Saturday, February 28, 2009 0 comments ++[ CLICK TO COMMENT ]++

For oil bulls with high risk tolerance... Iraq

I'm bearish on commodities, including oil & gas, but many, including my readers, aren't. For those who are bullish and can tolerate extremely high risk, one area they might want to check out is Iraq. Report on Business magazine, The Globe & Mail's magazine insert, has an in-depth story of the activities of several Canadian oil & gas companies that are prospecting for oil in Iraq. I didn't read the full article yet but it's interesting.

It's quite obvious why Iraq is risky. The government is as unstable as the country. USA will be withdrawing from Iraq within two years according to Obama's plan. After the withdrawl, USA will be leaving behind a theocratic government*, and possibly a dysfunctional military and police apparatus. The legal system is questionable and property rights are uncertain.

Of importance to these oil companies, who are operating in the Kurdistan region, is the question of the legality of the contracts they signed with Kurdistan. It's not clear how the Iraqi government will handle the Kurdistan issue. The American government used to support the Kurds but seems to be slowly withdrawing support for them. I have no idea what is going to happen there but I have always said that if USA withdraws from Iraq, there is a possibility of a major civil war with the potential for Iraq to break into three. I hope that doesn't happen for everyone's sake but I am just a distant observer. I also hope that Iraq somehow strengthens their property rights and treats foreign firms fairly--not easily but fairly--because oil is one of the few hopes for the Iraqi economy.

Why is Iraq attractive if you are bullish on oil? Because it is one of the few regions of the world with under-explored territory with huge potential. It is also one of the few places where cost of extraction is likely to be really low, if you do manage to find oil (contrast this with Russia or Canada, which is very expensive, either due to the quality of oil or the harsh climate.) To see how amazing the oil potential is, consider how in some regions "...crude seeps to the surface on its own initiative." I'm not saying this is going to lead to a major find but it reminds me stories I read, referring to the period 70 years or 80 years ago, of oil literally flowing out of the ground on its own.

If anyone is interested in the potential for oil in Iraq, they can consider investing in one of the four Canadian oil & gas companies that are mentioned: Talisman (TSX: TLM, NYSE: TLM), WesternZagros (TSXV: WZR), Niko Resources (TSX: NKO) and Addax Petroleum (TSX: AXC). The Iraqi projects are obviously early stage and hence is super-high-risk. Basically, if you don't find oil, you go bust. But only WesternZagros is actually a pure play on Iraq. Talisman is one of the largest oil & gas companies in Canada with a market cap of around $12 billion, so it isn't a pure play on Iraq. Niko and Addax have market caps around $3 billion. Niko mostly operates in India and I'm not sure about Addax. WesternZagros is the junior that is pure-play on Iraq. It was spun off from Western Canadian Oil Sands, an oil sands company, and is a tiny company that trades on the Venture Exchange (basically a penny stock).

Anyway, thought some of you might be interested in these companies.

(* As a side note, I hate to get political but it is worth pointing out what the US government has done in Iraq. This has to be one of the greatest blow-backs in many decades. Not only did USA end up losing many lives on both sides, destabilize the region, and temporarily disrupt oil supplies, it ended up creating a theocratic state. Think about the irony in this for a minute. You have a hardcore Christian like George Bush, whose core supporters aren't a fan of anyone out of the Middle East except certain hardcore conservatives from Israel, ends up creating a theocratic state. The leading party in Iraq, the one that runs the government right now and will likely retain support for many years, is run by clerics. The Iraqi Constitution that was written with the aid of Americans was written by these clerics, and although I have not read it and am not a legal expert of any sort, I'm sure will not support liberties of any sort. I'm not saying Saddam Hussein was a virtuous leader that we should support. But Iraq wasn't run by clerics when Saddam was in power and it wasn't a theocratic state.)

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Wisdom from the Oracle of Omaha... Thoughts on Buffett's 2008 Shareholder Letter

I don't usually cover Warren Buffett's shareholder letters since it is covered in detail by almost everyone else. You are probably also better off reading some thoughts from some value investor or Berkshire investor than someone like me who doesn't really follow him closely. Nevertheless, the latest letter, the 2008 Berkshire Hathaway Shareholder Letter, is worth reading in order to get a feel for the thinking of Buffett in the middle of a major stock market crash. I also thought it was worth covering it on my blog given how he devotes a section to the monoline bond insurers.

As is generally the case on this blog, rather than summarizing his letter, let me present my opinion on some things I find interesting...

Worst Year Ever

Warren Buffett evaluates his performance of Berkshire Hathaway by looking at book value. I think this is the proper metric in the long run, especially since its holdings are not public, but short-term investors are probably correct in looking at share price performance. Ever since he took complete management control Berkshire Hathaway in 1965, this has been his worst year. Book value declined 9.5% in 2008. The S&P 500 total return was -37% last year versus a -32%.

Berkshire is a diversified conglomerate that is primarily an insurance company. It is far more diversified than a typical company, and since two of its core holdings are insurance and utilities, it is not highly correlated with the economy.

Quite a number of investors invest in Berkshire Hathaway, not for its holdings, but for the investing skills of Warren Buffett. On that front, it seems Buffett made some mistakes last year but I believe that he has set up some investments with huge potential in the future (all those covertibles for instance.)


Utilities are a huge chunk of Berkshire these days. I personally don't think they are attractive for small investors given their low returns (almost always capped by government) and lack of mispricing (generally efficiently priced by the market.) What is attractive about them, though, is that they are not correlated strongly with the economy. As long as the utility isn't overly indebted, it will see a continuous cash flow whether the economy booms or not. I found it interesting that Berkshire hasn't really extracted any wealth from their utilities in the last decade or so:

In our utility business, we spend all we earn, and then some, in order to fulfill the needs of our service areas. Indeed, MidAmerican has not paid a dividend since Berkshire bought into the company in early 2000. Its earnings have instead been reinvested to develop the utility systems our customers require and deserve. In exchange, we have been allowed to earn a fair return on the huge sums we have invested. It’s a great partnership for all concerned.

It seems Berkshire hasn't received a dividend from its utility holidng and instead reinvests all the earnings. This builds the business and likely increases its moat (utilities tend to be monopolies or oligopolies so their moat likely doesn't matter as much as if they were in a highly competitive industry.) I suspect that an arrangement like this cannot be pursued by many others. It requires very-long-term thinking and the ability of someone to invest billions without getting paid for a decade. It's like owning a non-marketable zero-coupon bond whose benefit you can't realize for a decade or more. How many can do that? Private equity or hedge funds would want to be paid back quickly and retail investors also would be impatient waiting a decade to be paid.

As Buffett remarks later on, this ability of Berkshire to behave this way shines a favourable light in the eyes of regulators:

In the regulated utility field there are no large family-owned businesses. Here, Berkshire hopes to be the “buyer of choice” of regulators. It is they, rather than selling shareholders, who judge the fitness of purchasers when transactions are proposed.

There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business, including a willingness to commit adequate equity capital.

Given how Berkshire Hathaway is very large and can only make big investments, utilities provide opportunities for it. Berkshire Hathaway is primarily an insurance company but it would be not surprise me if it ended up being mostly a utility in 20 years. Once Warren Buffett leaves, I suspect insurance operations, which are very complex and only a few understand, will lose their favour.

Subprime Mortages Aren't the Problem

Buffett clearly shows how subprime is not the problem with the mortgage crisis. Rather, it is the lending standards and the thinking of the borrower.

Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy.

Clayton’s 198,888 borrowers, however, have continued to pay normally throughout the housing crash, handing us no unexpected losses. This is not because these borrowers are unusually creditworthy, a point proved by FICO scores (a standard measure of credit risk). Their median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated “sub-prime.” Many disastrous pools of mortgages on conventional homes are populated by borrowers with far better credit, as measured by FICO scores.

Yet at yearend, our delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. (In addition to our originated loans, we’ve also bought bulk portfolios of various types from other financial institutions.) Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.

Why are our borrowers – characteristically people with modest incomes and far-from-great credit scores – performing so well? The answer is elementary, going right back to Lending 101. Our borrowers simply looked at how full-bore mortgage payments would compare with their actual – not hoped-for – income and then decided whether they could live with that commitment. Simply put, they took out a mortgage with the intention of paying it off, whatever the course of home prices.

I think this is an important point to discuss given how it seems that a theory is gaining popularity on the right that this was all due to subprime borrowers and the government, through Fannie Mae and Freddie Mac, were the cause. The fact of the matter is that, here we have a case where many of Berkshire Hathaway's subprime borrowers are actually paying off their mortgages. In contrast, we have a whole hoard of higher quality borrowers (some subprime but also Alt-A and prime) who are defaulting en masse.

The following is another point that is missed by many:

Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.

There are many bearish estimates that project losses simply based on upside-down home mortgages. Although some people will walk away in those cases, others won't. The ones that will likely default upon an upside-down mortage value are the speculators/investors and those that clearly cannot afford to pay--even if rates are low these two sets will walk away. The government, in my opinion, should try to help the at-risk borrowers who don't fall into these two categories from defaulting. It's easier said than done and I'm not knowledgeable enough about mortgages to know how you go about doing that. The easiest "solution" would be to strengthen the economy but I'm a free-market-type who doesn't believe the government controls the economy (they just influence it.)

Oh, one other thing... I keep saying this but it seems many still think that we are dealing with a subprime residential mortgage problem. I wish if it were only so. Instead, what we are facing is a credit bust. Although the subprime residential mortgages are a big part of the problem, we also have looming problems in commercial real estate, corporate debt, and even government debt (particularly in emerging markets.)

Adverse Impact of Government Intervention

It's commonly known that government intervention can result in adverse outcomes. That's why most of us who are free-market-oriented (although not to the same degree) like to keep government intervention limited. Buffett provides an example of how the recent government intervention threatens companies in good standing such as his firm:

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

This is an issue that I raised many months ago when the CEO of BT&T bank blasted the government actions. Needless to say, small banks like BT&T were disadvantaged while the megabanks were getting literally free money.

To be fair, it should be noted that Berkshire also benefits from government funding of some of its holdings. For instance, I have a feeling that Goldman Sachs and G.E. may have been very close to bankruptcy if it weren't for the cheap funding from the government. G.E. in particular saw the secrutization market lock up and it may have seen catastrophic losses without cheap funding from the government. So, although Clayton is hurt by the cheap financing of competitors, G.E. and Goldman Sachs would have been far worse off.

Having said that, I think Buffett's example can be used to illustrate the negative side-effects of government actions. This is one of the main reasons I am in favour of nationalization of failing firms, followed by the break up of such firms. Ideally, the failing firms themselves should break up on their own but the executives, directors, and shareholders seem unwilling to do that. All these failing companies need to be broken up and sold off. AIG, for example, has no business staying together as a massive conglomerate. Similarly, Citigroup's business model is dead and it'll be impossible to keep it together. I would even go as far as to say that Ambac, once the largest holding for me, should be allowed to fail if it can't survive on its own. It'll be painful for me and other shareholders but Ambac has no business underwriting bond insurance if it doesn't know what it's doing.

So far, I'm encouraged to see that Royal Bank of Scotland seems to have been taken over by the government. I also like how RBS seems to be retrenching back to Britain by selling off its foreign assets. I don't know if this is just for show but if it is genuine and is indicative of the start of a break-up, it will be welcome. Countries like Britain, Switzerland, Ireland, and others, may have some difficulty breaking up the banks since there are only a few banks in those countries. It should be far easier in USA where there are thousands of banks, many of them well-run and untouched by the subprime mortgage mess, that can buy off some of the assets.

Bond Insurance

Buffett has a section devoted entirely to monoline bond insurance (if you are interested start at page 13). Buffett actually says that the offer he made to the tainted monolines for the muni bond business, which was rejected, was way too high.

We would have charged a 11⁄2% rate to take over the guarantees on about $822 billion of bonds. If our offer had been accepted, we would have been required to pay any losses suffered by investors who owned these bonds – a guarantee stretching for 40 years in some cases. Ours was not a frivolous proposal: For reasons we will come to later, it involved substantial risk for Berkshire.

The monolines summarily rejected our offer, in some cases appending an insult or two. In the end, though, the turndowns proved to be very good news for us, because it became apparent that I had severely underpriced our offer.

Thereafter, we wrote about $15.6 billion of insurance in the secondary market. And here’s the punch line: About 77% of this business was on bonds that were already insured, largely by the three aforementioned monolines. In these agreements, we have to pay for defaults only if the original insurer is financially unable to do so.

We wrote this “second-to-pay” insurance for rates averaging 3.3%. That’s right; we have been paid far more for becoming the second to pay than the 1.5% we would have earlier charged to be the first to pay. In one extreme case, we actually agreed to be fourth to pay, nonetheless receiving about three times the 1% premium charged by the monoline that remains first to pay. In other words, three other monolines have to first go broke before we need to write a check.

I think Buffett's comment is misleading. He says that the offer made initially was too high. But that is only because the distress later on allowed Berkshire to write insurance at far better terms for already insured bonds. I doubt that if Berkshire Hathaway Assurance were to ramp up to the level of the portfolio he was offering to buy, he would have been able to charge high rates.

In terms of new business, it looks like BHAC has solidy taken the lead in the bond insurance business, with Buffett remarking: "In addition to our book of secondary business, we have also written $3.7 billion of primary business for a premium of $96 million." Roughly speaking that's a premium of 2.6% which seems to be a leverage of around 39. The market is in stress, with some even claiming that bond insurance is useless, so I'm not sure what the future holds. The $3.7 billion is very small by historical standards. It remains to be seen if BHAC will remain in the market. Although the probability of companies like MBIA or Ambac recovering seems remote, Jay Brown, CEO of MBIA, has remarked how Berkshire is a bit player and will leave the market when it becomes unattractive.

Muni Bond Insurance Very Risky

Buffett also presents a view that I hadn't seen being discussed elsewhere. Namely, muni bond insurance can end up being far riskier than it seems. There are a lot of people who talk about the potential for increasing municipality defaults and financial crises and that's not new. What is new, however, is the possibility of municipalities/states/etc seeking concessions from the bond insurers.

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace.

Buffett makes some great points about muni bond insurance. One problem he mentions is that many municipalities are going to have serious issues with pension obligations (as a aidenote, this is also problem for some corporations.) Unfortunately, baby boomers have been promising themselves way beyond what anyone can afford. This is something that will end, similar to how the pension plans of American automakers are going to be cut eventually.

The core problem that Buffett cites with muni bond insurance is a social issue tha I had never considered--and I suspect very few running any of these insurers have either. Bond insurers have faced serious problems in the past including the New York City debt problems, Eurotunnel default, and hurricanes Katrina and Wilma. But I don't think anyone has considered what Buffet is talking about. Namely, what if the municipalities/states/public-private partnerships/quasi-govt entities/etc simply refuse to balance their books without big concessions from the insurers? This is a serious threat to any insurer. I wonder what will happen. It's also not clear what the legal rights of insurers are in those cases. Something for management of bond insurers to think about...

Investment Mistakes & Successes

Although Buffett sold off a huge chunk of Johnson & Johnson (JNJ) and some Buffett fans were wondering if JNJ was a mistake, that seeems to have been to raise money to fund the Goldman Sachs, G.E., and Wrigley deals. Instead, the big mistake seems to have been ConocoPhillips (COP):

Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.

ConocoPhillips isn't going bankrupt but it does look like a mistake. Commodities are very volatile so who knows what will actually happen in the end but so far, the picture looks bleak. On top of declining commodity prices which will lower their profits, many commodity businesses, whether it is oil&gas companies or copper miners or natural gas producers or steel companies, are producing huge non-cash losses from writing off big chunks of their book value. Although it's a non-cash loss, these are still indicative of wealth destruction. Generally these write-offs are due to buying assets (land, mines, competitors, etc) at inflated prices in the last few years. Barring a strong recovery in the world economy, all these assets will end up being near-worthless and uneconomic. Commodity investors that rely on book values should pay careful attention and discount all the goodwill and other overvalued asset purchases in the last few years.

Buffett does say that he thinks oil will be higher in the future but I don't share that view. I can actually see it bouncing up and down but I don't think it will rise significantly enough to make a macro bet on it.

I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

LOL Reminds me of my Ambac investment, except it was a large holding of mine whereas Buffett's picks are very small for him. I'm surprised that Buffett got totally blown up with this. I remember looking at some Irish banks last year (I think I even mentioned it as worth investigating) but the macro situation was very flaky over there.

On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus.

I like these deals. I think he is setting himseful up for a win a few years down the road. Very reminiscent of his Gillette purchase in the early 90's. The macro outlook for financials is poor but I like the structure. He basically gets convertibles that allow him to profit fully on the upside, while the downside is somewhat limited. Even if we get stuck in a multi-year bear market, he'll do well (as long as the companies don't go bankrupt, which I don't think they will.)

The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

I think it's way too early to call it a government bond bubble but government bonds are certainly unattractive from a long term point of view.

Derivatives Are Dangerous

I'm not into derivatives but anyone interested should read his letter, where he devotes many pages to it (including Berkshire's derivatives bets.) What is interesting to me is his suggestion that the Black-Scholes formula, which is widely used to value options, misprices long-term options.

The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.


The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)

Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-Scholes formula now place on our long-term put options overstate our liability, hough the overstatement will diminish as the contracts approach maturity.

I wonder if this means that writing put options will end up being profitable in the long-run. I wonder if the same applies to writing call options. Anyway, I'm not into derivatives and likely won't ever use them (unless I work in this field or something.)

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Thursday, February 26, 2009 4 comments ++[ CLICK TO COMMENT ]++

Jeremy Grantham 4th Quarter 2008 commentary (Part 2)

Thanks to GuruFocus for pointing me to Jeremy Grantham's latest two-part commentary (4Q 2008). I can't remember if I covered part I before but I believe I did, so I'll just go over part II. Jeremy Grantham, for those not familiar, is a macro-oriented value strategist for GMO funds. I find his writing hilarious at times so it's always a fun read. I wish I had read his stuff 3 years ago (I dismissed him back then because he seemed like an extreme permabear--a big mistake on my part :( ).

Jeremy Grantham is one of the best macro thinkers out there (another great macro thinker is Marc Faber.) Unlike many other macro thinkers, he is very unique and comes up with insightful ideas. Most people, including me at times, cover the beaten down ideas of global trade, economic growth, bear market cycles, and so on. Grantham, in contrast, comes up with ideas that I haven't seen anywhere else. It is a sign of a great thinker!

Overall, he says that the high-probability investment ideas are gone and we are stuck with low probability ones. For example, the markets have historically overshot on the downside but whether the stock market falls another 15% is a low probability call. He says he has started to study, for the first time, the major busts (in the past he has concentrated on studying bubbles.) There is some really insightful stuff about value traps so if you don't have time, check out the first section.

(source: Obama and the Teflon Men, and Other Short Stories. Part 2. By Jeremy Grantham. GMO Quarterly Letter - February 2009)

(Underline within quotes are from original author. Bold within quotes are mine. Quoted text is messed up but I don't feel like fixing them up.)

The Year of the Value Trap

Grantham spends a section discussing his theory of value traps and why so many value investors fell into them. Being a fan of Bill Miller, I feel like some of Grantham's words describe Miller. I don't know if everyone would agree with Grantham's thinking but it's interesting.

I don't know how to cover Grantham's thoughts witout extensively quoting him but let me see if I can capture his words.

Since time immemorial, the most successful value
investors have been the bravest. The greatest advantage
of value investing has always been that when your cheap
stock goes down in price, it gets even cheaper and more
attractive. This is the complete opposite of momentum
stocks, which lose their momentum rating as they decline
and hence become unattractive.
But averaging down
in value stocks can take lots of nerve and considerable
ability in convincing anxious clients of the soundness of
the strategy. For at least 60 years, those value investors
who managed these problems and bought more of the
stocks that had tumbled the most emerged with both the
strongest performance and the most business success.


Outsiders could view this as a return to bravery, but it
was also a return to risk. The cheapest price-to-book
stocks are those deemed by the market to have the
least desirable assets. And Mr. Market is not always
a complete ass. Because these companies are so often
obviously undesirable and are seen as such by clients,
they represent a career or business risk to the manager
who owns them.
This career risk is usually reflected in an
extra discount that will deliver an extra return for bearing
the career risk. This “career risk” return is in addition
to the discount for buying lower quality companies with
more fundamental risk.
Problems arise when this pattern
of over-discounting and handsome recovery has taken
place dependably for several cycles in a row. It begins
to look like the natural, even inevitable, nature of things
rather than merely the most usual outcome. The growth
in the number of quantitative investors exaggerated this
tendency because quants model the last 10 or 20 years (or
even 40) without really requiring a full understanding of
the very long-term pattern and why it behaves the way
that it does. And none of us modeled data that included
the last great value trap: the Great Crash of 1929.

In mild economic setbacks, even the wounded value
stocks recover fully. In substantial setbacks, a very small
number fail, but not nearly enough to offset the large
discounts. Only in the really severe economic setbacks
do enough casualties occur to bring home a truth: priceto-
book (P/B) and price-to-earnings (P/E) are risk factors.

Buying them and averaging down routinely has an element
of picking up not nickels in front of the steamroller – that
would belittle the substantial returns – but, say, $1000
bills in front of the steamroller. Because of the extra
discounts for career risk in the long run (at least for those
who are not dead), the strategy will probably still pay off
even if the rare, severe fundamental crises are included.
But investors should be aware that the fundamental part
of the risk premium is justified by the pain of these outlier
events and is absolutely not a free lunch.

Jeremy Grantham is essentialy arguing that the classic value investing strategy of buying cheap assets is not free. I think some would disagree with that but many who followed that in the last few years will agree that it hasn't been a free lunch.

He points out that there is substancial risk in buying seemingly undervalued assets. It just so happens that very few faced a serious value trap since the last big one, at least according to what Grantham implies, was during the Great Depression.

The whole notion of a value trap scares the hell out of me. I have been thinking a lot about that for months. I think value investors, but more importantly contrarians of various stripes, should be really careful that the businesses they are investing in are not value traps. People have always talked about value traps--I even keep referring to them--but the value traps Grantham is referring to are the very serious once in a century type traps. You will also see below that many value stocks were a disaster during the Great Depression and, in fact, you would have been better off owning growth stocks such as Coca-Cola.

The value problems of the last two years were particularly
bad because of the outperformance that value stocks had
between 2002 and 2007. They won for five years in a row,
so that by mid 2007 the value/growth spread was about
as unfavorable as possible for value stocks in the U.S. ...

To put a measure on how awful the value trap was
during this time, please see the Fall 2007 edition of
the Outstanding Investor Digest. This publication
concentrates on a dozen or so of the top value investors
and is readable, interesting, and chock-full of insight.
However, that particular issue is a heartbreaker as one
after another of these superior investors put forward the
case that – down 30% to 50% – AIG, Lehman, Wachovia,
Fannie Mae, etc., were ridiculously underpriced, and
represented enormous long-term franchise value that the
nervous market was missing.

Unless you were a value investor that didn't invest in financials, a lot of value investors lost a fortune on financials. The unfortunate thing is that, unlike the momentum investors who made a killing owning many of these names in the prior 5 years (and hence had huge gains before that,) value investors tended to start investing after these stocks had been cut by a third or more, and they lost everything.

The following point is very important. Grantham points out how value stocks did poorly during the early stages of the Great Depression:

It has long been my view that the pricing of value stocks
has a folk memory of the Great Depression when many
cheap companies went bust and the expensive Coca-
Colas survived the best.
Remember, you cannot regress
from bankruptcy. Using proprietary research data, we
examined one fixed time slot: October 1929 to June 1932.
With no rebalancing, the data showed a massive “value”
wipeout in which high P/E stocks declined far less than
low P/E stocks.

When I say Grantham is often insightful, you can see what I mean. After all, how many people knew that high P/E stocks did better than low P/E during the 1929 to 1932 crash? I certainly didn't.

None of this is to say that one should avoid stocks with low valuations; rather, what it implies is that a lot value stocks can be major value traps and will end up bankrupt during severe recessions/depression.

Near Term Outlook

Whether 2009 will see a snapback for
value is an important question, and not one that we can
answer clearly. On the one hand, value stocks are now at
least much cheaper on a relative basis than they were a
year ago. On the other hand, they can get a lot cheaper,
and they face the worst economy since 1938. I would give
them at best a 50/50 bet this year. (“Thank you very much
for such useful advice!”)


I share similar views as Grantham. I think the market can drop a lot more but it is difficult to say whether it will.

Time to Research Busts

We at GMO have another problem: almost all of our
work has been aimed at the study of bubbles or upside
outlier events. Until eight minutes ago, the study of a real
bust seemed, in comparison, academic. Now, however,
we have thrown ourselves into studying the reverse. This
very morning – true story – I unpacked The Panic of 1819,
a new book by Murray Rothbard. As I write this at our
large and untidy breakfast table, I can see the recently read
The Forgotten Man by Amity Shlaes. It is a book about
the plight of working men and FDR’s erratic experiments
with stimulus programs in the Great Depression. At
GMO, we are now in full-court press mode, studying
the patterns of economic and market lows and looking
for predictive clues (with luck, see next quarter’s Letter).
But this is a relatively new effort after spending 12 years
studying bubbles. Ah, well. Of course, this is all written
assuming that we are indeed heading to extremes of

Grantham is a professional and far more knowledgeable so his reading material is way beyond me. I'm just a newbie but I'm also doing a similar thing by reading books like The Anatomy of the Bear.

Given the massive destruction in wealth, I suspect we will see further declines, or a prolonged, mild, bear market. As I have said before, don't spend all your capital with the assumption that the bull market will start soon. It could, but if it doesn't, you would be stuck owning assets that may get much cheaper.

The Lack of Ethics

Grantham has a section on the weak ethics exhibited by those in the investment world. I'll just quote his words about Madoff:

Certain European private banks, for example, charged
a substantial fee for investing their clients’ money with
Fairfi eld Greenwich Group, who, in turn, charged a lot
to invest with Madoff, who actually did the “work!” At
least Madoff had the decency to waive his fee. Settling
for the principal was enough.
You could call this a fund
of funds of funds of Ponzi.

LOL ;)

Perhaps the investment industry never had ethics but it certainly has very little these days. When this is all said and done, it would not surprise me if investment bankers, portfolio advisors, hedge fund managers, et al, were looked up unfavourably by the public.

Bullish on High Quality US Stocks

But our biggest bet
recently has been on quality stocks in the U.S. – a bet on
the great franchise companies. Our U.S. Quality Strategy
became more than 90% of our U.S. equity money in our
Global Balanced Asset Allocation Strategy. And 50% of
the quality stream was injected into our venerable U.S.
Core Strategy. This was the fi rst important override of our
U.S. quant model in its 29-year history!

As I have referenced before, Grantham expects, over the next 7 years, high quality US stocks to outperform small-cap, mid-cap, low quality, and various other asset types (the only ones that beat high quality US on his forecast model are emerging markets.)

More Opportunity in Asset Allocation

Asset allocation is simply much easier
than adding alpha to a fund, since there is more to sink
your teeth into. Counter-intuitively, asset classes are
more inefficiently priced than stocks.
There is a large and
relatively effi cient arbitrage between stocks, and the career
risk of picking one stock versus another is quite modest.
In contrast, when picking one asset class against another,
it is painfully clear when mistakes have been made. This
immense career risk makes it likely that there will always
be great ineffi ciencies, for investors are reluctant to move
money across asset boundaries. Consequently, there is
great advantage to be had in getting out of the way of
the freight train, rather than attempting to prove your
discipline by facing it down. The advantage is in both
higher return and lower risk.

Grantham says that it is easier to outperform by switching between assets, than if you just switched between stocks. I think this applies more to institutional investors than small investors. The problem for small investors is that we generally don't have enough knowledge about non-popular asset classes (like emerging market bonds, timber, foreign stocks, etc) and the cost is very high. For instance, I have been looking at buying some junk bonds and it's really tough to get a good price.

In any case, ignoring some specific debt (loans/bonds/etc) (such as mortgage bonds or select corporate bonds,) I suspect that stocks are more attractive than the rest. I don't think we need to concern ourselves with asset allocation right now, even if we were able to invest in other assets easily.

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Wednesday, February 25, 2009 2 comments ++[ CLICK TO COMMENT ]++

Secular stock market cycles & Ten year rolling returns

Crestmont Research publishes some excellent macro-oriented documents on their website. I typically hit their site once or twice an year and, I have said this before but, I'll reiterate my recommendation of their 100 year S&P stock market return matrix. The best thing is that all this is free :) If you are macro-oriented, I recommend reading all the documents on their site. One may not necessarily agree with their thinking but it covers the main bases of macroeconomics pertaining to investing.

Given how we are going through a nasty bear market, I pulled some tables/charts that are highly relevant right now. One of them deals with secular bull and bear cycles, while the other is about 10 year rolling returns.

Secular Bull & Bear Markets

The table below, extracted from Secular Bull & Bear Markets presents secular bull and bear markets (as defined by Crestmont) over the last 108 years.

Everyone has their own way of defining bull and bear markets and nothing is ever perfect. This table uses the DJIA average, which some consider seriously flawed and not worthy of study, and excludes dividends, which tends to be a big component of total return. In any case, all this is just a rough reference and it's good enough for me.

I always like looking at this because it presents all the key information--DJIA return, P/E values, price inflation, starting/ending DJIA level--in one easy to analyze table.

You can easily see the worst bear market in history (1929 to 1932) which resulted in the Dow dropping from 300 to 60! Yikes! Another disastrous one, possibly the 2nd worst bear market of all time, is the 1901 to 1920 (I believe this bear market started in the late 1800's but this table only starts in 1900.) In this bear market, the Dow started at a level of 71 and went to 72. In 20 years! Yes, the price index didn't go anywhere for 20 years, although dividend returns, which aren't captured in this table, would have yielded some return (even if you included dividends, real returns would have been horrible given the high inflation in the late 1910's due to WWI--you can see the high price inflation numbers in the table.)

The longest bull market is from 1942 to 1962--the post-war boom. The bull market with the most cumulative return is the one from 1982 to 1999. However, unknown to most people, is the #1 bull market of all time: 1921 to 1928. Not only did you post an annualized return of about 18% (without even counting dividends,) it was with periods of severe deflation so the real return were unbelievable. Think about how big the 1920's returns were: Warren Buffett, possibly the best investor of all time, has a long term return of around 20% per year. Yet, the broad market returned 18%+dividends in the 1920's. If the market was around 18%, I'm wonder what superinvestors of that era were earning. Roaring 20's they called it.

Coming to the present, there is some good news. Our current bear market, which this table assumes started in 2000, is past the average bear market length. If the bear had gone into hibernation in 2002, it would have been one of the shortest in history. But given the huge collapse last year, most of the pain is past us. But--yes there is always a but--the P/E ratios are way too high. Interest rates are much lower and inflation is likely to be low so perhaps a higher P/E is warranted. Nevertheless, the high P/E indicates that we don't have a clear buy signal. This is one of the reasons I keep saying that 'stocks are attractive but not exceptionally cheap.' All prior bear markets have had much lower valuations. Unless you come up with some 'this time it is different' theory (such as arguing that more people invest in stocks and this pushes up prices, or the argument that other assets are less attractive than stocks so people will pay more for stocks) there may be more downside. The presently high P/Es, even after the massive decline over the last 8 years, shows how much of a bubble we had in the 1990's.

10 Year Rolling Return Breakdown

The following chart illustrates the 10 year rolling total return (from Stock Rolling Returns by Crestmont Research):

The 10 year rolling return is the return you would have had if you were invested for the prior 10 years. The average 10 year rolling total return is around 10%. From the top chart, it seems that 10 year returns rise after hitting a return of 3% or less. If you buy when the prior 10 years yielded around 3% or less, you are likely to end up with more than 5% returns in the future.

The good news for us is that the current 10 year rolling return is below 3%. There is no guarantee that this year's or next year's returns will be positive, but it is likely that returns in 5+ years from now will be higher than 5%. This further confirms the point, made in the prior secular market section, that the worst is likely behind us.

(As a side note, you'll realize how powerful the bull market in the 1920's were by noticing that the rolling 10-yr return was actually positive in 1932 or 1933--even after the massive decline from 1929 to 1931! The rolling return only collapsed in 1937 or somewhere around that--this would be the case for those unfortunate enough to start investing in 1928, 1929, or possibly 1930.)

The botton chart illustrates the various components that contribute to returns: change in valuation (P/E in this case,) dividend yield, and earnings growth. A huge chunk of the return in the 80's and 90's was due to an increase in valuation (P/E went up) and this is reversing. The P/E contraction will likely continue for many years (as mentioned in the prior section, the P/E is still way too high compared to the past.) If you look at the chart, you'll also notice how there were always multiple red bars in prior bear markets. It is unlikely that the P/E ratio will stabilze or start increasing this year or next.

The most important question is whether dividend yield and earnings growth will compensate for the P/E contraction. If they can't, we are looking at a nasty bear market where losses will bleed you dry.


I hope all of you enjoyed the information and my commentary (thanks to Crestmont Research for providing the tables and charts.) I have uttered a lot of seemingly contradictory comments but it all makes sense. The stock market is not excessively cheap and therefore we will get conflicting signals. If, however, the market does become really cheap then I'm sure differing macro signals will be consistent with each other. It should also be noted that we don't have enough data points so the results aren't exactly statistically meaningful.

None of what I have presented implies that the market will necessarily decline further. I personally think there will be further declines (already we are down 10%+ this year) but most of the severe bear market correction has likely occured (barring some crazy event like war or something.) Since I tend to be conservative--not with my stock picks but my macro stance--I feel better hanging out with the bears rather than the bulls. If you are a stockpicker, right now is an excellent time to consider buying, or at least researching something. I do think it's worth keeping some capital available since valuations may drop far below what one may think is likely. Come up with and research a bunch of dream stocks that are overvalued and put them on your watchlist.

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Bruce Berkowitz thoughts on Sears

In his recent conference call with shareholders and fundholders, Bruce Berkowitz had some thoughts on Sears (transcript here; audio here.) I haven't mentioned Bruce Berkowitz before on this blog--at least I don't think I have--and FYI, he runs the Fairholme family of value mutual funds. His recent record won't show it but he has been quite successful over the years. He is one of the few value investors who avoided overloading on financials. Presently, on top of some legacy positions, he seems to favour healthcare and defense. His core investing strategy seems to rely on looking at free cash flow. He is one of the few bulls on Sears and here are his thoughts on Sears:

Bruce Berkowitz:

What are the – next question, what are the top successes of Eddie Lampert’s
track record as a capital allocator? (Our key) is rather wide. How do you get
comfortable with his ability for much of what he does and his hedge fund is
not public?

Well, we – Eddie Lampert’s overall record is still quite deep and I don’t know
you know that paper trail is important, but what’s most important to us is
studying, see his balance sheet, its liquidation value. I have a whole bunch of
more question on Sears that are coming a little – that – (of to an) answer and
we go into a bit more detail. But we’ve always shares based upon its
liquidation values and always thought that we were buying below liquidation
values and we shall see. I still believe that Sears is quite reminiscent of
Berkshire Hathaway’s days with the – with Warren Buffet’s days, I should
say, with the Berkshire Textile Mills and that inflection point, that point when
we decided it was time to move on and reallocate the cash to more productive
uses. There’s nothing I see at this point which tells me that will not happen at

I don't think one should invest in Sears with the expectation that it is going to be like Berkshire Hathaway in the 70's. However, Berkowitz is correct in pointing out that, if Sears is able to produce cash flow anywhere near it has in the last few years, it can re-deploy it into better things. At worst, knowing that Edward Lampert is a good capital allocator, the cash can be used to buy back shares.

Bruce Berkowitz:

Moving on to Sears, could you explain how you have tried to kill Sears and
could not? For example, how long can Sears whether the poor economic
conditions, which may persist for the next two, three more years? When for
the next few years – how can they pay their annual interest payments of 300
million a year, plus meanwhile annual revenues of 50 billion in operating
income off 0.5 billion? Well $50 billion, even of declining revenues, is quite
a significant amount of revenues and so is an operating income of 1.5 billion
with only 120 million shares. Also, when you take a look at the company’s
balance sheet, and we really have truly assessed Sears based upon its balance
sheet, you’ll see over $10 billion of inventories, payables, four-and-a-half
billion – I mean just the inventories alone equal the price of the stock. If you
want, cut it in half. We haven’t even gotten to real estate, Kenmore,
Craftsman, DieHard, Landon, the brands, cash on the balance sheet.

In 2008, Sears had operating cash flow of around $1.5 billion and around $1 billion free cash flow. It is likely to decline for the next few years but it's not clear what would be sustainable long-term cash flow.

On the bullish side, you have the argument that profits are depressed due to the housing bust and the weak economy. Bulls argue that long-term normalized profits will be higher.

On the bearish side, the argument is that, even though the earnings may be depressed, Sears may be underspending on capex. Some claim stores aren't maintained properly and brand value is eroding by the day. If this is true, what seems like fairly high free cash flow is actually an artifically high free cash flow.

Bruce Berkowitz:

Has our evaluations of liquidation value declined in this environment? The
answer is yes. Is it still dramatically above where Sears is trading today? The
answer is yes.

The collapse in commercial real estate, along with tight capital availability, ensures that the liquidation value will be much lower now than at any point in the last 5 years.

Bruce Berkowitz:

Question, can Sears pay off their debt? Can they refinance at reasonable
terms? I think – I think the answer to both questions is yes and if Eddie
Lampert has any difficulties I think he should call Fairholme cause we would
be willing to help him at the right price.

And let’s see. If Sears retires a debt, but stops or curtails stock buybacks,
what happens to the stock price when Sears can’t fend off the short-sellers?
Well, probably if the short-sellers are still there it goes down. And I think – I
hope the stock does go down because it will be to our long-term benefit. I
mean after all, when you take a look at the $500 million chunk of cash he’s
using to buy back stock, that half-a-billion dollars goes an awfully long way at
$40 per share.

I haven't looked deeply but Sears doesn't seem to have much debt maturing for a few years. But it does have a big revolving line of credit which may be cut if Sears doesn't meet creditor requirements. I don't think financing will be a problem--Sears is one of the few retailers with a good balance sheet--but it all comes down to how low earnings will end up being during the worst part of the recession.

I always cringe whenever someone says that collapsing price is good because one can buy more at a cheaper price (Jim Rogers is famous for saying this about commodities.) Unlike fund managers or wealthy investors, small investors like me don't have a continuously flowing fountain of money that can be used to average down. Declining prices also causes psychological issues because newbies like me start doubting the analysis whenever prices decline. I have mostly been a concentrated investor who avoids income producing assets but I'm thinking of pursuing a strategy of investing in income producing assets, so that I can use the income to fund future investments. It won't be much but it will provide the ability to average down.

Bruce Berkowitz:

One other question, how will you know when Eddie Lampert reaches the
point where you have to sell the underlying real estate at distressed prices in
order to prop up the retail side of Sears? Wouldn’t it be wise to meet with
Lampert to get a sense of whether he actually has a turnaround or asset sale
plan? I guess we’ll know when he sells, but even when he starts to sell, we
always say that they’re going to have to be careful. I mean the real estate
probably very much matches up with some type of – and in our opinion is
correct – some type of 80/20 rule, where you have 20 percent of the real estate
is very, very valuable, even today, and 80 percent may not be as valuable as
some might think.

In terms of meeting Eddie Lampert, it’s probably a good time, but it – just like
Buffet though, I think if you – if you – if you read his letters, if you go
through the queues and the news releases, I think he pretty much tells you the
plan. And the plan does match up in my mind, again, with how Warren Buffet
behaved with the Berkshire Textile Mills.

I don't know much about Edward Lampert given how he runs a hedge fund and nothing is public. However, he does seem like a clean character (for the most part) and I think his thinking captures some of the key concepts Buffett has promoted. I don't like the fact that he is so secretive (doesn't even have an investor relations site accessible to investors) but he seems better than many other successful hedge fund managers.

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Ambac announces 4Q 2008 results

Not surprisingly, Ambac announced a massive loss for the 4th quarter (you can access the presentation here):

Ambac Financial Group, Inc. today announced fourth quarter 2008 net loss of $2,340.8 million, or a net loss of $8.14 on a per share basis. This compares to fourth quarter 2007 net loss of $3,273.9 million, or net loss of $32.03 on a per share basis. The fourth quarter 2008 results reflect ($594.4) million net change in fair value of credit derivatives.


Quarter Summary

  • The deferred tax asset valuation allowance amounts to $2,053.0 million at December 31, 2008, representing an increase of $1,534.0 million from September 30, 2008. Over the past 24 months, Ambac has recorded significant mark-to-market losses on its CDS portfolio and has incurred losses in its insured RMBS portfolio...

  • Net loss provisioning of $916.4 million was recorded for the quarter primarily relating to the RMBS insurance portfolio. The quarterly provision was offset by a benefit resulting from an increase in estimated recoveries from substantiated representation and warranty breaches in certain second-lien RMBS transactions.

  • Net change in fair value of credit derivatives amounted to ($594.4) million. However, estimated impairment losses in this portfolio did not change significantly. As previously announced on November 19, 2008, four CDO of ABS transactions with an aggregate of approximately $3.5 billion notional outstanding were settled with counterparties in exchange for a total cash payment by Ambac Assurance Corporation (AAC) of $1.0 billion.

  • As previously announced on November 6, 2008, Ambac received approval from the Wisconsin Office of the Commissioner of Insurance (OCI) to utilize the resources of AAC to resolve the ratings-driven liquidity gap in the financial services business and, as of this date, all collateral requirements of that business have been met

It's complicated to figure out the reality of the situation, given the multiple moving parts. If I'm reading it correctly, Ambac posted almost $916 million of actual losses. It's not surprising given the collapse in the economy in the last quarter but it's terrible news for Ambac. No sign of stabilization in anything--all this without potential future losses from auto loans and corporate loans in the future. Ambac is very close to being insolvent.

Management's focus seems to be to get its public finance bond insurer, called Everspan, up and running. Unlike MBIA, Everspan will be a subsidiary of Ambac Assurance (rather than the holding company.) This is not good news for shareholders but it may not matter as much in the end. I'm skeptical and have leaned towards a complete shut down and run-off the company, so I don't think it matters whose subsidiary Everspan ends up being.

I have extracted some useful slides from their 4Q 2008 Financial Highlights presentation below (all slides from Ambac and current as of February 25 2009.)

Cumulative Losses

It's dissapointing, although not surprising, to see the losses keep mounting. There is some work done in commuting some deals but one cannot count on them. We need to see losses stabilize and that hasn't happened. I have been completely wrong on expecting losses to stabilize (not surprising given how I was expecting a 20% decline in home prices and that will end up being optimistic--home prices look like they will drop between 35% and 40%.)

Current Insured Portfolio


Most of the insured portfolio is still investment grade but the BBB and BIG components, most of it in HELOC and CES, are a huge risk. Monolines insured with very thin margins and small changes wipes out everything.

Direct RMBS

I remember mentioning many months ago that Ambac will likely go bankrupt or survive based on the performance of HELOC and CES. As the economy worsens (although it's possible the economy will start improving, slowly, this year) greater losses are possible. The only minor positive, if any, is that most of the downgrades related to direct RMBS may have already occurred (the ratings shown are Ambac ratings but I suspect it'll be similar to rating agency ratings.)


This chart clearly shows how toxic the CDOs were. What strated off as being rated as AAA, AA and A (these are Ambac ratings but rating agency ratings will be similar) have completely dissapeared. Practically all the CDOs are BBB or Below-Investment-Grade right now. It's difficult to say how bad the losses will be since they are paid out over a long period of time (discounted value may not be as bad.)

CDO (excluding CDO of ABS)

The high ratings imply no problems so far. I wouldn't be concerned as much with corporate loans. Some are probably questionable but corporate balance sheets of non-financial firms in America are relatively strong.

Student Loan ABS

As Ambac says on the slide, almost half is backed by the government. The rest are questionable but manageable.

Auto Loan ABS

A lot of auto ABS are BBB but they were originally BBB as well. This, hopefully, means that Ambac priced them with a bigger margin with an expectation of some defaults. In contrast, many mortgage bonds were rated AAA and were priced as such, which obviously turned out to be a huge mistake. Autos also depreciate so we never had the situation of pricing the asset as if it would appreciate--a key problem with mortgage bonds.

Payment Schedule

The above chart outlines the payments that Ambac expects to make over the next 50 years or so. There are some large payments related to HELOC and CES that need to be made within 2 years but the rest will occur decades from now. (I haven't looked up why there is a negative payment in 2011.) As I have mentioned several times before, monoline bond insurers are special type of business that can become insolvent long before they are illiquid. These insurers can stay alive, paying out claims as they come due, for 50 years even though the company has gone bankrupt.

Adjusted Book Value

Ugly numbers but it all comes down to the degree of reversal in the mark-to-market losses.

Tuesday, February 24, 2009 1 comments ++[ CLICK TO COMMENT ]++

Dubai bubble bursts

Dubai, Glitters in the Arabian Night
(source: Original source unknown. Downloaded from CIV1120)

Looks like the real estate bubble in Dubai has burst. On top of some real estate builders running into problems, it seems that consumer defaults are rising:

For the UAE, a country more accustomed to the upward side of the economic curve, this is unchartered territory. The country has had few dealings with the bankruptcies and bad debts that follow financial storms, as demonstrated by the UAE's opaque insolvency legislation. Worse, banks are unsure how to deal with loans racked up by expatriates during boom-time, which are now looking increasingly shaky.

Across the country job losses are mounting as the real estate market flounders. In December, Dubai state-backed developer Nakheel made 500 of its staff redundant. Dubai-based Damac Properties has cut 200 jobs while Al Shafar General Contracting has laid off 1,000 workers.

Outside the property sector redundancies have also been felt with Dubai's Shuaa Capital cutting 21 jobs and Dubai World shedding 100 of its staff.

Many expatriates have since been left high and dry with significant debts.

In recent years the UAE's rapid inflation has outpaced wage growth, while a housing market that typically demands tenants pay a year's rent in advance has forced many residents to take out personal loans.

At one point, Dubai had 30,000+ construction cranes--and this, for a single city.

(source: Image posted by Iraqeya at AliIraqi)

This might be the end of the boom in Dubai for the time being. However, I don't think all is lost and think that Dubai has permanently taken a place in the world. Although many billions will be lost on the bust, Dubai will end up with physical infrastructure that can be used for decades. The following image shows how Dubai has gone from an outpost in the desert to a vibrant city.

(source: Image posted by Iraqeya at AliIraqi)

If political problems do not arise, and if Dubai keeps liberalizing and opening up, I suspect it will become like Singapore. Not my idea of a nice place to live but many wealthy people, as well as many conservatives, will love the place... All this is assuming it doesn't implode as the real estate projects fall apart in the near future.

An Unfinished all Real Estate Projects Are

(source: Image posted by Iraqeya at AliIraqi)

Monday, February 23, 2009 0 comments ++[ CLICK TO COMMENT ]++

We know when we are facing a massive consumer credit bust when...

Credit card companies--American Express in this case--pay people to cancel their credit cards:

American Express Co. is offering a $300 incentive for customers to cancel their accounts as the card issuer grapples with surging loan delinquencies and soft card-member spending.

The company is offering a $300 prepaid card, which can be used anywhere American Express is accepted, to certain customers who pay off their entire balance between March 1 and the end of April. Enrolling in the deal automatically cancels the customer's account, regardless of whether he successfully pays off the balance.

It only applies to select customers but we can be sure that they are high risk credit card users. Something like this would have been unthinkable two years ago when it seemed like every company was handing out credit cards to anyone that wanted them.

The contraction in consumer credit is inevitable--consumers are the weakest link in America and Canada--and financial profits will decline materially over the years. If you are thinking of investing in a business, try to figure out how much of the profits are actually financial profits. These may not exist 5 years from now. The market is re-pricing everything--G.E. isn't down 60% because of insolvency risk but because its huge financial profits won't be there in the future--but some companies may still be overvalued.

Sunday, February 22, 2009 4 comments ++[ CLICK TO COMMENT ]++

Gold vs Stocks... The end game is near

(source: Lustre lost, Market.view, Feb 22nd 2009)

The graph is disarmingly simple. It simply shows the ratio of the Dow to the gold price since 1920. As can be seen, there have been three clear peaks in this ratio: in 1929, in the mid-1960s and in 2000. And it also shows three lows: in the early 1920s, in the 1930s after the crash and around the time of gold’s record high (in real terms) in 1979-1980. At those lows, the Dow and gold were almost equal.

With gold flirting with $1,000 per ounce, could we be headed there again? A Dow/gold ratio of 2 would imply the former falling to 2000 or the latter rising to $3500 an ounce. Enormous profits would be made by those who got this call right.

-- Buttonwood in Lustre Lost, The Economist

The above, from a nice article by Buttonwood of The Economist, summarizes the 90-year performance of gold in relation to stocks. The above chart is a popular one that is used by many to gauge the attractiveness of gold against stocks. It is not signalling good things for gold bulls.

Before we go further, as the article points out, there are many flaws with that chart such as the fact that it doesn't account for dividends (stocks would crush gold's returns if you compared total returns) and the fact that stocks of a growing economy should be upward sloping whereas there is no reason for gold to continuously rise (notwitstanding goldbugs' accusations of money printers populating the central banks of the world ;) ).

Given how this is a ratio chart and both the numerator and the denominator can change, it is the type that is almost useless in the sense that bulls and bears will come to different conclusions from the same chart. For instance, one may argue that the Dow is going to fall signficantly while gold stays the same so buying gold is a very good idea. Conversely, one can argue that the chart seems to be nearer the bottom than the top hence going long stocks and shorting gold is a better idea. I share the latter view and am in the gold bearish camp.

The way I look at that chart, gold is neither cheap nor is it out of favour. Gold should have been bought in the early 2000's. I do see gold going up while stocks decline a bit further. However, I feel that one thing is certain: one going long stocks right now will likely beat one going long gold in the long run.

It's too early to be bearish on gold; it is also too late to be bullish.

Regardless of whether one is bullish on gold or not, I suspect everyone will agree on one thing with Buttonwood: enormous profits are to be had for those getting this call right.


Last decade almost as bad as during the Great Depression

Although it may not seem like it, especially if you only started investing a few years ago and missed the 2000 crash, as I did, but, in real terms, the last decade has been as bad for stock investors as the 10 years subsequent to the stock market crash of 1929. Michael Mandel of BusinessWeek produced the following chart (accompanying article here):

The chart plots the 10 worst years of the 1930's against the last 10 years. Both periods involved a 50% decline in stocks. It's not clear to me if this is based on a price chart that excludes dividends but I imagine the picture would still be similar with dividends.

Looking at the chart, it seems that the vast majority of the suffering, at least for stock investors, is likely out of the way. The Great Depression was far worse for America than the current econmic crisis yet the stock market crashed almost as much in the last decade.

But there is a bearish undercurrent that needs to be considered. One should be careful with these comparisons because the starting point matters so much. The stock market was far more overvalued in 2000 than it was in 1929! Therefore, even though both markets, the 30's one and the present one, dropped 50%, it is possible that the current market may decline much further. Other measures, such as the 10-year P/E ratio or (the formerly high) corporate profit margins implies that the market can drop much more (one can also argue that the market can overshoot on the downside but that's more of a speculative macro reasoning than anything founded on real numbers.)

The way I am approaching the environment is to assume that we will be in a bear market for several years--this may mean sideways market rather than further declines--and take my time picking some solid companies. No need to rush. Also, unlike the past 10 years, large-cap and mega-cap stocks are somewhat cheap so one doesn't have to wander off into the wild jungles of small-caps and microcaps (although the smaller ones that survive will produce far greater returns.) I also don't think contrarians necessarily need to be looking at distressed or beaten-down stocks. You may recall how I looked at distressed sectors like forestry, newspapers, autos, banks, and Japanese stocks, over the last two years but one can move up the value chain if they want.

One thing that should be said is that, some articles say that a big chunk of the market return is based on a few months, or even days, of appreciation. This seems to have been the case in 1933/1934 and 1975. You saw huge gains within an year of the bottom in 1933 and 1974 and then the market sort of bounced around in a range after that. My strategy is not based on picking the bottoms--leave that to the traders and technical analysts--but it does imply that have some exposure to the market at all times is a good tactic. I'm not talking about having market exposure for the sake of having exposure but, rather, picking a few good stocks and investing early even if the future may look poor. Perhaps owning some undervalued dividend-paying stocks may fit into this thinking.


Moody's predicts junk bond defaults hitting 16% by end of 3rd quarter

I'm still thinking of investing in high yield bonds. I'm not sure if I can do it in an affordable manner (brokers seem to require very high minimum investment and chart very high commissions--do note that I'm only talking about attractive illiquid bonds.) My thinking is that the credit markets may lock up again when governmenats nationalize banks and bondholders end up with losses. I'm thinking that is a good time to buy. But this is pure speculation and I may be missing out on an opportunity (yields have fallen significantly from December.)

Research Recap summarizes a report from Moody's stating that it expects a 16.4% default rate for junk bonds by November 2009, compared to 4.4% in 2008 and 1% in 2007. That's a huge jump and it goes to show why one should not draw much conclusion from the 2004-2007 time period. In fact, it is outright dangerous to use a chart like the one shown on that blog entry, and look back a few years in order to gauge valuation. Risk premium was so low a few years ago that I would consider that chart completely useless. I would want to take that chart back to the 1930's or if not possible, at least the early 80's and pick up the 1982 recession.

Moody's also says that $190 billion of speculative bonds need to be rolled over in the next 3 years. This doesn't seem as bad as the situation in Europe (although I'm not sure how much of the European bond threat is from speculative vs investment-grade) but it is still a big risk.

Canada's Financial Post also had a story a week ago covering the high yield bond environment:

The Merrill Lynch High Yield Constrained index is yielding 17.9% annually, up from a 52-week low of 9.87% in 2008. The index was priced for outright disaster back in December when it hit a high of 24.9% before spreads came in slightly. Yields have eased from white-knuckled induced highs but risks are clearly elevated, to put it mildly.

The simple math says that an 18% yield on an index of high-yield credits is easy money. A 16% default rate and 50% historical recovery of assets on those defaults translates to an 8% loss of capital this year and plenty of room for profits.

"We really don't know how high default rates will get," says Ben Cheng, veteran portfolio manager and President, Aston Hill Financial.

"Moody's default prediction is a best guess, but at the end of the day maybe default rates get to 20% or 25%," says Cheng.

One problem with the simple math is that historical rates of return have misled investors into complacency leading into this crisis. Critical analysis suggests that recovery rates in default situations will be much lower than in the past. If the typical creditor recovered 50% to 60% of assets in the past, those numbers could fall closer to 20% on current defaults.

There are two reasons why recovery rates will be lower than in the past. The first is that companies issued bonds with very light covenants at the expense of bondholders who invested with a herd mentality. Worrying about default protection seemed frivolous to bond investors only too happy to collect record low coupons.

The second reason is that defaulting companies have less access to capital needed for creditor protection. The cold calculus is that liquidations will be higher and creditor recoveries lower.

I have said this several times before but it's worth reiterating two points. Although yields are high, raw yields are still not extremely high. Analysts who keep referring to the opportunity being better than the during the Great Depression are only looking at spreads (against US Treasuries.) The spreads are very wide and higher than during the Great Depression (the junk bond market wasn't large and didn't really exist back then so analysts just use a rough comparison.) If you are an amateur investor, all you care about is the actual yield. The spread is very high but it is possible that US Treasury yields are too low (I don't buy this view but many think that US Treasuries are in a bubble.)

Secondly, as the article alludes to, recovery rates are likely to be lower so we need higher yields to compensate for the risk. Liquidating in this economic environment is going to be a disaster for creditors, with assets being sold at fire-sale prices.

The article finishes off by suggesting the type of bond that is attractive:

Take the Opti Canada Inc. high yield credits paying an 8.25% coupon maturing in 2014. Hedge funds were forced sellers of these bonds earlier this year, says Cheng, and the bonds are undervalued based on his analysis. The company, a joint venture partner with Nexen in the Long Lake oil sands deposit, recently sold 15% of its stake to Nexen for $735-million in cash to pay down debt.

With that cash, the Opti bonds, trading at 50¢ on the dollar, are attractive, says Cheng. Bondholders will be "made whole" come 2014 promising a current yield to maturity of 25%.

I think bonds like the (Canadian) OPTI bond suggested above is the ideal one to consider buying. Even though I'm bearish on commodities, I think bonds of commodity companies are attractive. A lot of commodity companies are beaten down and have assets worth owning. Even if these companies go bankrupt, bondholders may end up owning the company if it can be successfully restructured. Remember how Martin Whitman's best investment of all time is Nabors Industries, an oil&gas driller if I remember correctly, that went bankrupt after the commodity bust in the early 80's. Whitman is an expert and played an activist role in that but I'm just using that to illustrate a backup plan in case the company goes bankrupt.

Stocks vs Bonds

One of the risks with bonds is the opportunity cost. In this case, I am primarily referring to the cost of owning bonds as opposed to stocks. There is a very high opportunity cost right now for buying bonds. There are many companies trading with non-cyclical P/Es between 8 and 12. If it's a P/E of 10, that's an earnings yield of 10% with additional upside. Is it really worth owning a bond that has a fixed upside of say 15%?

For example, I had been looking at Sears (SHLD) bonds for a while. You may be able to find a bond with a yield of around 20% with a yield to maturity of possibly 30%. Well, given how the stock has sold off so much and may drop further, the stock starts becoming more and more attractive (assuming bankruptcy risk stays the same.) It's really hard to tell but Sears may have a normalized earnings yield of 25% (assuming its business doesn't completely collapse.) You can see how it's a tricky decision if one were to consider Sears bonds. Do you go for the, say, 30% yield to maturity in a bond or do you go with the stock with, possibly, 25% earnings yield (which will likely increase over time)?


Gold passes $1000...bubble forming?

Gold hits $1000 -- Third time lucky?

I guess any time one contemplates investing in gold, either taking a long position or a short one, we leave the value investing arena and move into the purely macro battleground. Many mistakenly think that you can compute the intrinsic value of gold--or commodities for that matter--whereas my opinion is that it cannot be done. It is nothing more than a speculative macro bet.

Gold surpassed $1000 for the third time within two years. In the prior two cases, it quickly fell back below $1000 and stayed there. Is this a bubble being formed? Or is it simply representing fair value based on the world economy?

One of my big bets this year was going to be shorting gold--likely through one of the inverse ETFs--so I have been trying to develop a bearish case. I know I said an year ago that I'm not going to be shorting anything ever again after my questionable experience shorting the TSX (which was a bearish bet on commodities.) I'm still uncertain but I think it may be something that is attractive given the investing climate. My goal this time around, if I do pursue this short, is to bet on a longer time frame and to only enter the position when price rises parabolically. Hedge funds and other speculators are clearly moving into gold but I would wait until it becomes a 'heads I win, tails I win' bet for them (kind of like how oil was such a bet for them early last year.)

National Post--Canada's equivalent to The Wall Street Journal but not as sophisticated--has an article written by Levi Folk touching on the bullish and bearish case for gold. It's a good article covering both sides and let me pull some of the key points.

(source: Gold next bubble, by Levi Folk, Financial Post. Published: Friday, February 20, 2009)

The Bull Case for Gold

Many top economic analysts believe that current monetary policy will be highly inflationary and that view has led to widespread purchases of gold. "Not only is there no modern precedent for this wholesale money printing," writes Jim Grant in Grant's Interest Rate Observer, "but, also, so far as we know, there is no theory."

There is a fixed supply of gold in the world, but money knows no bounds, and investors are now acutely aware that current central bank policies, especially in the United States, could be the forerunner to high inflation.

It used to be that the Fed would increase the money supply through purchases of U. S. government bonds. Money was the liability of the Fed and treasury securities were its asset. Those monetary operations have been abandoned for far more heterodox initiatives.

Not only has the Fed doubled its asset holdings on its balance sheet, thus expanding the money supply, but it has also reduced the quality of those assets by buying mortgages and other complex securities created by Wall Street, assets of such dubious quality that no one but the Fed will hold them.

The money supply is expanding at its fastest pace since 2002, notes Jim Grant, because the Fed is "stuffing the banks with dollars." The question is when the economy recovers whether central bankers will affect an orderly winddown of the money supply. Grant for one doubts it.

Part of the problem the Fed will have with reducing the money supply when the economy recovers is that the securities it has to sell are less liquid than its typical holdings of U. S. treasury bonds. Shrinking the money base by selling treasury securities is a breeze compared with selling, say, the structured investment vehicle (SIV) called Maiden Lane III LLC, a current holding of the Fed's. This SIV is stuffed full of "multi-sector collateralized debt obligations," which happen to be the former toxic mortgage assets of insurer AIG.

There are many bullish arguments for gold, including ones ranging from the end of the world, to the end of the US$ or Canadian dollar or whatever you are measuring gold in, to declining gold supply/increasing demand, and so on. The one that I am interested in, and the one that is likely driving gold higher right now, is the one that is quoted above. Namely, the view that the capital injections into economy by the FedRes and other central banks, will lead to high inflation.

Ben Bernanke argues that the FedRes can withdraw most of the injected money quite easily:

In a rare appearance before journalists at the National Press Club, Bernanke said the Fed will be able to quickly reverse much of what it's done to expand credit, once the economy improves. Read his full remarks.

"A significant shrinking of the balance sheet can be accomplished relatively quickly," Bernanke said.

Many of the programs are designed to automatically disappear once market conditions improve, he said, while others will require more active intervention by the Fed.

(You can read his full speech here. Professionals and those interested in details should refer to his numerous other speeches that have dealt in detail what the FedRes can do.)

IANAE and don't really know the technical difficulties of withdrawing liquidity. My amateur investor view is that I have little reason to suspect what Bernanke says may be incorrect. Some of the money that the FedRes has injected seems to be short to intermediate term obligations that will be paid back if the FedRes ever decides to stop rolling them over. A lot of the rest will also likely end up simply replacing destroyed capital, rather than adding to the existing capital base.

I suspect that the FedRes will be late in withdrawing liquidity, when we do get out of the deflationary abyss, but that will likely lead to higher inflation rather than perpetually high inflation.

One other thing is that, nearly all cases involving high inflation were due to a purposeful act by the government. Typically this has been to finance wars, pay foreign debts, and the like. I am building my case with the view that the US government will not do that (many gold bulls also share my view and aren't betting based on such a low probability event.)

The Case Against Gold

The current wedge between the gold price and inflation is a weak banking system. If banks are not lending, money supply expansion is unlikely to be inflationary. There is in fact a real danger of a "prolonged bout of deflation" in the U. S. economy, according to Paul Dale of Capital Economics, which is the current preoccupation of the Fed.

The current economic recession is global in scope and demand-pull inflation pressures are absent. More than 20 million migrant workers in China are out of work, due to weak exports and excess supply. China was a major exporter of deflation earlier in the last decade and is likely to be again.

Moreover, the fall in trade balances in surplus nations -- Japan, China and OPEC countries --is also deflationary. In recent years these trade surpluses represented dollar earnings that were bought by foreign central banks and recycled into U. S. treasury bonds. This process was inflationary for all participating countries. As it slows or even reverses, money growth also slows or is sucked out of the system.

The quoted sentences pretty much captures my thinking. The world had inflation in the last 10 years but given how everything is almost the exact opposite now, we will likely get deflationary currents blowing across the planet.

I also take the view (not widely accepted) that China's banking system is partially insolvent and that it has massive overcapacity in manufacturing, and possibly a real estate bubble (although small and only in major, coastal, cities.) Chinese banks have reduced their NPLs (non-performing loans) in the last decade but I just wonder how reliable the numbers are. One may recall a theory that I referenced a while ago speculating that Chinese firms do not factor in depreciation properly into their businesses (i.e. companies not profitable if worn down machines had to be replaced.) If so, there will be massive wealth destruction in China and it will be deflationary.

I also see some gold bulls argue that gold will do well in deflation. Well, I don't buy that. If gold does well during high inflation and it does well during deflation, then does it ever do poorly? I suspect these investors will say it never does poorly. Anyway, we'll see how events unfold. My feeling is that gold may hit a peak in April and then fall in May/June; or it may keep rising until fall due to the rising popularity of stagflationary views (this could easily happen if inflation ticks up for a few months while the economy is weak.)

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