Monday, June 30, 2008 4 comments ++[ CLICK TO COMMENT ]++

MBIA $4 Billion From Its Investment Portfolio; Ambac's Investment Portfolio

Ambac shares are really getting killed today (down 20% on no news). I wonder if it has to index changes (Ambac was removed from Russell 1000 on Friday and inserted into the Russell 2000 today.) Further decline will result in a risk of being de-listed from NYSE (although that risk is not near)...

MBIA disclosed that it liquidated a portion of its investment portfolio, to the tune of $4 billion to satisfy collateral and early redemption requirements due to it being downgraded. It also denied a report from last week's Wall Street Journal saying that it had sold muni bonds. The bad news is that it resulted in $300 million in losses. The losses were supposedly already taken before but the sales crystallized the unrealized loss to a real loss.

For those not familiar, the investment business is seperate from the insurance business. The monolines agree to manage the funds collected by municipalities and others in exchange for payments. If the monolines get downgraded, they are requireed to post collateral and/or refund the funds.

William Ackman's main argument for the collapse of FSA has to do with its investment contracts. MBIA took a $300m loss on them and Ackman claims that FSA's loss on its investment portfolio is going to bankrupt the monoline. As for Ambac, here is the required actions at various rating levels:

If Ambac gets cut to A, it has to collateralize most of its portfolio and return some of it. Here is the underlying ratings of the portfolio:

The portolio looks fine but the problem is that, given the credit crisis and irrational pricing, liquidating en masse may result in losses. If the portfolio is held to maturity, losses will likely be small.

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Vanity Fair: Bringing Down Bear Stearns

The collapse of Bear Stearns is a pivotal event that will live on in our memories--even for those of us simply sitting on the sidelines and never stepped on Wall Street. Bringing Down Bear Stearns, a feature-length Vanity Fair article by Bryan Burrough, chronicles the events surrounding the collapse (thanks to The Big Picture for the original mention.) As is generally the case with these events, everyone has their own biased story so we really have no idea what the truth is.

If you have time to kill, pick up the magazine or check out the story online. This is not going to help you with your investments but you'll look back in 20 years as if history was being written all around you. Here is a taste of it...

(source: Bringing Down Bear Stearns, by Bryan Burrough. Vanity Fair. August 2008)

It was an uneventful morning—at first. Molinaro sat in his sixth-floor corner office, overlooking Madison Avenue, catching up on paperwork after a week-long trip visiting European investors. Then, around 11, something happened. Exactly what, no one knows to this day. But Bear’s stock began to fall. It was then, questioning his trading desks downstairs, that Molinaro first heard the rumor: Bear was having liquidity troubles, Wall Street’s way of saying the firm was running out of money. Molinaro made a face. This was crazy. There was no liquidity problem. Bear had about $18 billion in cash reserves.

Yet the whiff of gossip Molinaro heard that morning was the first tiny ripple in what within hours would grow into a tidal wave of rumor and speculation that would crash down upon Bear Stearns and, in the span of one fateful week, destroy a firm that had thrived on Wall Street since its founding, in 1923.

The fall of Bear Stearns wasn’t just another financial collapse. There has never been anything on Wall Street to compare to it: a “run” on a major investment bank, caused in large part not by a criminal indictment or some mammoth quarterly loss but by rumor and innuendo that, as best one can tell, had little basis in fact. Bear had endured more than its share of self-inflicted wounds in the previous year, but there was no reason it had to die that week in March.

What happened? Was it death by natural causes, or was it, as some suspect, murder? More than a few veteran Wall Streeters believe an investigation by the Securities and Exchange Commission will uncover evidence that Bear was the victim of a gigantic “bear raid”—that is, a malicious attack brought by so-called short-sellers, the vultures of Wall Street, who make bets that a firm’s stock will go down. It’s a surprisingly difficult theory to prove, and nothing short of government subpoenas is likely to do it. Faced with a thicket of lawsuits and federal investigations, not a soul in Bear’s boardroom will speak for the record, but on background, a few are finally ready to name names.

“I don’t know of any firm, no matter the capital, that could have withstood that kind of bombardment by the shorts,” says a vice-chairman of another major investment bank. “This was not about capital. It was about people losing confidence, spurred on by rumors fueled by people who had an interest in the fall of Bear Stearns.”

Saturday, June 28, 2008 0 comments ++[ CLICK TO COMMENT ]++

Why I Don't Care If We Are In a Bear Market, and Some Random Articles for the Week That Started the Bear Market Talk

Actually, the talk of a bear market has been ongoing for months, if not years. However, this is the first week where I am seeing sentiment shift marktedly towards the bear camp. It wouldn't have been hard for anyone reading or watching any of the media to see mention of the Dow possibly entering a bear market after the unofficial definition of a 20% drop occurred. Given that the broader S&P 500 and technology-heavy NASDAQ haven't dropped 20%, is it really a bear market? Who knows? Who care?

This would be my first bear market--assuming we are entering one. I actually invested some money in the stock market back in late 1999 or 2000 but I wasn't seriously pursuing investing back then (it also wasn't a lot of money given that I was in university and cash-strapped--this was a good thing or else I would have done a lot of dumb things and probably lost it all :)). I remember caring a lot more about bear markets when I first started investing about 4 or 5 years ago. Nowadays, I really don't care after switching my investment strategies and learning some things for the Oracle.

The first reason I don't care about a bear market is because I'm more a bottom-up investor and into contrarian, out-of-favour, investments. If you are a bottom up investor (value investing would be one such style), you are picking specific companies which may do well even if others are failing. As for contrarian situations, they are not impacted much by the broad market because they are already beaten-up pretty badly. If you ever read David Dreman's monumental book on contrarian investing, Contrarian Investment Strategies in the Next Generation, you'll notice that out-of-favour stocks tend not to decline much if there is further bad news. This is not to say that you won't take paper losses or that the contrarian investment won't go bankrupt; all it means is that, in general, the contrarian stocks decline less than the popular stocks if there is bad news.

For example, I'm looking at newspaper stocks and a lot of them have severe negative news priced into them. Whether we enter a recession or not likely has little impact on them because the market is already pricing in huge declines in advertising from other threats such as the Internet. I'm not recommending newspaper stocks (for all I know this could a dying industry in a secular decline as analyst consensus holds) but it provides an example of why further bad news on, say, the economic front probably won't do much.

Related to the above point, even if we enter a bear market, some industries may have already posted most of their declines. This is just a guess (and I'm not a good guesser) but I think financials and retailers may not drop much from here (again, it depends on the specific stock so don't blindly assume that every stock will be fine). In contrast, the high-flying technology stocks or the energy complex looks vulnerable. I also don't feel that the traditional safe havens during a slowdown, healthcare and consumer staples, will do well. Both of these look expensive on a P/E basis. For example most of the branded consumer staple companies have above-market P/E hovering around 17+. So, it all comes down to what industry you are picking during a bear market.

The other reason I don't care about bear markets, and in fact look forward to them to some degree, is that they provide buying opportunities. If you are young and/or don't have a lot of money and/or have a long investment time horizon, then bear markets may provide once in a decade buying opportunities. My investment time horizon is not 5 years or even 10 years; rather, it is 30 years (hopefully :) ). It was very difficult to find decent companies trading at, say, a P/E of 10 a few years ago. Now, practically the whole financial sector is trading around that. Retailers of all stripes had been on an ascent over the last 5 years but now practically all of them (except some select ones like Wal-mart) are down 30% to 60% (from peak). If you found some of your favourite picks trading at prices out of reach, you may find an opportunity to pick them up during the bear market (if they actually correct for irrational reasons.) Value investors reading this blog may find this to be a bizarre pick, for me, the dream pick would be something like Amazon (AMZN). If it drops 50% and its P/E goes under 15 or maybe above 100 (depressed earnings), I would take a look at it (this is assuming it dropped due to poor near-term outlook and not due to deterioration of competitive position).

Having said all that, I hold the opinion that if I can't survive a bear market then I am not a good investor and probably am not cut out for investing (but you need to look at the full cycle and not at the bear market bottom.) Enough of my commentary...

Articles I Found Interesting

Here are some articles I found interesting. As usual, there is no rhyme or pattern to my list. Some may not help you with investing--it may even turn you off investing ;)

Can Anyone Spell HyperInflation?

The 21st century isn't starting off well when the beautiful country formerly known as Rhodesia falls apart with hyperinflation, while its "elected" dictator is indifferent to the suffering of everyone. WSJ Marketbeat had a blog entry touching on Zimbabwe's hyperinflation:

Amid political chaos this week, residents scrambled to buy foreign exchange, sending the value of the Zimbabwean dollar ever lower. The Old Mutual Implied Rate, used as an unofficial proxy for the value of a Zimbabwean dollar, estimates that one U.S. dollar today is worth Z$64,575,990,281, which is more than Thursday, when it bought about Z$62 billion, but down from a peak of about Z$80 billion Tuesday, according to the Web site

Financial-services firm Old Mutual lists shares in both London and Harare, among other places; observers can calculate — roughly — what a Zimbabwean dollar is worth using share prices on both exchanges.

The OMIR doesn’t necessarily correlate to the rate you’d get on the street. But foreign exchange is the easiest store of value in Zimbabwe these days, said Rob Stangroom, who runs as well as other sites on African companies.

(source: WSJ Marketbeat. Chart originally from

Capital markets often have interesting benefits to society and here is one such example, where you are able to compute exchange rates using the difference in prices of identical shares. This is not an accurate result given that liquidity, investor sentiment, and various other factors can impact prices. Nevertheless, it provides a guide when the government manipulates everything.

I hate to think how much Zimbabwe has fallen apart. Believe it or not, when I was small (maybe around 10) I temporarily lived in Zambia, which borders Zimbabwe, for a few months. At that time, Zambia was thought to be in a worse shape (based on my impression of what my parents were saying at that time.) Zimbabwe was doing well and it seemed destined to be a successful African country (such as Kenya.) Unfortunately, history didn't turn out that way. If Zimbabwe ever recovers and if anyone is visiting Africa, Zimbabwe arguably has the best waterfall on the planet: Victoria Falls (this border Zambia so you can visit from Zambia too.) It also has some good wildlife parks. I really don't know what is going to come of Zimbabwe :(

China & The Hot Money Problem

You know I'm not a pure value investor by noticing how I pay attention to a lot of macro stuff. The Economist, which is one of my main reading sources, has an article on the problems faced by China due to the hot money (aka speculative money) flowing into it. Here is a chart that they had (note that the chart is a crude estimate):

The problem faced by Chinese central bankers is to weaken the hot money flow while not harming the economy. Here is a quote capturing the essence of the problem:

Massive hot-money inflows present two dangers to China’s economy. One is that capital could suddenly flow out, as it did from other East Asian countries during the financial crisis a decade ago and Vietnam this year. China’s economy is protected by its current-account surplus and vast reserves, but its banking system would be hurt by an abrupt withdrawal.

A more immediate concern is that capital inflows will fuel inflation. The more foreign capital that flows in, the more dollars the central bank must buy to hold down the yuan, which, in effect, means printing money. It then mops up this excess liquidity by issuing bills (as “sterilisation”) or by lifting banks’ reserve requirements. But all this complicates monetary policy. China’s interest rates are below the inflation rate, but the PBOC fears that higher rates would attract yet more hot money and so end up adding to inflationary pressures. The central bank has instead tried to curb inflation by allowing the yuan to rise at a faster pace against the dollar—by an annual rate of 18% in the first quarter of this year. But this encouraged investors to bet on future appreciation, exacerbating capital inflows. Since April the pace of appreciation has been much reduced, in a vain effort to discourage speculators.

Think about the inflation problem. If too much money flows in, it causes inflation (too much money chasing too few goods.) So the central bank can raise interest rates or tighten bank reserve requirements to cool inflation. But, to combat inflation, if they raise interest rates or let their currency appreciate, it will attract even more hot money. So what should they be doing?

I think there is going to be a bust (or a slowdown of some sort). Hopefully, for the sake of Chinese and everyone else, it won't be a severe one. I have a bad feeling that this is following the path of present-day Vietnam. Vietnam was really hot a few years ago so money was flowing into it (it was even called a mini-China.) I wasn't following Vietnam closely but my impression was that the market was thinking that the Vietnamese Dong was going to appreciate and economic growth was going to be strong for a long time, if not forever. Well, due to a bunch of reasons, including too much hot money flowing into the country, we ended up with high inflation. Now we have a situation where there is high inflation along with a weakening currency. I'm not saying the exact same thing will happen in China but there are some similarities.

Riches To Rags

Yes, you read that right: riches to rags! Not quite something to inspsire you. The Toronto Star has an article about Rudi Sagl, a developer of police radar detector, who went from a millionaire to living on government paychecks. This has nothing to do with investing per se and is more on the gossipy side so skip it if you wish. For a quick summary for those not reading the article, it goes like this... Rudi Sagl becomes a multi-millionaire off the radar detector boom in the 90's. His company runs into problems and he ends up losing it. Then he ends up losing all of his wealth (according to his account--I don't believe all of it) to divorce payments to his wife.

The article basically re-affirms what Buffett has said numerous times: marrying the right person is very important in life. I'm still single and love is the hardest thing in life for me :( but all I know is that if I mess things up with love, it's all over. With a nasty divorce, you can face problems that you never imagined was possible (not to mention the impact on kids or stuff like that)...

6 Questions for McCain and Obama

McCain and Obama answered 6 questions from Fortune magazine... politicians keep changing their mind all the time... not to mention the fact that they say one thing and do something else (George Bush's fiscal conservatism comes to mind)... but it's still worth checking out where they stand...

The Second Great Depression?

Some of the bearish readers of this blog may be in good company with Warren Brussee, author of The Second Great Depression: Started 2007/2008 Ending 2020 - 2nd Edition. Then again, this might be too scary even for the bears. Jim Puplava of Financial Sense Newshour conducted a radio interview of Warren Brussee a few weeks ago, where the author outlines his reasoning for expecting a depression on par with the the one in the 1930's (click on one of the mp3 or streaming links on the linked site to hear the interview).

This interview was conducted a few weeks ago but I just got around to hearing it. In true philosopher fashion, I like to hear and debate those with opposing viewpoints. I often seek out dissenting views for my investments. Sometimes, when reading a message board for an investment I'm contemplating, I skip the bullish views and spend most of my time reading the bearish views. I think everyone should read the dissenting views and see you can defend your position. This goes for anything in life--even politics or science or art. Anyway, anyone expecting a great depression is certainly taking an opposite position from me.

For what it is worth, Warren Brussee seems to have been prescient in calling for the housing bust and the unfolding credit contraction. His first edition of the book (published in 2005) supposedly predicted a bust in 2007 or 2008. Unlike many others calling for a severe bust, Warren Brussee actually put some hard dates which turned out to be correct.

He is also predicting a very long depression, stretching from 2007 to 2020. Yikes!

The evidence for expecting the Second Great Depression comes from the author's numerical analysis of various factors (such as when option ARM mortgages peak; the collapse of the American auto manufactuers and the resultant impact; etc.) Some of the scary predictions include a 70%+ drop in the stock market from the 2004 level, and 15% unemployment. Unemployment was supposedly 30% during the Great Depression but the author expects government to intervene and keep it at around 15%.

It was also mentioned that the depression may entail increasing prices in most items (except stocks and real estate), whereas the Great Depression resulted in almost everything deflating.

As for investing, the author suggested TIPS (treasury inflation-protected securities) in his 2004 version of the book. Right now he is more sanguine about TIPS given the big run-up in price and low yield.

Since I haven't read the book I can't pick off his points and critique it well. All I can say is that, like most superbearish views, everything is pinned on the collapse of consumer debt. I think it all comes down to what actually materializes. Everyone knows that it doesn't make any sense for Americans (and now Canadians too if I'm not mistaken) to have zero to negative savings rate. People living outside their means via debt is unsustainable; so is government spending without any concern for fiscal prudence. All this is going to unwind--I have no issue with that. The real question is how bad this will get. Will we have an orderly reversal or is it going to be a diaster?

I don't know. I'm investing as if we won't get another depression... but as Keynes has said, if conditions, I change my mind :)

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Mohnish Pabri Interview

Here is a Bloomberg interview with Mohnish Pabri (thanks to for the original mention.) For those not familiar, Mohnish Pabri is a hedge fund manager who is heavily influenced by Warren Buffett's teachings. Some say he is a future Buffett but I'm not sold on that yet. Just like how every new star that blazes a trail in the NBA is called the next Michael Jordan, only to end up nothing like Jordan, you are not going to find the next Buffett from some media proclamation.

I don't have access to Mohnish Pabri's hedge fund publications but my impression is that he has been doing very poorly lately. Some of his investments, such as Delta Financial (DFC) and CompuCredit (CCRT) have been terrible. Having said that, I still respect Pabri because he supposedly did very well during the 2000 to 2003 bear market. I think anyone that not only survived but also posted good returns deserves respect.

For those that didn't listen to the clip, here are some few points that were mentioned, along with my comments:

  1. Pabri thinks oil will face some headwinds in the future: He was citing the decline in miles driven in the US. This miles-driven statistic rarely declines and it declined in March for the first time since 1979! However, as I and others have pointed out repeatedly, the real big question is what happens in Asia. Most of the incremental demand in oil--and nearly all of the expectation of future growth--is coming from Asia.
  2. Mohnish Pabri likes muni bonds: He pointed out that muni bonds are yielding higher than Treasuries (this is very rare) and if you factor in taxes, the difference is quite large. One of the reasons for this anomaly with muni bond yields, of course, is due to the problems with the monoline bond insurers and the ARS (auction rate security) market. He thinks muni bonds are a good investment. I share that view but would qualify that. Namely, if you had to invest in bonds then muni bonds look better than Treasuries. But if you didn't have to invest in bonds then it is a tougher decision. If inflation takes hold, bonds of any type (except junk bonds) are going to get slaughtered. One of the most overvalued asset out there is the long-term US Treasury bond. Its yield is quite low (which means price is high) because of deflationary threats. If we get a deflation, you'll make a killing on these, but if we get inflation it is probably the worst place to be.
  3. Sticking to Buffett's principles (actually it's more like Benjamin Graham's principles), Mohnish points out that you can make money on high growth stocks or on zero growth stocks. You can even make money on industries with declining sales (if I ever take a position in a newspaper company, it would be this case.) The key thing, he says, is price!! Everything comes down to the price.
  4. He finds Berkshire Hathaway attractive here: He says if you value it as consisting of an operating unit and an investment unit, it is worth a lot more than the current stock price. He thinks there is room for appreciation over the next few years. He also thinks Berkshire will be fine if Buffett isn't with us anymore. I personally do not find Berkshire attractive. It is just too big and hence has difficulty growing. Berkshire also trades at a high multiple (something like 20x P/E) versus a typical insurance company around 12x and S&P 500 around 20x. But I'm not sure if the reported P/E for Berkshire uses look-through earnings (i.e. consists of earnings from investment holdings).
  5. Pabri says that if someone doesn't know much about investing, they should buy an S&P 500 index fund; but if they are little bit more comfortable then 50% in S&P 500 and 50% in Berkshire Hathaway is reasonable.

Thursday, June 26, 2008 0 comments ++[ CLICK TO COMMENT ]++

Ambac Monthly Data: April and May

In order to improve transparency Ambac is releasing monthly data related to some of their key subprime mortgage exposures. According to the disclaimer from Ambac, some additional items are only calculated at the end of each quarter so the final numbers may differ materially from what is reported. In any case, here are the April and May numbers (April was released a month ago but I didn't post it because it is meaningless without a comparison.)

It looks like Ambac paid out more in claims in May ($23.1m vs $16.2m). If you extrapolate these numbers (this is a very crude calculation) then you are looking at Ambac burning around $270m per year.

The mark-to-market losses seem to be much lower in May but I am not sure if Ambac is keeping the comparison consistent (I really hope they are keeping it the same and not misleading investors.) It looks like credit spreads narrowed in May so you are seeing some positive news there. However, I suspect spreads have widened quite a bit in June so next month's numbers are likely to be poor.

Holding company cash level actually went up slightly. A few months ago Ambac had enough cash at the holding company to pay interest on debt for two years.


Jean-Marie Eveillard Very Bearish

I have only been following Jean-Marie Eveillard for a few years but, boy, does he seem bearish. Nothing really new in this article but let me pick off some of his thoughts.

Fed policies under Greenspan, Eveillard says, precipitated "one bubble after another" -- from the implosion of technology stocks in the late 1990s to the recent real-estate price collapse and the related financial-services industry meltdown.

"In the last two or three years, the financial acrobatics were extraordinary," Eveillard said. "You could get a mortgage without having to document your income, your assets, or whether you had a job.

Why do gold bulls always take a dim view of the Federal Reserve (not that Jean-Marie is necessarily one)? Or is that a pre-condition for being accepted into the fraternity of the brotherhood of the elite exclusive group for the shiny yellow element of Aurum? ;)

I personally am not as critical of central banks as many others. I think Alan Greenspan is overrated (what people took for wisdom from him is really obsfucation) but like Ben Bernake so far. It's extremely difficult to run a central bank and always easy to say things in hindsight. Although Alan Greenspan may be responsible to a minor degree for some things, I feel that the individual is ultimately responsible for their actions. In the case of the housing bubble, was it not the homebuyers and the lenders/investors who were fully responsible? I find it puzzling that some who claim to be libertarian (or libertarian-leaning) end up blaming the central bank for most of the problems instead of blaming the individual. (anyway, what I say here has nothing to do with Jean-Marie Eveillard.)

"Banks and brokerages are disguised hedge funds," the fund manager said, disparagingly. "There is no transparency; nobody knows what's there. Some of them may already be quite bargains. The problem I have is that if I bought them, I would be buying blind."

That said, he hasn't completely ignored financial services. "The financial sector is more than just banks and brokerage firms," Eveillard pointed out. "So we bought some American Express."

I have commented on Eveillard and American Express (AXP) before. American Express is getting whacked because it has credit risk. It actually issues cards, whereas Visa and Mastercard are simply credit card processors.

Still, North American firms in general don't really attract Eveillard, who is a native of France and is based in New York. Nowadays he's more interested in putting money into Japanese stocks, which make up 30% of his fund, and Western Europe, where another 30% of assets are committed.

He's also looking closely at the emerging markets of Asia. "The future lies in Asia," he said. "We have to adjust to the fact that that's where the action is going to be."

Asia is going to go through a whole bunch of crises so investors will likely have plenty of time to invest there.

A cash-rich balance sheet and an underappreciated business is, for him, a winning combination.

"Many analysts and portfolio managers seem to ignore the cash on the balance sheet" in valuing a company, Eveillard said.

Japanese small-cap companies in particular, he explained, have a tremendous amount of excess cash on hand. Said Eveillard: "Cash and securities, net of liabilities, are in excess of market capitalization," which he added is like getting the business for free.

Half of Japanese stocks (last time I checked a few months ago) is trading below book value! And quite a few are trading below cash (as Jean-Marie here alludes to). Unfortunately for small investors, many of these are small-caps and English information is hard to find. If any reader is following Benjamin Graham's strategies, Japan is pretty much where you should be focusing your efforts.

Another opportunity lies with Japanese industrial companies, Eveillard said. As examples, he points to SMC Corp. (JP:6273: news, chart, profile) , which makes pneumatic machinery, robot manufacturer Fanuc Ltd. (JP:6954: news, chart, profile) , and Keyence Corp. (JP:6861: news, chart, profile) , a maker of automated products.
"All of them are multinational, have very large global market share, and are extremely profitable," he noted. Yet their share prices, he said, are "extremely modest."

No new information here. I have touched on these before. Fanuc made me look into Yaskawa, an industrial robots concern. I have narrowed down my decision to Toyota Industries, a Martin Whitman pick, but haven't invested yet.

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Tuesday, June 24, 2008 10 comments ++[ CLICK TO COMMENT ]++

Marc Faber Speech in Tokyo

UPDATE: Added a short summary of some points that were mentioned

Poor audio quality but Bloomberg managed to capture a speech by Marc Faber at a Tokyo investment conference (click here for the audio). I'm not sure if I'm exceeding the fair use limit by quoting the majority of a short article but, in any case, here is what Bloomberg says:

Japanese stocks, Asian real estate and commodities are investors' best bets as faster inflation erodes returns in the rest of the world's markets, investor Marc Faber said.

``Demand for commodities and oil will not vanish,'' Faber, the Gloom, Boom & Doom Report publisher, said at a conference in Tokyo. ``The shift in demand that drove up commodity prices is not going to go away.''


Faber, who told investors to buy gold as the metal began a seven-year rally, predicted inflation may boost Japanese share prices and Asian property will benefit as more people gain access to mortgages.

``For Japan, inflation is favorable,'' said Faber, who oversees about $300 million at Hong Kong-based Marc Faber Ltd. It ``will bring cash out of the mattress and into equities and real estate.''

Marc Faber isn't always right but him, and his friend Jim Rogers, are two of the commodity superbulls who jumped on the train long before anyone even knew it took off. He also tends to be plugged into Asia more so than others and provides a unique opinion.

I'm taking an opposite position from Marc Faber when it comes to commodities in general and oil in particular. I am expecting oil to drop due to demand contraction but Faber seems to think that demand is not going to decline.

The most interesting thing to me is the fact that Marc Faber likes Japanese stocks (Jim Rogers has also indicated that he likes the Yen but not sure about his views of stocks.) It is also interesting to see that inflation is actually considered positive by some in Japan, whereas it is getting to be a detrimental problem elsewhere.

I don't know about the outlook for inflation but all I know is that Japanese stocks are depressed (in book value terms) and there is a massive Yen carry-trade that is a de facto bet against Yen-denominated assets such as Japanese stocks. The big problem in Japan, though, is that the economy has very low growth potential due to a whole hoard of issues (demographics and government interference foremost reasons) and their economy is very cyclical. A big chunk of their economy consists of industrial companies that are dependent on exports. Although exports to growing regions in Asia and elsewhere is strong, USA still represents a big chunk of their economy. Japanese real estate may be a better bet than other companies.

Well, there is a reason they call him Dr. Doom. Here is a quick summary of some interesting points (not in any order):

  1. Bullish on commodities in a general sense and bearish on most financial assets
  2. Bullish on farmland
  3. Believes S&P 500 corporate earnings for 2009 are too high and hence market has to price everything down
  4. Bearish on financials and thinks it can get worse... financials (including finance arms of industrials eg. G.E. Capital) made up something like 10% of S&P 500 in the 70's and they made around 40% in 2007 so he sees it dropping
  5. Likes Asian real estate
  6. Thinks tourism in Asia has the potential to take off... cited some figures about tourism in Britain and other places versus China. There is practically zero tourism in China and this will increase.
  7. Bullish on global infrastructure... my question for the infrastructure bulls is how some of these countries are going to finance them. Some countries making a lot of money off commodities can but how about the rest?
  8. Bullish on Africa... says corruption is high--similar to Asia but big potential
  9. Bullish on Japan... 13 year bear market... thinks the rally from 2003 to 2007 was the first bullish ascent, with a bear market from 2007 to present... sees potential in Japanese financial institutions... cited some figure (don't recall exactly what it was) indicating that Japanese bank capital as a precent of world capital was semething like 40% in 1989 and is only 10% now. He thinks that figure can go up to 20% or 30%... He thinks inflation will help Japan, since it will get people to spend money parked in low-yielding cash accounts. During deflation, which is what Japan has been going through, cash is valuable; during inflation, cash is deflating so no incentive to keep it... My big problem with Japan is that their companies are very inefficient. Hard to find companies with 10%+ ROE. Although small steps are being taken in favour of shareholders, it remains to be seen how fast anything will happen.
  10. He think regional US banks are the next shoe to drop... sees risk arising from construction and commercial real estate loans... he is of the opinion that commercial real estate will also correct hard... This is very bad news for the financial sector and bad for bond insurers with commercial real estate exposure (such as MBIA). I think Faber is wrong about commercial real estate but we shall see. I don't see any grave problems in commercial real estate because subprime loans weren't really an issue. Subprime basically refers to people with low credit quality and unlike residential home buyers, commercial real estate does not seem to have undergone similar loan underwriting. Risk was under-priced in practically all assets (including emerging market bonds, the next shoe to drop IMO) but the degree differed. Subprime mortgages had one of the worst mispricing, whereas, say, corporate debt wasn't as bad. Although people will lose money on corporate debt (especially those dubious LBOs with weak economics,) it won't be anywhere near the losses in subprime mortgages... looking at history, we had financials getting whacked during the savings & loan crisis due to commerical real estate problems but residential real estate wasn't a big problem (house prices dropped during the 1990 recession but it was normal.)
  11. Not a fan of Federal Reserve, Ben Bernake, or weakening currencies...

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Does It Help If Short-sellers Are Forced To Disclose Their Positions?

Too Sullivan of ValuePlays is of the opinion that short-sellers get a slight advantage from the fact that they do not have to disclose their positions (Todd has no problem with short-selling itself (neither do I)). I am not too sure if the lack of disclosure is much of an advantage but Financial Services Authority (FSA), the regulator in Britain, is forcing short-sellers with sizeable positions to disclose their positions in a rights offering (thanks to WSJ Deal Journal for original mention):

The Financial Services Authority shocked the trading community a fortnight ago when it announced that investors would be compelled to disclose short positions of more than 0.25 per cent of share capital in companies carrying out rights issues.

The announcements started on Friday, and continued yesterday with 20 investors, predominantly hedge funds, disclosing short positions in seven companies that are in the process of carrying out rights issues.

The article also mentions a familiar name with short position (Harbinger Capital):

Harbinger Capital Partners, run by the former Barclays Capital trading boss Philip Falcone, revealed that it held 3.29 per cent of HBOS's market capital on loan. Harbinger is a US fund that focuses on distressed investment situations, and its HBOS position is valued at about £348m.

GLG Partners, the UK hedge fund that listed in the US last year, said it had taken more than 7 per cent in Bradford & Bingley.

I have covered Phil Falcone before, who made a fortune betting against housing last year and even alluded to the possibility of him being a Wilbur-Ross-in-the-making.

It's not clear to me if the lack of disclosure by shorts really hurts the market. Forcing them to disclose positions (so far FSA only requires it during rights issues) means that people can bet against them (this can be lethal to short-term investors if some big hedge fund or a proprietory desk at a bank attacks them). Short-selling accounts for a tiny portion of the market (but it is higher during bear markets) and generally does not have a big impact on the broad market. The only problem I see is when shorts spread rumours (taking a book from spy agencies, shorts know that the best rumours are the ones that can neither be confirmed nor refuted and simply introduces doubt) or attack small companies (small ones don't have the resources to defend themselves).

Monday, June 23, 2008 3 comments ++[ CLICK TO COMMENT ]++

Monoline News: Dexia Injects $5 Billion Into FSA; Talk of Commuting Insurance Contracts

Another news-filled start in the world of bond insurers...

Dexia, the French bank, injected $5 billion into FSA (via a credit line). This is in response to William Ackman's assertions that FSA is the next big one to fall due to deteriorating assets. I think William Ackman is going to be proven wrong with his claim but that doesn't mean he won't make money off this. Dexia's stock sold off last week, and FSA's CDS seems to have widened so he is likely already in the black. I think his strategy will fail in the end because he needs to introduce doubt about Dexia and that's much tougher. Since FSA has largely steered clear of the questionable subprime mortgage insurance, Dexia is likely to support FSA. As long as that happens, Ackman will be wrong unless he can bring down Dexia.

In other news, Financial Times is reporting that MBIA, Ambac, and FGIC are discussing with the insurance buyers (mostly banks) of ways to commute (cancelling) some of their insurance contracts. This is something that some have mentioned may happen. Although this can benefit shareholders if a reasonable deal is worked out, there is a big risk that the monolines may give up a huge chunk of their equity or future profit potential in order to cancel the contracts.

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Added to Watch List: Torstar (TS.B); Dropping AbitibiBowater

One of the worst industries for investors over the last 5 years has been the newspaper industry. If you ever want to know what seems like a value trap, this industry may be it. Just look at the chart below of some of the leading US newspapers, along with the Canadian TorStar (WPO=Washington Post; NYT=New York Times; GCI=Gannett; TS.B=Torstar):

Needless to say, it has been disastrous for anyone that bought any of the newspaper companies back in 2004. But, rightly or wrongly, disastrous situations are what attracts me so it's time to consider investing in them.

I have indirectly tracked newspapers for a few years. Initially because I was looking at newsprint/forestry stocks, such as Abitibi, whose main customers were the newspapers. Later on, I started looking into them because several value investors took positions in them (or at least were talking about them.) Finally, I have decided to take a deeper look and possibly take a position based on the steep price declines in the last year or so. Some of these are probably hitting the point where normalized P/E ratios are close to or below 10; dividend yields are 5%+ (most plan to maintain their dividends); and recession sentiments are being priced into the stocks.

An industry such as oil&gas is highly popular these days and what used to be cyclical for the last hundread years is thought to be high growth these days. Consensus view holds that the energy complex is in a long-term secular bull market. Well, if you have contrarian tendencies and want to find the opposite, newspapers fit the bill. Most analysts have said that the newspaper industry has entered a long-term secular bear market. Analyst prediction skills notwithstanding, the market seems to agree with that thesis. But value investors are a weird bunch and often take positions against the consensus. Some of the prominent investors that have taken favourable positions in newspapers include Phil Falcone (Media General, New York Times) and Francis Chou (Torstar).

I've looked at a few and have decided to concentrate on Torstar, a Canadian newspaper company that generates most of its revenue from publishing newspapers and books. I decided to go with Torstar because:

  1. I understand it slightly better: hometown paper... somewhat familiar with their other Canadian properties, websites, etc...
  2. Has a high 5% dividend yield: company doesn't plan to cut dividends this year but you just never know...
  3. Trades at a favourable price to book value: I have to double-check the numbers but it seems to trade just slightly above book value, whereas Washington Post, New York Times, and a few others, trade a higher book multiples. However, do note that the media mix can be different, and some brands such as New York Times has much higher value.
  4. Reasonable debt: Again, need to double-check the numbers but its debt/equity ratio is a reasonable 0.7. The great Walter Schloss' main strategy of avoiding debt should be kept in mind--this is especially true for distressed firms with potentially declining sales.
  5. ROE around 10%+: Nothing spectacular but as long as these media companies have a ROE of 10%+, it's all good...

There is one big downside to Torstar and many other newspaper companies. Most of these companies have dual-class share structures, with insiders or family members of the founders generally controlling the voting without having similar economic/ownership interest. This is a huge negative! I have historically avoided companies like this but am still looking at this company for several reasons. First of all, the share price erosion has been so bad that even the family trust (or whoever that owns shares) will get concerned about massive losses. Secondly, many of these organizations are changing their culture and endorsing outside views. Even if they don't give up on the voting structure, they are letting public shareholders and activists get seats on the board of directors and/or influencing the business strategy.

Symbol: TS.B (dual-class share structure; vote controlled by closely-held A shares)
Industry: print media (Canada)
Current Stock Price: $12.13
Market Capitalization: C$835 million
P/E: 11.6/8.9 (trailing/forward) (I would not trust the forward numbers)
P/Book: 1.1 (need to check)
ROE: 11.3%
Debt/Equity: 0.7 (need to confirm)

Given the overlap between the newsprint producers and newspapers, I'm going to drop AbitibiBowater from my watch list. The distressed forestry stocks provide far greater upside but the newspapers have better downside protection.

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Sunday, June 22, 2008 0 comments ++[ CLICK TO COMMENT ]++

Add Another Prominent Voice To The Write-Up Bandwagon

I belong to the group that thinks that financial institutions writing down a lot of assets due to mark-to-market pricing are going to end up with mark-to-market gains in the future. The market still doesn't buy that (mostly because of incompetent accountants in love with fair value accounting) but we shall see. Add Frank McKenna, deputy Chairperson at TD Bank (one of the big Canadian banks), to the side that expects reversal of the marks:

“This quarter, we're going to see massive continuing writedowns in the financial services sector, but over the next number of years we're going to see the pendulum swing up entirely the other way and we're going to see massive writeups, I would submit, as markets unfreeze and as the value of some of these underlying assets are shown to be worth a lot more,” Frank McKenna told a conference of finance professionals in Toronto.

TD Bank really hasn't really taken any big write-downs related to the credit crisis so it's reassuring to hear someone from that organization expect reversal of the marks (one can't claim this is a self-serving opinion for the bank.)

“There's going to be a very serious look at accounting rules, particularly mark-to-market rules in the United States,” Mr. McKenna said. “A lot of people feel that the crisis has been accelerated by mark-to-market accounting, and that when there's no real market - because the market has seized up - using mark-to-market creates a false impression.”

Other bank executives have been pointing to this issue in recent months. Royal Bank of Canada chief executive Gordon Nixon recently told analysts that “one of the big questions is how much of the writedowns are mark-to-market issues - rather than permanent impairments - and therefore will eventually be brought back into earnings.”

The accounting profession seriously needs to look at themselves in the mirror. So far, no one has really criticized them to any appreciable degree. All the blame and attacks have been directed towards rating agencies, investment banks, bond insurers, and some even blame the investors. If my expectation (similar to Frank McKenna above) comes true, accountants would end up destroying hundreads of billions in damages by forcing capital raising at depressed values. It's really difficult to cause billions in damage but accountants, like politicians, are capable of it.

If my view turns out to be right, fair value accounting will end up becoming a joke just like Efficient Market Hypothesis (EMH). That is, something that seems fine theoretically but completely wrong in real life--especially during stressful times. It may make a lot of sense to use market prices to value things but it completely falls apart when there is no bid. I think it's notions like these that separate investors from non-investors (e.g. accountants, economists, etc). One of the first things an investor--successful or not--will learn from the markets is that psychology plays a huge role. But those detached from investing, such as accountants or economists, often don't put the same weight on such factors.

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Impact of Moody's Upgrade of Muni Bonds

AccruedInterest has a good post on the expected impact of Moody's change of municipal bond ratings:

Investors should care for two reasons. First it appears that most municipal bonds will soon be upgraded by Moody's. It is not currently clear what the timing of the ratings revisions will be, but Moody's has previously published a guide to "mapping" municipal credits to the Global Scale. For direct obligations of States, anything rated A1 or higher on the muni scale would be Aaa on the Global Scale. That means every state would be Aaa except Louisiana. For other general obligations, including cities and counties, anything rated Aa3 or better would be upgraded to Aaa. A general obligation bond rated Baa3 would be upgraded to Aa3. Even riskier credits like hospitals would enjoy at least a 1-2 notch upgrade, according to Moody's mapping.

There is still a lot of uncertainty over this whole re-rating strategy undertaken by the rating agencies. Even if almost all states are rated AAA, would the market require a weaker state like California to pay a higher yield? Or would the differences dissapear?

I'm In any case, although the final outcome is uncertain, this will significantly reduce the muni bond insurance market size. If the market simply relies on the rating (i.e. doesn't price different states, cities, etc differently even though they have the same rating), the bond insurance market is pretty much reduced to the weaker municipalities, public-private partnerships, and other issuers who don't have strong taxing power.

I'm not too familiar with bond ratings so I'm not sure what the impact will be on foreign "municipalities" ratings (Europe, Japan, developing countries, etc.) I don't know what scale is used for the global entities and whether changes will be made there as well.

If the muni bond insurance market is significantly reduced, bond insurers pretty much have to make a living off structured products or foreign "muni" bond insurance. This is one of the big reasons I am not a huge fan of the current strategy being pursued by MBIA, Ambac, and others, to create a new insurer primarily to insure muni bonds (i.e. get a AAA rating to generate new muni bond business.) Given all the uncertainty in the muni bond market, it might take a long time before we know what is insurable and appreciated by the bond buyers.


The Two Hares and the Turtle that Suvived the Internet Bust: Yahoo, E-Bay, and Amazon

(Illustration by David Simonds; The Economist)

Yahoo!'s descent, first gradual then sudden, during this decade marks a surprising reversal of the fates of the only three big internet firms to have survived since the web's earliest days. Back in 1994 Jerry Yang and David Filo, truant PhD students at Stanford, started to publish a list, eventually named Yahoo!, of links to cool destinations on the nascent web. Around the same time, Jeff Bezos was writing his business plan for a website, soon to be called Amazon, for selling books online. The following year, Pierre Omidyar, a French-born Iranian-American, put an auction site on the web that would become eBay.
--The Economist

I was quite bullish on Amazon in the post I wrote yesterday, and this article from The Economist provides a simple overview of how the turtle, Amazon, overtook the two hares, Yahoo and E-bay. Amazon looks wildly overvalued on earnings basis (trailing P/E around 70; forward P/E around 40) but I would take a look if its valuation declines (perhaps during a bear market?).

As for Yahoo, contrarians may find it attractive based on its stock price decline, but I am not sure what will be left once Carl Icahn ends up 'doing his thing' with Yahoo...


Does It Make Sense To Buy Stocks That Have Fallen Off A Cliff?

Does it make sense to buy beaten-down stocks (say those that have fallen 50%+)? Most traders have a rule that says that one should never buy anything that is falling and hitting 52wk lows. Well, I'm not a trader so I don't follow that rule, but should one still avoid them?

A stock that has fallen 50% would have wiped out 100% of its gains in the past since returns are geometric. For example, a stock appreciating from $5 to $10 results in a 100% gain, but if it falls to $5 then it is a 50% loss from the higher level. Roughly speaking, given that the stock market yields a long-term return of around 10% per year, that means it wipes out around 8 years worth of gains (10% compounded over roughly 8 years = 100%). Although stock price gains do not necessarily match profit growth, one can, in a simplistic sense, think of it as wiping out 8 years worth of company profits. A lot of the financial stocks in America have dropped 50% (or more) and are back to levels in early 2000's. Is it worth investing in them?

Deep Value Investing

One of the main strategies that tries to capitalize on extremely depressed stocks is called deep-value investing. It is essentially extreme contrarian investing. A sub-set is what is called distress investing but not all beaten-down stocks would be considered distress investments (some companies are just out-of-favour and in "ancient" or niche industries--if you don't like companies under storm clouds, you can look at obscure industries that have reliable profits but are ignored for various reasons (possibly because of low growth, smaller size, regional focus (eg. unrecognizable brand names)). I have no idea if I'm cut out for what I'm pursuing these days (I'm trying to figure it out). I remember reading on some message board that deep value investing is the hardest technique out there. Some say it's even harder than momentum investing (momentum investing is also very tough and many studies say it is one of the worst in the long run.)

The biggest problem with going after these beaten-down stocks is that you can end up with massive losses if you are wrong. Any value investor or contrarian investor can end up catching a falling knife or falling into a value trap, but a mistake with these deep-value investments is like falling into a pit filled with spikes. I think it was Buffett who said that most junk bonds are junk and end up almost worthless. Well, I think many of these beaten-down stocks are junk and the underlying companies may end up near-worthless as well.

Another risk with going after beaten-down stocks is that they can fall precipitously--often without any news or change in fundamentals. All it takes is for one unhappy institutional investor to unload and the price gets killed (depending on the size of the market cap.) One just needs to look at a company like Ambac to see how it moves 10% per day with practically no major news (unless you count regurgitating 5-day old news as new). Other companies that I have followed, although not commented on much in this blog, like AbitibiBowater, a distressed forestry company have also seen their stock price drop substancially on some days with seemingly no news.

Criticism of Those Buying Collapsed Stocks

The reason I am writing this is to address Synchro, who challenged the notion of buying stocks that have fallen 70%+ (his comment was a few weeks ago but I just finished writing this up now). I believe his main criticism is towards Bill Miller, who has averaged down into stocks that have fallen substancially. In some cases, Bill Miller already had a position in these companies, while others are brand new. Synchro's skeptical view can also apply to Seth Klarman (a master deep-value investor), Martin Whitman (master distress investor), and others. His view also applies to lesser-mortals like me and ContrarianDutch, who took a position in Ambac a few weeks ago. I have no idea if any of my picks, or any of Bill Miller's for that matter, will work out. So I can't disprove Synchro for any of these stock picks. However, I can try to show why his argument, if blindly applied across the board, fails.

Synchro: When a stock drops 70% ~ 90%, the market's verdict seems pretty definitive. I can understand one "second-guessing" a 20% or 30% drop. There's a pt beyond which it may make sense for one to get serious about whether his own analyisis is objective/rationale or delsuion/wishful thinking.

It's kind of funny but I have the total opposite view from Synchro. That is, if the price drops 20% or 30%, the market may be pricing in fundamentals. But if it drops 70%, the market may be irrational. I'm not saying that is the case for everything but I really believe that the market is far more irrational during stressful times than during normal times. A 20% drop happens during normal times while a 50%+ drop is generally during some stressful period.

Past Examples of Successes

Let's take a look at some classic examples. I mentioned in my response to Synchro's comment that I'll look at Buffett's American Express purchase but I can't find free charts going back to the 1960's so I'll look at few other cases (actually, I can go to the library and scan some chart from an old stock guide but I'm too lazy to do that :) ). Before we get to the charts, I'll point out that I'm cherry-picking the stocks but I think that doesn't detract from my argument given that the whole point of our investing style is to pick stocks not to blindly buy everything that drops 50%.

The point of presenting the charts below is to illustrate that the market can be incorrect even if the price drops 50%+. What Synchro says should be kept in mind but that should not preclude one from investigating individual picks.

(all prices in charts below are split-adjusted so they are not the original prices; Let me know if there are mistakes in my understanding of some price declines (eg. if division was spun off; stock dividend was offered; etc); charts courtesy

Washington Post in the 70's

The following chart captures one of Warren Buffett's best investments of all time (on a side note, his #1 investment of all time is GEICO.)

The chart plots Washington Post in the early 70's when newspapers were falling out of favour. In this case, the stock had dropped around 66% from peak to trough. Now does it look like the market is right when prices drop almost 70%?

I'm not as familiar with Warren Buffett's record as some Buffett fans are--and I know many of you are reading this :)--but the beauty of this pick isn't necessarily the returns. Instead, it is a very good investment because the downside was low. Buffett explained that the liquidation value of the firm was much higher than the market price. So even if Washington Post went bankrupt, he would not have lost any money. That is what we should look for whenever we venture into these distressed investments.

Anyone investing in a bond insurer, for example, should try their best to figure out the run-off value. Martin Whitman believes that the run-off value is higher but it's up to you to figure it out. Similarly, anyone investing in Sears Holdings should have a good grasp of its break up value. William Ackman thinks that the asset value is much higher than the stock price but you need to do some work and come up with your own estimate as well.

Citigroup During The Savings & Loans Crisis

Here is a chart of Citigroup during the early 90's:

For those not familiar, the prior real estate collapse was in the late 80's/early 90's and led to the savings & loan crisis. The collapse wasn't widespread since it was limited to select areas, such as Texas, but some companies faced lingering problems. Although some of Citigroup's problems during that time were with commercial real estate loans, the real culprit seems to be the economic recession at that time period (possibly caused by the S&L crisis that was festering.) This is quite similar to the current period in that, the real estate losses being taken by financial firms may be tolerable but if the real estate bust causes a severe recession, the financials could face serious problems in other areas. No one obviously knows what will happen so the tactic followed by investors such as myself is to only invest in financially strong firms. In any case, Citi was facing huge problems as you can tell by the 65% drop in stock price.

One of John Neff's brilliant investments was Citigroup during this turmoil (for those not familiar, John Neff was one of the most successful mutual fund investors in the 70's and 80's and managed (what ended up becoming) the largest mutual fund of that era, Vanguard Windsor.) Citi, like most other financial institutions that survived, went on to be a great investment. If you ever look at long-term charts (most of which are just price-only charts), don't forget to factor in the dividends of these companies. Financials, in particular, have paid fairly good dividends over the years and they seem worse on the charts than they really are.

If the P/E ratio on these charts are accurate, Citi's P/E went below 6 during the crisis. Although P/E ratios can be misleading at times, they do provide a good starting point for beaten-down stocks. It's hard to ignore a company with a P/E of 6 if you think it won't go bankrupt. One other item I want to point out is that the market never placed the same multiple on Citi after it recovered in 1991. Although this is just for the short to medium term, it illustrates why one should not expect P/Es to hit normal levels even if the company recovers. I suspect that if financials get out of the current crisis, the market will price them lower. This is almost a certaintry given that financial companies are deleveraging (lower leverage generally means lower profits.)

Fannie Mae During Savings & Loan Real Estate Crisis

David Dreman has been a fan of Fannie Mae in the past (I think he still likes it now but not sure if he would invest right now.) However, note that David Dreman holds a diversified portfolio so I'm not sure if this was a big bet or just a contrarian pick among the financials (he also invested in a lot of the other regional banks at that time.) Fannie Mae declined around 40% during the S&L crisis. I wasn't investing back then so I'm not entirely sure if the decline was due any fundamental business problems or simply due to the market selling off any bank with real estate exposure.

In any case, Fannie Mae was a spectacular investment. From the bottom in 1990 to the peak in 1998 (or ultimate peak in 2000), it posted around 80%/year in gains (similar to Berkshire Hathaway.) I'm not an investor who thinks about the big upside potential but it's interesting to think about the big run-up in some of these companeis in the booming 90's. I'm not sure how many investors, even Fannie Mae shareholders, thought it could do so well when all the talk was about technology stocks.

Dell In The Mid-90's

Some investors do not consider Bill Miller to be a value investor and his investment in Dell is one of the reasons that is given. The following is a chart of Dell in the mid 90's:

Contrary to a misguided view, value investing does not preclude one from investing in growth stocks. Instead, what distinguishes value investors is their strategy--reasoning. Value investors have picked computer companies in the past but Bill Miller's pick in 1996 was questioned by some. Typically value investors buy stocks that are undervalued. One of the commonly followed theories for cyclical stocks--PC manufacturers were cyclical in the 80's and early 90's--is to buy when P/Es are super-high or infinite (i.e. earnings depressed) and sell when P/Es are low. So most value investors would have bought Dell in the early 90's and sold when they ran-up and hit fair value. Bill Miller bought in 1996 and most value investors who bought around that time would have sold when the price rose substancially. Bill Miller never sold!

Bill Miller didn't sell because he said that Dell was earning high returns on its capital and its business was growing. Bill Miller was overloaded on growth stocks and got clobbered in the 2000-2002 bear market but I agree with his thinking. Someone asked why he he held Dell with P/E of 35 versus Gateway with a P/E of 12 and you can see Bill Miller's strategies in his answer (I recommend this interview to anyone interested in Bill Miller. He may be loathed by some and I wouldn't quite put him in the class of Whitman, Templeton, or Lynch, but he is certainly unique):

(source: Fred W. Frailey "The Fine Art of Value Investing - William Miller of Legg Mason Value Trust - Interview". Kiplinger's Personal Finance Magazine. March 1999. 21 Jun. 2008.

Q: Even though the price-earnings ratios of these tech stocks are soaring in the stratosphere?

Bill Miller: P/E ratios by themselves are irrelevant. They capture one factor in a stock and often have little to do with underlying values. Let me explain my approach this way: Somebody said to me six months ago, how could I own Dell Computer and not Gateway because Gateway is a much better value? I said, what do you mean? Well, he said, Gateway trades at 12 times earnings and Dell trades at 35 times earnings, so Gateway is obviously a better value. So I replied that I had two businesses for him to invest in. In one he could earn a 200% return on his investment. In the other he could earn 40%. Which would he choose? Why, business number one, of course, he said--it's five times as profitable. I said, you just described the difference between Dell and Gateway. Dell earns 200% on its capital and Gateway 40%, yet Dell trades at only three times the P/E ratio of Gateway.


Q: Why did you buy Dell and AOL? Those are stocks you never find in a value investor's portfolio.

Bill Miller: AOL never, but lots of value investors bought Dell when it traded at six times earnings. If you look at historical valuations of personal-computer stocks, their prices used to bounce between six and 12 times earnings. When Dell fell to a P/E of six, value investors moved in. When it rose to 12, value investors sold.

Q: Why didn't you sell Dell then?

Bill Miller: Because we analyze businesses, not historic stock-trading patterns. I was surprised to find that Dell was worth four times what we paid for it--that is, when we bought it for $2, adjusted for subsequent stock splits, I figured its real value at $8, based on our analysis of free cash flow and other factors, including a return on capital of 35%. Since then, the company's revenue growth has far exceeded what we projected. And return on capital rose in 18 months from 35% to 229%--the highest in American industry. Now if it was worth four times the $2 we paid, and subsequently became seven times more profitable, you can understand why we kept raising the value of the company. We estimate its value in the low to mid $80s, versus its current price of $75.

Maybe Bill Miller is just a one-trick pony as some suggest but, so far, I'm disinclined to believe that. I actually like his thinking and feel that he has unique skills.

You can see how Miller's strategy differs from a pure value investor such as Seth Klarman. Klarman would never look at half the stuff Miller invests in but in addition to that, Klarman's strategy is to sell when something hits fair value. This is what is followed by most value investors and many other type of investors who venture into beaten-down stocks. In contrast, Miller's strategy is to hold if profitability is still strong. Warren Buffett also holds (eg. Coca-Cola in the late 90's; Washington Post in 2000's; etc) but he is a control investor and likely will suffer reputational damage if he sells.

It's difficult to say if Miller is simply lucky with his Dell investment or if his thinking was bold and unique. Dell certainly resulted in huge gains because it became the #1 PC manufacturer in an industry with super-high growth. So, was Miller simply saved by Dell's unanticipated high growth or is he right in holding companies with high returns on capital?

He doesn't mind holding if growth is strong, even if the stock looks wildly overvalued on many value investing metrics (such as P/E ratio or P/BookValue.) He is following a similar investment scheme with Amazon, which I will discuss below.

Anyway, the point here is that, it looks like a joke in hindsight but the market actually chopped off 50% of Dell's market cap back in 1996. That is a huge drop and some might say that the market is correctly predicting further problems, I think it is worth looking at those opportunities.

Lehman Brothers During Russian Debt Crisis

The current crisis facing Lehman Brothers must seem like deja vu to employees and shareholders. Lehman shares actually dropped around 70% back in 1998:

The Russian debt default in 1998, along with the collapse of the Asian Tigers before that, caused all sorts of problems for investment banks, particularly someone whose main business was in bonds as Lehman was/is. Similar to the clouds hanging over some financial firms right now, the survival of some were questioned back then.

I'm not saying an Ambac is a Lehman in 98, but anyone fleeing the stock because of the huge collapse in price turned out to be wrong. If you are risk averse or are not a stockpicker then you should avoid these situations but otherwise...

Amazon During .COM Bust

Investing in Amazon throughout the 2000's shows the prototypical Bill Miller; but it is also what makes many disapprove of his strategies. Amazon got killed after the .com bust. It declined 90% from peak to trough, had very high capex in early 2000's, and had no earnings until 2004.

Bill Miller bought early but he averaged down after the stock dropped. Synchro and others are not big fans of averaging down into seeming bankrupt companies (Amazon dropping 90% would have been a candidate if you relied on the market price to gauge reality) but this example goes to show when, how, and why it works!

Bill Miller was likely down significantly on his Amazon investment in 2001, but by 2004 I think he would have more than made a handsome return. Massive price declines are lethal to portfolios but the upside from averaging down on those losing positions is pretty high, assuming they work in the end:

For example, let's say you invested $1000 in Amazon at the peak price of around $100. It dropped 90% in 2001 to, say, $10. No doubt you would be ready to jump off a cliff, assuming there are cliffs in your area--can't find any in Toronto ;) . If you are pretty certain that fundamentals are still solid then if you invest another $1000 @ $10, then there is the possibility of making back your loss and a lot more. When Amazon recovered to $50 by 2004, your return would have been 175% (30%+ annualized). Even though Amazon is actually down 50% from its peak, you are still up quite a bit. Now, this is an extreme example--the drop, as well as the recovery--and I do not think you can expect similar returns in other cases. Nevertheless, I think it makes sense to average down if you invest in distress situations.

Much to the criticism of many, what Bill Miller is attempting to do with his current portfolio is similar. I have no idea if his bets on Countrywide Financial, Yahoo, Pulte Homes, and so forth, will work out. But I don't see how one can criticize the strategy if the reasoning for the business is sound. You shouldn't blindly average down into every single losing position. Some companies will certainly go bankrupt. But if you are certain that the fundamentals or the business itself had not changed, then I think it is a reasonable strategy.

Someone reading this blog might think I'm dumb for saying this but if I had to develop some skill in investing, it would be to pick companies like Amazon. Believe it or not, Amazon is a dream stock to own for me (but it's wildly overvalued right now so I can't buy it.) Before I was seriously into investing, I thought Amazon was going to go bankrupt. I held this view as recently as 2005. But after reading some thoughts from Bill Miller, I have completely changed my view of Amazon (and other growth stocks.) My opinion is that Amazon has absolutely massive moat (I never realized this initially and only changed it after looking at Amazon the way Miller did.) Amazon has 50% ROE (even if unsustainable, it leaves lots of room for erosion), very low debt, strong brand, and global potential. The only problem--and a big one at that--is that it is trading at ridiculously high valuations. Trailing P/E is around 70 and forward P/E is around 40. I think if growth investors get tired of it, or if the bear market chops down the price, it is worth investigating further. The US government is trying to tax online retail sales and if that causes a big sell off, it is worth looking at.

Whenever people read Buffett's words, they seem to think of what he is good at: insurance, branded consumper products, etc. For instance, Buffett likes companies with high return on equity, low debt, recognized brand, strong moat, financially sound, and so on. Newbie investors generally seem to think that what Buffett is saying means we need to find some consumer-branded business like Coca-Cola, Pepsi, Kraft, P&G, or some such business. Yet Amazon satisfies most of what Buffett looks for. Admiteedly, it is hard to value and seems wildly overvalued (at least on a P/E basis) but how come hardly anyone even takes a cursory look at it? The closest to a value investor dabbling in these businesses would be Francis Chou and his investment in

We Are Stockpickers--Or At Least Trying To Be

Synchro: For a stock to drop 90%, it needs rise 10x to break even. What are the odds?

But that's why most investors who pursue that strategy average down. I would agree with you that a 90% drop would be hard to make up. But something like a 50% drop can be made up (just requires 100% gain.) The key thing is that you will only likely make up that gain if the market is irrational pricing the stock. It would be very difficul to make up that gain through busines fundamentals (i.e. it will literally take 10 years to generate profits to create a 100% gain.) (I should note that the revenue argument doesn't apply to financial companies right now since most of their losses are mark-to-market losses, which can reverse without much effort by the business operators.)

Anyway, I think the big difference between your thinking and mine is that, I assume that people who follow these strategies are stock pickers! Or at least trying to be :) When you say "what are the odds?", that's totally meaningless in my eyes. One may not know what the odds are but one may have an idea of the upside if they were picking individual stocks. If you understood the company, it wouldn't be based on trying to guess the odds of recovery, and instead would be based on some fundamental reason. I hope no one is investing based on the blind notion that something may recover because it dropped; someone should be investing due to their expectation of the upside based on fundamentals (the outcome may or may or may not be what one imagined but at least you have some logical reasoning.)

Last Word

I think everything comes down to the strategy followed by the investor. Just like how some people believe in high diversification while others don't, I think investing in stocks that have collapsed may be risky to one but not to another. For me, I think these stocks are no more risky than, say, trying to ride the latest trend (commodities right now, but real estate and technology/growth stocks a while back.) I don't think one can criticize someone like Bill Miller just because they invest in beaten-down stocks.

I'm sure the skeptics will be thinking that the investment cases I cited involve superinvestors. Are we those superinvestors? Who knows, but I'm trying to see if I can develop some skill. I'm sure anyone reading this blog or doing stock picking (as opposed to passive investing or betting on sectors) are trying to see if they will become a successful investor as well. We don't need to make super-high returns and make the front page of the paper; we just need to beat the market by a few percentage points and we'll be fine!

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Friday, June 20, 2008 2 comments ++[ CLICK TO COMMENT ]++

Supreme Court of Canada Rules In Favour of BCE Shareholders; Deal Likely to Proceed

The Supreme Court of Canada ruled in favour of BCE shareholders, overturning a lower court decision favouring the bondholders. Decision was unanimous and the reasoning is to be given later.

Furthermore, it looks the banks are signalling a positive outcome:

BCE Inc.'s $35-billion sale to Ontario Teachers' Pension Plan can proceed after the Supreme Court of Canada ruled in favour of the takeover. And the banks say they are onside to provide the funding.

“The banks expect that the transaction will close in accordance with the Definitive Agreement between BCE and the sponsors. We continue to negotiate the financing documents in good faith with the sponsors and stand behind our original commitment to the transaction,” said a statement from the banking group. It is led by Citigroup, and includes Deutsche Bank, Royal Bank of Scotland and Toronto-Dominion Bank. They have committed to provide the $32-billion of debt portion needed to fund this sale.

Bank financing can still run into problems but that is the most positive thing I have heard from the banks in a while.

Toronto lawyer James Morton, who represented some debenture holders at the original trial, said the top court clarified an area of securities law that had been muddied by the Quebec Court of Appeal.

“If the owners of the companies had to look after stakeholders such as employees and other people like that, it could have led to vast amounts of litigation and I'm sure that's one of the factors that made the Supreme Court decide the way they did,” he said in the marbled courthouse lobby after the ruling was released.

“The shareholders are the boss and remain the boss.”

If shareholders were not treated as the ultimate owners of a business, it would have seriously eroded property rights in Canada. Shareholders come first. Period. The only exceptions should be in some extreme case involving human rights, death, military secrets, or some such thing.

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Thursday, June 19, 2008 0 comments ++[ CLICK TO COMMENT ]++

A Quick Look at Sweet Light Crude vs Sour Crude Spread

A poster on the forum, DaveinHackensack, quoted a hypothesis of a poster by the name of MathAnalyst on the Yahoo message board. The author's guess was that the steep run-up in oil prices since 2006 was due to government regulations implemented in 2006 that altered the sulfur content. His/her guess was that this caused the increase in sweet light crude oil. The answer seems to be that the hypothesis is incorrect. Here is the original post, followed by my quick look into this:

MathAnalyst: So, why have crude oil prices risen so sharply since early CY-2006 - - - even faster than the rate of increase starting in CY-2001? Here’s my answer - - - which you won’t hear on CNBC, Bloomberg, Bill O’reilly or the Halls of Congress:

In CY-2006 the Federal EPA began to require the use of Ultra Low Sulfur Diesel (ULSD) having less than 15 ppm sulfur. To achieve this stringent requirement, the demand by refiners for light-sweet (low sulfur) crude oil began to rise, while the demand for the heavier-sour grades of crude oil began to fall. During this period, the total amount of crude oil being consumed in the US remained nearly unchanged, but balance between light-sweet crude oil and heavy-sour crude oil changed. The amount of ULSD produced in the US since Mar-2006 has risen by 2.9M BPD, or a factor 25. The net result being that the price of WTI began to rise on increased demand pressures. Furthermore, supplies of light-sweet crude oil are falling at about 7%/year - - - this also puts more upward pressure on prices. Hence, in my opinion, the rise in the price of WTI crude oil can be laid at the feet of the Federal Government – and NOT some group of “speculators” in crude oil futures as the Congress would like us to believe.

Of course, this is all just my technical opinion - - - the nice folks at CNBC may have a different take.

One quick way to test this theory is to look at the spread between the sour crude and light crude. If the sweet light crude with the lower sulfur was in higher demand, its price would have gone up much more than that of the sour crude. There are many types of oil but I looked at the Saudi Arabian crude (light vs heavy) prices availabe from the EIA website. Without being an expert in the crude types, I just picked those since they had a long-term history and, since Saudi Arabia has been the #1 oil producer, their oil prices represent world prices. Now, I have no idea if the Saudi oil is what USA imports (it probably isn't--I think the heavy stuff from there goes to Asia.) But that should not detract from the argument since we are talking about the world oil price anyway. Here is a chart showing the difference in price ($/bbl) and percent difference:

You can tell from the chart that the spread isn't unusual since 2006. Without digging deeper (perhaps into other types of oil), I see no reason to think that government regulations are primarily responsible for the oil price increase (they likely had some impact but it is probably minor.)

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Moody's Downgrades Ambac to Aa3 and MBIA to A2

As telegraphed a few weeks ago, Moody's just downgraded financial strength rating of MBIA insurance company from Aaa to A2, and Ambac Assurance from Aaa to Aa3. MBIA surplus notes were downgraded to Baa1, and the holding company rating to Baa2 from Aa3. Ambac's holding company rating was cut from Aa3 to A3. Click through for the details along with my comments...

Some interesting observations:

MBIA is cut one level lower than Ambac. However, as short-seller John Paulson has remarked at a Monaco hedge fund conference, Ambac is leveraged more to the residential real estate industry. This is primarily because Ambac is the biggest insurer of CDOs. But according to the stress tests from Moody's and S&P, MBIA is expected to post slightly higher losses due to HELOC/CES and commerical real estate exposure (Ambac has zero commercial real estate exposure.) Note that these agency numbers are purely theoretical estimates. MBIA also has slightly higher leverage as the following chart from FSA's 2007 presentation illustrates:

From a claims-paying point of view, the bond insurers have leverage similar to twice some of the highly leveraged investment banks (Bear Stearns was 25x to 30x or something like that). The bond insurers actually have some of the craziest leverage you will ever see in your life. Ambac, MBIA, FGIC, FSA, and even Berkshire Hathaway Assurance all have around 100x leverage.

By witholding around $900 million at the holding company, MBIA's holding company is strongly capitalized, and it can service its investment business better (this has nothing to do with bond insurance.) No doubt the short-sellers and their interests went livid upon hearing that MBIA was holding onto the money (for the time being) because most of the short-selling is done at the holding company level and bankruptcy becomes more of a remote possibility.

Moody's increased its estimated loss slightly. Moody's said that they increased their expected losses but the details are not clear. They also said that the portfolio amortization over the last 6 months cancelled out the losses. By doing nothing, the bond insurers lower their exposure and amortize more of their pre-paid earnings. This won't save the company from bankruptcy (since this won't make up for any huge loss) but it will pay for operating costs, lower the leverage, and so on.

Ambac plans to continue with its plan to capitalize a new insurance unit under Connie Lee. Ambac released a response to Moody's downgrade stating that. If I recall, Connie Lee is presently in run-off and is licensed in something like 40 states. I'm not a huge fan of this idea but it really depends on the details. I just don't want to see outside investors given lucrative deals that will harm the parent company in exchange for capital. Again, the short-sellers and others will be in the media bashing such a plan but if it can generate new business or if it can be used to re-insure downgraded muni bonds, I can see it working.

I'm going to quote a huge chunk of the press releases because I want to write it here for future reference (one of the reasons for starting the blog was to write down thoughts and reference key articles.)

MBIA Rating Downgrade

(source: Moody's downgrades MBIA's rating to A2; outlook is negative. Global Credit Research, Rating Action. June 19 2008. Moody's)

New York, June 19, 2008 -- Moody's Investors Service has downgraded to A2, from Aaa, the insurance financial strength ratings of MBIA Insurance Corporation (MBIA) and its affiliated insurance operating companies. In the same rating action, Moody's also downgraded the surplus note rating of MBIA Insurance Corporation to Baa1, from Aa2, and the senior debt rating of the holding company, MBIA, Inc. (NYSE: MBI) to Baa2, from Aa3. Today's rating action concludes a review for possible downgrade that was initiated on June 4, 2008, and reflects MBIA's limited financial flexibility and impaired franchise, as well as the substantial risk within its portfolio of insured exposures and a movement toward more aggressive capital management within the group. The rating agency said that while the group remains strongly capitalized, estimated to be consistent with a Aa level rating, and benefits from substantial embedded earnings in its existing insurance portfolio, these other business factors led to the lower rating outcome.

MBIA gets cut quite a bit. MBIA is getting downgraded primarily due to qualitative factors.

Based on Moody's revised assessment of the risks in MBIA's portfolio, estimated stress-case losses would approximate $13.6 billion at the Aaa threshold and $9.4 billion at the A2 threshold. This compares to Moody's estimate of MBIA's claims paying resources of approximately $15.1 billion. Moody's noted that its stress case estimates for MBIA's residential mortgage-related exposures increased by roughly $500 million to $5.9 billion, which was largely offset by insured portfolio amortization since year-end 2007. Relative to Moody's 1.3x "target" level for capital adequacy, MBIA is currently $2.6 billion below the Aaa target level and is $2.8 billion above the A2 target level.

Big cushion above A2 rating requirement so MBIA should be ok for a few more quarters (unless Moody's decides to downgrade based on some intangible factor again.)

The rating agency noted that MBIA's recent decision to retain at the holding company the $1.1 billion in proceeds from its most recent equity offering is indicative of a more aggressive capital management strategy, and is a negative credit consideration for the insurance company's rating. Such decision, however, puts the holding company in a strong liquidity position, said Moody's, providing additional comfort about the firm's ability to manage the effect of acceleration and collateralization in its GIC business triggered by the downgrade.

Ambac Rating Downgrade

(source: Moody's downgrades Ambac to Aa3; outlook is negative. Global Credit Research, Rating Action. June 19 2008. Moody's)

New York, June 19, 2008 -- Moody's Investors Service has downgraded to Aa3, from Aaa, the insurance financial strength ratings of Ambac Assurance Corporation ("Ambac") and Ambac Assurance UK Limited. In the same rating action, Moody's also downgraded the debt ratings of Ambac Financial Group, Inc. (NYSE: ABK -- senior unsecured debt to A3 from Aa3) and related financing trusts. Today's rating action concludes a review for possible downgrade that was initiated on June 4, 2008, and reflects Moody's views on Ambac's overall credit profile in the current environment, including the company's significantly constrained new business prospects, its impaired financial flexibility and increased expected and stress loss projections among its mortgage-related risk exposures relative to previous estimates. The outlook for the ratings is negative, reflecting uncertainties regarding the company's strategic plans going forward, as well as the possibility of further adverse developments in its insured portfolio.

Nothing surprising here...

Based on Moody's revised assessment of the risks in Ambac's portfolio, estimated stress-case losses would approximate $12.1 billion at the Aaa threshold and $9.6 billion at the Aa3 threshold. This compares to Moody's estimate of Ambac's total claims paying resources of approximately $15.4 billion. Moody's noted that its stress case estimates for Ambac's residential mortgage-related exposures increased by roughly $200 million to $5.6 billion, which was largely offset by insured portfolio amortization since year-end 2007. Relative to Moody's 1.3x "target" level for capital adequacy, Ambac is currently $225 million below the Aaa target level and is approximately $3 billion above the Aa3 target level.

It's never a pretty sight when shareholders get diluted massively (~66%) only to see a rating cut and $3 billion of excess capital. We paid a steep price. At least it gives a bigger cushion. I just hope that Ambac management doesn't fuck up and do something stupid.

Moody's will continue to evaluate Ambac's ratings in the context of the future performance of the company's risk exposures relative to expectations and resulting capital adequacy levels, as well as changes to the company's strategic and capital management plans as a Aa-rated company. Ambac has announced it intends to pursue opportunities in the public finance market through its Connie Lee Insurance Company subsidiary.

If anyone doesn't have enough topics to write about, they should follow the bond insurers. A day doesn't go without some form of action one way or another... If USA enters a depression, we are at the center of it; if not then this could be a once in a millenium investment opportunity (ok not really ;) )...

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