Paul Krugman, an economist, who thinks the housing mess can get much worse). Written by Shawn Tully, the article, titled The end of Wall Street as we know it, points out three root problems at Wall Street firms.

Everyone should consider the three issues that I quote below before investing in any investment banks. I think the article is very good at identifying why investment banks are often better at enriching employees than shareholders.

The three big weaknesses of Wall Street are deeply embedded in its culture.

First, firms rely far too heavily on trading as opposed to solid, reliable fee-based businesses favored by big commercial banks. As we'll see, one type of Wall Street trading is consistently lucrative. The rub is that firms always blow it on the risky trading.

Second, firms embrace leverage levels so dangerous that even the best risk management can't prevent a collapse.

Third, an outsize share of the gains go out the door to CEOs, CFOs and traders when times are good­­ - or rather, when firms get lucky - ­­leaving shareholders with far less wealth when markets go sour.
(source: The end of Wall Street as we know it, Shawn Tully, Fortune)

I'm just a newbie and haven't observed Wall Street for many years but I can identify the aforementioned issues at the root of many of the problems with the Wall Street investment banks. One can more easily understand how a top 5 Wall Street investment bank like Bear Stearns can collapse so quickly by considering the three points mentioned in the article. Bear Stearns, for example, wouldn't have faced half the problems it ran into, if its leverage was much lower.

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Yen Carry-trade Continues to Unwind

The Yen carry-trade is continuing to unwind as the US markets weaken. The Yen is up around 10% for the year against the US$ (the chart shown below is Yen against a basket).


Many investors, including me, have been expecting the Yen carry-trade to unwind for a while now. If the US markets correct much further, I actually think the US$ may stabilize or start to rally. It seems unlikely but there has often been big capital flight into US$-denominated assets during crises in the past.

The strengthening Yen will present an interesting situation for Japan. For the last decade or more, Japan has relied heavily on exports. This is why the JCB was always tried to manipulate their currency downwards. If the Yen strengthens, Japanese exports will get hit and the economy can't depend on exports to the same degree as they have in the past. It remains to be seen how well Japan adjusts to the stronger Yen (assuming the Yen does strengthen permanently). Their government isn't very free-market-oriented (I mean, they can't even pick a central banker replacement without political problems) and their population is aging.

The ultimate investment would be something like Japanese real estate--if real estate actually ends its 18-year bear market. You would get the benefit of a strengthening Yen on an asset coming out of a multi-decade bear market. (I posted about historical Japanese land prices in a prior post).

Sunday, March 16, 2008 0 comments ++[ CLICK TO COMMENT ]++

JP Morgan Chase Acquires Bear Stearns

JP Morgan Chase & Co just announced that it is acquiring Bear Stearns in a stock swap deal. It values Bear Stearns at $2/share (around $270 million) and the Federal Reserve is providing up to $30 billion in funding for some of Bear's less liquid assets. Given that the shares closed at $30/share on Friday (for a market cap of $3.5 billion), it's pretty much a total loss for Bear Stearns investors. Its most recent book value (back in November I believe) was around $80/share. I have only been investing for a few years but I have never seen a company vaporize so quickly.

The situation with Bear Stearns just goes to show how opaque and complicated financial businesses, especially investment banks, are. Supposedly $16 billion in liquid cash evaported from Bear Stearns' balance sheet within a week.

The JP Morgan Chase takeover, which was facilitated by the central bank, avoids any counterparty risk that would have arose if Bear Stearns collapsed on its own. Overall this is good for the capital markets, but I would have preferred if a company other than JP Morgan Chase (say, HSBC or Royal Bank of Scotland, or even a Chinese bank) had taken over Bear Stearns. My concern is that, if I'm not mistaken, JP Morgan Chase has the largest derivatives book of any bank and taking on Bear with its mortgage assets may increase the risk (however, I will note that Bear Stearns' mortgage assets are primarily in CMBS and Alt-A mortgages, and the $30 billion from the FedRes is more than enough to provide adquate capital).

Bear Stearns' liquidity problems seem to have started due to its Alt-A mortgages--not subprime! Bear Stearns was the dominant bank working with mortgages over the last few years so it isn't a total surprise that they are the worst hit. The other big mortgage player is Lehman Brothers (LEH) and speculation seems to be that they are on more solid footing.

I remember reading a theory that stated that financial companies trade at a lower valuation (it's not uncommon for them to have a P/E around 10) compared to othe sectors because of their opaque business. Even though financial companies have done exceptionally well and have generated a large amount of profit over the last few decades (they might actually be the #1 wealth creator in the last 40 years (have to check)), they always tended to trade at relatively lower valuations. You can see how risky they are. Even Goldman Sachs, which has largely avoided the subprime virus, is reportedly going to see a 50% drop in profits (although a big chunk of it is due to the decline in the share price of Industrial & Commercial Bank of China).

(On a sidenote, some Berkshire Hathaway bears have held the view that BRK is overvalued because it trades at a huge premium to a typical insurance company. I don't have a strong opinion, either bullish or bearish, on Berkshire but just pointing it out.)

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Saturday, March 15, 2008 2 comments ++[ CLICK TO COMMENT ]++

Added to Watch List: Kenneth Cole Productions (KCP)

I need to diversify my investments a bit and have been looking at the other big beaten-up sector in the US markets last year: consumer discretionary. Lately I have been looking for a good food products, clothing, or retail business. Sears Holdings (SHLD) is one option that I'm looking at. Another new one I'm considering is Kenneth Cole Productions (KCP).

Kenneth Cole Productions is a small cap company that designs and sells shoes and apparel targetted at the fashionable middle-class. Like most clothing or shoe companies, it is down about 50% from its peak in the past year. The company has been on a downtrend for the last few years, with weak sales and earnings. There are a lot of other companies with similar characteristics so it's hard to say if this company is uniquely attractive.

Ticker: KCP
Market cap: appox $300 million

P/E: 44.80 (depressed)
Forward P/E: 16.59
P/S: 0.59
P/B: 1.24

ROE: 2.84% (depressed)
Debt/Equity: no debt

The chart below, courtesy Morningstar, shows some key figures for the last 10 years along with some of my comments.

source: Morningstar

Sales and earnings have been weak over the last few years. I don't forsee this improving any time soon, given the state of the US economy. P/E is really high and ROE is really low, but this is due to depressed earnings. Historically the company has had good ROE that was above 10%.

The company has a strong balance sheet (no debt; lots of cash). The company has a dual-voting share structure, with the founder having around 90% voting power with only about 30% of the voting shares. However, given that the owner, Kenneth Cole, is the person behind the brand, it is an acceptable risk worth taking. Nevertheless, corporate governance can be problematic if the company runs into financial problems.

The stock isn't cheap on a P/E basis but it is trading at a decade low in terms of price-to-book and price-to-sales. I think this is worth investigating if it drops to a p/b of 1 (30% drop from here). Given the deteriorating stock market, we may hit that number by the middle of this year.

One additional item foreign investors (I'm Canadian) need to consider is the US$ decline. If you think the US$ will decline much further then it is somewhat risky to invest in US stocks (assuming you are not hedging it).

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Value vs Glamour

Being contrarian generally means buying out of favour assets. Often, contrarians and value investors are indistinguishable and they follow the same strategies. Does buying out of favour stocks work well over time?

David Dreman has shown in his books that low valuation stocks, as measured by P/E, P/B, P/S, or dividend yield, outperform high valuation stocks. John Neff has also remarked that his highly successful strategy of the 70's and 80's is best considered as a low P/E investing strategy. If you want to see how out of favour stocks can do better than the popular ones, consider the following example from the Brandes Institute, run by the value investing firm, Brandes. In their article entitled Value vs Glamour: The Challenge of Expectations they present the following example of 5 largest popular stocks from the 1st decile vs 5 largest unpopular ones from the 10th decile:

source: Value vs Glamour: The Challenge of Expectations, Brandes Institute

The 5 stocks in the top decile (in 1998) were popular, had excellent profitability ratios, and seemed to have the future under their control. The five in the bottom decile had declining profits, very low ROE and ROIC, and were generally considered "old" companies with a deteriorating future. Although this isn't a statistically signficant sample, note that the sample is reasonably unbiased in including companies from different sectors. Would you have been better off investing in the top decile in 1998?

The answer is a resounding no! Over the next 5 years, the top decile had a 1.4% return versus 14.7% for the bottom decile (all figures annualized). The article points out that this pattern (of bottom decile outperforming top decile) is the case for 87% of all the rolling 5 year periods between 1980 and 2007.

David Dreman has also pointed out similar results with low valuation stocks (P/E, P/B, P/S, dividend yield) versus high valuation stocks. It does pay to look in the trash bin!

So how come very few seem to follow a strategy to exploit this? The main difficulty is human psychology. It's really hard to overcome the temptation to avoid beaten-down or unfavourable businesses.

The other problem I see for stockpickers is that it is difficult to figure out which of the unfavourable stocks are safe enough to worth investing in. As the table shows, even if you look at 3 year averages (of say ROE or income growth), the unfavourable businesses look terrible. It is awefully tough to put your money into something that posts poor results not just for one year but even for a 3 year period. How does one get comfortable with knowing that the weak profitability is an anamoly rather than the norm?

Investors like David Dreman mitigate the risk by buying a large number of stocks. But if you don't have enough money to buy many (eg. transaction costs too high) or are following a concentrated stockpicking strategy, these investments are awefully tough to make. Such difficulty, of course, is what produces the rewards...

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Friday, March 14, 2008 0 comments ++[ CLICK TO COMMENT ]++

Bear Stearns Collapses

Bear Stearns, one of the largest Wall Street investment banks, is on the verge of collapse and had to borrow money from the Federal Reserve today. Since Bear Stearns can't borrow directly from the Federal Reserve (it's outside of the Federal Reserve system of banks), its borrowing was done through J.P. Morgan Chase & Co. The key problem is, courtesy of WSJ MarketBeat blog, is a withdrawl of funds by customers:

Mr. Molinaro notes that both he and Mr. Schwartz said earlier in the week that liquidity issues were not a problem at the beginning of the week, but “I would would say on Thursday we experienced pretty broad cash outflows from a number of different sources,” including prime brokerage and repo, and also saw “mark-to-market calls on open derivatives contracts. It was from a lot of places and there was a lot of concern in the market, and we had a significant level of outflows.”

The main problem at Bear Stearns is one of liquidity. It looks like their customers have ceased doing business with them, and hence resulted in large withdrawl of funds. Such a scenario is lethal to investment banks who depend on the ability to do business with counterparties.

Bear Stearns, if you recall, was one of the first financial companies to show signs of being infected by the subprime virus. It has a long, storied, history but this may the end of it as a standalone company...

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Ambac Chairperson's Letter

Ambac released a letter from the CEO talking about their situation. It is a typical public relations letter with very little substance. The only noteworthy point in the letter (at least to me) is their strategy of staying in the structured finance business.

Ambac’s business has been and will continue to encompass more than U.S public finance. Diversity of our business strengthens Ambac, as acknowledged by the rating agencies. In the U.S. we will continue to insure student loans, utility issues and certain other structured finance issues that meet our enhanced risk parameters. Outside the U.S., Ambac will continue to insure securities funding hospitals, roads, schools, public transportation and so forth.

In contrast, unless I am misunderstanding MBIA, it looks like MBIA wants to wind down its structured finance business and concentrate on municipal bond business. MBIA is also trying to split over the next 5 years, whereas no word of any split from Ambac. My guess is that Ambac gave up on the split idea after looking into it deeply over the last month.

Although it's fashionable to cast a negative light on structured finance products, I personally believe the future growth is in that area. I really don't think structured products are going to dissapear.

The structured product area will also provide a significant competitive advantage since Berkshire Hathaway Assurance Corporation is not entering that field. Smaller monolines also likely don't have the expertise to challenge the (formerly) dominant players like Ambac or MBIA. You can also survive with a AA rating in structured product insurance so if Ambac ever gives it up and loses its AAA rating, then it will be doomed.

Having said this, structured product insurance will face greater losses in the future due to the weakening US economy. My expectation is for higher losses in student loans, auto loans, credit card loans, and so forth. Hopefully Ambac didn't misprice insurance for these areas. I have greater confidence with Ambac's underwriting in, say, auto loans because they generally had a low original rating (originally BBB) and are priced as if the asset is depreciating (cars depreciate). In contrast, houses were priced as if they appreciate in general and their underlying ratings were often AAA. Student loans also look safer than mortgages but it depends on specifics (my impression is that student loans depend a lot on government regulations).

In insurance, higher insured losses are part of the business and not necessarily a bad thing. When losses are higher, premiums generally increase so your future business will earn more; when losses are low, premiums are low and competition is also higher. The key thing is to price the riks properly and have enough excess capital such that your ability to pay claims isn't questioned.

Wednesday, March 12, 2008 1 comments ++[ CLICK TO COMMENT ]++

US Government Hearing Over Municipal Bond Rating

The American Congress will be holding hearings on rating of municipal bonds. The issue being discussed is whether municipalities, which includes public-private partnerships, quasi-government entities, and so forth, should be rated using the same scale as corporate debt. Presently, the munis are rated on the sovereign (national government) debt scale. Those who are not familiar with the bond ratings right now (I suppose this would be casual investors because debt investors would clearly know the differences and what they mean) may be confused with having multiple scales. The municipalities are of the view that they are paying too much since they are being under-rated.

It's not clear to me if the government is seeking one scale to rate everything or if they just want to rate municipalities on the corporate scale, excluding national governments.

The question if one scale is adopted is, of course, whether municipalities are under-rated or whether corporations are over-rated. Does a AAA-rated corporation, like G.E., mean the same as a AAA-rated government like the US government?

On another note, although the government likely doesn't care about this but chances are another new scale will be introduced in the future to handle structured finance products. It looks like the rating agencies are moving in that direction given all the confusion over ABS of various types and CDOs. If one thought there was confusion over the municipality ratings, structured products are even worse. Needless to say, introducing an addtional scale runs counter to the argument made by the government for muni bonds.

As for the impact on monolines, those that rely on the AAA ratings would suffer somewhat if municipalities are rated higher (say an intrinsic AAA rating). However, the impact will likely be less than some imagine because something like 70% of so-called muni bonds are entities that likely won't be rated AAA under a single scale. The real benefit of muni bond insurance is not with the high quality muncipalities or with GO (general obligation) bonds (which generally have taxing power); rather it's with small towns, public-private partnerships, and so forth (these would never get a AAA rating either because they are too risky or they can't afford to pay for the rating so would rather pay a small spread to the monolines). Historically, like any type of insurance, bond buyers value bond insurance not for the low-risk municipalities but for the uncertain entities.

Monday, March 10, 2008 4 comments ++[ CLICK TO COMMENT ]++

Battle Between Fitch and MBIA Heating Up

Wow, Fitch won't just go away quietly. The battle between MBIA and Fitch is getting heated by the minute. Here are some headlines from

1 minute ago - Fitch calls MBIA info destruction request 'disingenuous' - by Wallace Witkowski

11 minutes ago - Fitch asks if MBIA seeking equal S&P, Moody's concessions - MarketWatch

14 minutes ago - Fitch: MBIA requested destruction of key portfolio info - MarketWatch

16 minutes ago - Fitch willing to waive rating fee for MBIA - MarketWatch

22 minutes ago - Fitch sees conflict in MBIA partial rating withdraw request - MarketWatch

23 minutes ago - Fitch 'considering' MBIA request to withdraw IFS ratings - MarketWatch

Fitch is calling MBIA's bluff (the excuse that the fees are too high) and says it will waive its fee... Fitch also seems to suggest that there is a conspiracy between MBIA and the other two big rating agencies.

As an Ambac shareholder, I personally feel that Fitch isn't of much use and maybe Ambac should consider dumping Fitch as well. I will note however that this is a risk that can be backfire if some feel that the ratings of the other two aren't adequate. For what it's worth, those that don't trust the current ratings won't care one way or another; and those that do trust the rating are more likely to believe Moody's or S&P since they are more respected and have better brand recognition and analytical resources.

Saturday, March 8, 2008 2 comments ++[ CLICK TO COMMENT ]++

Ambac's Swan MBIA Thoughts

Well, Ambac just gave away 2/3 of its company. Last week was probably the worst feeling for me as an investor. It's one thing to take investment losses because of poor business decisions or market price fluctuations. But it's another when management does something that one feels is not sufficient. Ambac, one of my biggest holdings, just gave away 2/3 of the company with a huge stock issuance at a very low stock price.

Ambac completed its $1.5 billion capital raising plan outlined earlier this week. The deal is horrendous for shareholders but it satisfies Moody's and S&P--for now.

Ambac Financial Group, Inc. today announced that it has priced its $1.155 billion public offering of 171,111,111 shares of common $6.75 per share and has granted the underwriters a 30-day option to purchase up to an additional 25,666,667 shares of common stock to cover over-allotments, if any.

In addition, Ambac announced that it has concurrently priced its $250 million public offering of 5 million equity units, with a stated amount of $50 per unit. The equity units carry a total distribution rate of 9.5%. The threshold appreciation price of the equity units is $7.97 which represents a premium of approximately 18% over the concurrent public offering price of Ambac’s common stock of $6.75 per share. Ambac has granted the underwriters a 13-day option to purchase up to an additional 750,000 equity units to cover over-allotments, if any.

Ambac also placed 14,074,074 shares of common stock in a private placement for $95 million with two financial institutions.

If anyone needs an example of terrible executive management of a business, this provides a good example. The original plan was scrapped, and led to losing its AAA rating from Fitch, because the share price of $5 was too low. Now, after months working with bankers, they end up raising money at $6.75. Is this why you pay bankers hundreads of thousands per year for?

The big problem I see with the current strategy is the half-hearted nature of it. They either should have gone into run-off or raised far more capital at better rates. If you are going to dilute shareholders, why not attempt to raise a lot more money. Given the massive dilution, 10% or 20% less doesn't mean much.

Ambac's main bankers, who I believe are Credit Suisse, who is also the lead underwriter to the current share issuance, should also be fired! They may well have ended up issuing shares near multi-decade lows. I also don't know why Ambac didn't do a rights offering where existing shareholders would have at least got something for giving away their company. I feel like Ambac, led by Michael Callen, is essentially lying by saying that a public offering benefits shareholders when in fact it doesn't do much. Credit Suisse is also supposedly the bank that leaked the detailed security information to Bill Ackman for his open-source model so I don't know why Ambac still keeps them. I think Bill Ackman dislcosing the information is good, but when it comes from confidential bankers it raises a lot of questions in my eyes.

Impact of Dilution

shares outstanding: 101,550,000
book value: $2,275,735,500
book value per share: $22.41

capital injection @ $6.75/share: $1,249,999,999
shares outstanding: 286,735,185 (101,550,000+171,111,111+14,074,074)
new book value: $3,525,735,499
new book value per share: $12.30

For those that did not participate in the offering, we are looking at a company that is worth around $12/share (if you assume mark-to-market losses are real). Adjusted book value is slightly higher but that is a long-term value that cannot be unlocked within 10 years in my opinion.

This pretty much takes away one possibility that existed for existing shareholders: run-off. Run-off, which is basically liquidation/bankruptcy for an insurance company, would have yielded a much higher return for existing shareholders. I assume that either management is looking out for itself and/oor is incompetent; or was forced into this move by the New York state regulator. I think the latter is probably the reason. Eliot Spitzer came out with guns blazing and, although they really can't do anything unless Ambac defaulted on its claims, scared management into diluting shareholders.

The only way 'old' shareholders will see a positive return now is if mark-to-market losses reverse. I think the marks are not real and will reverse but it is hard to say when or by how much. Otherwise, the stock is worth $12 if you assume price-to-book-value should be 1.

Looming Conflict of Interest

There is a potentially big problem for existing shareholders with Ambac's plan. I will note that what I'm about to say here is speculation on my part--for the time being. We don't really know who purchased the new shares in Ambac. There is speculation ranging from investment funds (like Legg Mason) to private equity (Cerberus) to the banks that bought insurance. It looks like the private placement, which was very small, went to private equity or hedge funds (likely Cerberus). The vast majority of the shares may have been purchased by banks who bought insurance from Ambac. We don't know for sure.

If banks (who also purchased insurance from Ambac) do end up being the biggest buyers of shares, it is extremely detrimental to existing shareholders. It's one thing if they had provided a line of credit, bought debt, or even invested in the surplus notes. But it's another when they buy shares and end up with ownership. Since around 66% of the company was given away, it is quite possible that the banks, who are also buyers of insurance, now own the majority of the firm. There are two problems I see with banks owning Ambac.

The first problem is that banks, who bought insurance, tend to be conservative and may have working relationships with Ambac. One of the problems in Japan in the 90's was the keiretsu cross-shareholdings. Banks in Japan held large cross-ownership positions in many Japanese companies. This seemeed good when times were good, with the banks lending money, financing projects, and so forth. But some argue it was a disaster when Japan went into its long decline. The banks cared more about the companies paying them back than about improving the company. Many companies avoided taking on more risk, or trying to innovate, or change the corporate culture. This ended up creating, what I would call, zombie-like corporations that were big and powerful but didn't change with the times.

If banks take majority ownership of Ambac, I can see Ambac turning into a zombie. Instead of being innovative and trying to win business, the banks will want to simply maintain the status quo and avoid risk. In other words, the banks would want to get paid first as insurance buyers rather than as shareholders. In essence, you end up with a situation where a company is almost run by its debtholders rather than the shareholders. This was the case in Japan. According to some, one reason Japanese companies don't take on more debt is because the banks who have cross-shareholder ownership don't like it (it makes sense: the banks, who were taking huge writedowns elsewhere due to bad loans, were the creditors so it's bad to take on more debt; whereas shareholders will be in favour of a reasonable increase in debt).

The second problem is that banks may simply end up perpetually diluting shareholders forever! A "normal" shareholder will never let this happen since you are losing the value of whatever you own. However the banks have an economic interest in doing so. As Bill Ackman and others have pointed out, structured finance insurance buyers, particularly the banks, get a "ratings arbitrage" through the insurance companies. That is, the banks have higher capital requirements than insurance companies like Ambac. It is far more expensive for a bank to write down assets than it is for a monoline. Given that Ambac's shareholders don't care about ratings (except for the ability to write new business), whereas the bank insurance buyers do care, you can see the conflict.

For example, let's say Ambac is unable to write new business due to its business being permanently damaged. In such a case, a "normal" shareholder will want to go into run-off (i.e. liquidation). If the business can't generate new business, you liquidate the business or sell it off. It's as simple as that. However, a bank, who is an insurance buyer, will not want to do that. They would want to keep AA- (or higher) rating, or else they will have to take mark-to-market charges on their books. I can easily see the bank continuously diluting shareholders in order to keep high ratings, even if those ratings don't help generate business.

I don't know if management did this on purpose (to give up ownership to the banks) or if they were just too incompetent to see the potential problem here. I hate to say it but it wouldn't surprise me if Michael Callen, being close with Citigroup (the owner of Ambac in the 80's), decided to take it back under the wings of the banks. Warren Buffett always says that management is important because if they don't act in your interest, you are screwed. This is doubly so for OPMI (outside passive minority investors) like everyone reading this blog. I hope I am wrong with my distrustful view of Ambac's management but I really wonder why they didn't use debt-like instruments (surplus notes, debt, loans, etc) instead of giving away ownership via shares. I mean, even preferred shares would have been a whole lot better!

I will repeat that this is all pure speculation on my part. It may very well be that most of the shares were bought by existing shareholders, private equity, or mutual funds. The problem I mentioned above doesn't apply if these are the new majority owners. The best thing is if we can keep insurance buyers from taking ownership of Ambac.

Final Thought

The dissapointing thing to me are twofold. First of all, it turns theoretical losses into real losses. I never felt the share price really indicates anything but when you dilute your book value, that is a fundamental loss. Secondly, I feel it is a weak plan even a dumb guy like me could have come up with. Ambac initially decided not to raise capital because the price of $5 was too low. Well, now they end up issuing shares at $6.75, which is almost the same as before.

Essentially all this means that this is the last move as far as existing shareholders are concerned. Even if Ambac survives in the future, any additional dilution will likely be lethal to the existing shareholders. Furthermore, the new owners are not necessarily the same as the old ones and they may have different interests.

Bizarre Ambac Stock Price Movement

As I have remarked before, a day doesn't go without some excitement of one sort or another in the monoline world. There was some bizarre stock price movement in Ambac shares on Friday.


There was a huge block trade at the end of the day on Friday that caused the shares to jump. The price is down after-hours so I'm not sure if this is a data error or not.

If this was a real trade, I wonder if it is the underwriters (or some affiliated party) covering their hedge (short) position. Since no one backstopped the Ambac offer (although there was unofficial support supposedly), the underwriters may have hedged their position by shorting the stock. It also would have been in the interest of the underwriters to drive the stock price down as much as possible, then participate in the offer and then cover their position.

If you get a sense of disgruntlment with management, you can see why. How can you price your offering without any backstop and then possibly allow the involved parties to short the stock? The line between hedging and picking up shares cheap gets very blurred when management and Ambac's banker advisors sign these deals. I'm not even a well-paid banker or one with financial expertise and even I can see how ridiculous this plan was. To see a more professional and competent capital funding plan, look at MBIA. MBIA's offer was backstopped and it was at a fixed price which was nowhere near a stock price low.

Now for some action from Ambac's rival...MBIA...

Well, You Have to Hand it to Jay Brown

He sells off his exotic car collection and invests his money in MBIA. He postpones retirement and decides to take one of the toughest chief executive jobs out there. And he decides to complete the cycle that he started, when he led to MBIA into the structured product insurance business. He also caps his career by confronting his old nemesis that he defeated in the past, Bill Ackman of Pershing Square. The guy I'm talking about is, of course, Jay Brown, the CEO of MBIA.

He certainly has his critics, especially since MBIA pursued the structured product business under his watch in the early 2000's. But, boy, talk about coming out with guns blazing. He certainly doesn't mind confrontations. There were three confrontations that he initiated: (i) against Bill Ackman, (ii) against tax-sheltered insurers, (iii) against Fitch ratings agency.

Battle Against Ackman

The battle against Ackman is well known. Brown was possibly the person that placed the final straw broke the camel's back with Bill Ackman's prior hedge fund. Although Ackman had other issues with some real-estate deal gone bad, his investors probably pulled out their funds after SEC initiated an investigation due to MBIA's prodding. Ackman didn't do anything wrong and the SEC stopped its investigation but that was too late. Ironically, MBIA restated earnings and had to pay a fine (so Ackman was right) but it came out ahead. A similar thing may happen now. It is quite possible that MBIA may take big losses, though not as bad as Ackman's estimates, but Ackman may have to leave the battlefield. MBIA can survive much longer than Ackman can and I suspect that he will unwind his short positions long before MBIA ever goes bankrupt.

Attack on Taxes?

I wondered what the hell he was doing when he started talking about the tax benefits of off-shore insurers. Now I see what his tactic was--it's quite smart. It has less to do with taxes than deflecting the problems and attacking your main competitor.

The biggest threat to MBIA is not Ambac. We know that. Contrary to popular opinion, neither is it Berkshire Hathaway Assurance Corporation (BHAC). Berkshire charges too much and Buffett isn't doing anything special to help the crisis. He mostly seems to charge a lot and write insurance on top of the existing monoline insurance which doesn't really do much for the insurance buyers. This is one reason muni bond yields are exceptionally high, and structured product issuance has completely dried up (BHAC plans to write zero insurance for structured products). This is very lucrative for BHAC but you are not going to gain market share doing that. I suspect that BHAC will also withdraw from the industry when premiums decline in a few years. We can also rule out FGIC and SCA, whom likely won't retain their AAA rating. So, now does it seem obvious who the biggest competitor to MBIA is? It's Assured Guaranty (AGO).

Assuming MBIA survives ad regains some credibility with potential customers, Jay Brown correctly perceives the big battle with Assured Guaranty in the future. Although AGO is small, it can tap capital from Wilbur Ross and hence can become a formidable opponent. I'm not sure how long it takes to build up an operation anywhere near the size of MBIA (probably takes 2 to 5 years) but AGO will be trying to seize the opportunity.

By attacking AGO's tax-haven status, and threating to re-locate to a tax haven, Jay Brown is shifting the wrath of the government onto AGO. In the past none of this mattered (since MBIA and Ambac totally dominated the business on both sides, muni bonds and structured products). But with their weakened state, MBIA likely needs all the help that it can get. All it takes is for a few municipalities, which are by defintion run by politicians, to start favouring American-based insures and you can see what Jay Brown is trying to accomplish. There is also the remote chance the government may lower taxes for the monolines (highly unlikely but you just never know).

Generally, initiating some attack via the time-trusted excuse of 'unfair taxation of tax-havens' doesn't get far. But given that MBIA's status and reputation are near all-time lows, it has the benefit that any down-and-out person has: they lose nothing by trying something drastic. I like Jay Brown's move here.

Likely End of Fitch's Monoline Rating Business

The most drastic move by Jay Brown has been his attack on Fitch ratings. He asked Fitch to withdraw their ratings for MBIA's insurance subsidiaries (full letter he sent along with Fitch's response here). It still wants Fitch to continue issuing debt ratings (so this move is only in regards to the financial strength ratings assigned to insurance companies).

You can get some justification for his thinking behind his move by reading his March 3rd letter to owners. Fitch's models have always been the toughest and, as you may know, it was also the only rating agency to cut Ambac to AA.

What MBIA is doing makes sense but it is a risky move (since the market may perceive it as an attempt to hide losses). MBIA gives the standard excuses which have nothing to do with the real reason for this move. For instance, MBIA says Fitch tripled its fees and it is too expensive. MBIA is paying Fitch $850,000 to rate its insurance subsidiaries but that isn't a big deal (it's still lower than the $2million or $1.65m paid to Moody's and S&P, respectively).

The real reason for the move is that Fitch is not only aggressive with its cuts (it may cut MBIA in the near future), but because Fitch literally says that there is no way to assign a AAA rating to any structured product insurance company. This puts the monoline insurers with exposure to structured products at a huge disadvantage. It is very hard to compete in a business where ratings matter, when new entrants or those without structured product exposure can easily get a AAA rating.

I was always somewhat surprised that Fitch can't put a dollar figure on the amount of capital required to properly insure structured products. The main value-added job of rating agencies is to come up with ability to pay claims and if you can't do that then why are you even in business? Certainly it accomplishes nothing for MBIA, Ambac, and others, to pay Fitch for nothing.

If Ambac also follows through (speaking as a shareholder I hope so, since we don't need to pay an agency to say 'no amount of capital is enough', this is basically the end of Fitch's rating of monoline insurance subsidiaries (note that this is not the same as rating debt). With the (formerly) two largest insurers not paying Fitch, it will be hard-pressed to continue with any credibility. It won't have access to confidential information from MBIA and Ambac, and hence won't be able to do as good a job. It can use public information but that's nothing valuable and the market won't pay them for it. I suspect that others with structured product insurance, like FGIC, CIFG and ACA will also stop paying Fitch in the future.


In chess, the most powerful piece (not counting the King) is the queen. Warburg Pincus brough back Jay Brown and that is the queen here (I realize this isn't as good fit in terms of gender but that's not the point). MBIA is taking huge risks with the queen and basically playing for a win right here. The Fitch move, in particular, could backfire if insurance buyers perceive that as arrogant and hiding a risky business.

I hope Ambac doesn't wither away into a zombie-like state and actually plays to win as well. As the down and out Bill Miller says of his current strategy, "As things fall, you've got to play more and more offense, not defense."

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