Friday, February 29, 2008

Why I'm Focused on Capital Preservation

Almost exactly one year ago, I wrote an article predicting that the CDOs on many banks balance sheets (and off of them in SIVs and other conduits) were about to implode and this was going to make for some very tough time for financial companies. Essentially, I argued that banks would find that their balance sheets were overleveraged and be forced to liquidate assets (in many cases at bargain prices) in order to meet

My suggestion at the time was to keep the powder dry, since values were bound to begin popping up, eventually and in extremely unstable markets capital preservation and liquidity were the keys to success. He who has ready cash to deploy when everyone else is running for the hills can purchase terrific assets on the cheap.

A few days ago, I read an article that basically said that my thesis (which is shared by many) is an example of the usual nattering nabobs of negativity predicting the end of the world. The article, entitled How Banks Work, by Nathan Lewis of New World Economics, basically argued that the relative strength or weakness of banks balance sheets is not the major source of financial crises; it is borrowers’ willingness and ability to borrow which matters. Moreover he selected as his example Japan 1989-2003, my favourite example of monetary deflation because it happened with a modern central bank and all of the government statistical analysis available now that was not available in 1929-1933. This had me thinking – do I have it all wrong? Is the market far more resilient than I believe (in which case, I need to rethink my tactics)?

Let’s take a more in depth look at his claims. First, the issue that banks do not stop lending because they lack lending facilities (that is, banks don’t run out of money to lend). He states:

Typically, when banks have capital impairment (losses), there is much hue and cry that lending will shrink as a result, leading to recession. This is based on a very simple multiplication: banks typically have about 10:1 leverage. Their assets (mostly loans) are typically about 10x their capital base. So, this simple line of thinking goes, if capital shrinks by 20%, then loans must also shrink by 20% to keep the ratio in line. And indeed, the BIS capital ratio requirements mandate that large banks not get too far out of line regarding these ratios.

This was essentially my argument. But he counters:

But banks don't really work like that. This is a subset of a broader group of theories, that an economy can be managed by a sort of mechanical top-down monetarist approach. … They are all based on the idea that there is some amount of "money" (or capital), and everyone jumps up and down like puppets depending on this one quantity variable. Thus, if banks have capital, then they create loans according to some sort of inevitable mechanical multiplication function, and if they don't have capital then loans shrink by the same inevitable mechanical multiplication function.

The fact of the matter is that banks have indeed been forced to reduce their balance sheets. In fact, what we discovered in this process was that banks’ balance sheets were far weaker than we had been led to believe due to large off-balance sheet obligations. That the FASB and the SEC continue to allow this is amazing. Banks have been struggling to find means of raising liquidity so that they can continue to meet obligations and make new loans. They are struggling because other banks no longer trust the value of their collateral. So, bank balance sheet weakness does indeed lead to financial instability. It leads to higher rates and tighter credit conditions, under which borrowers may no longer find it attractive to borrow.

He goes on to argue that banks have a variety of ways to raise capital, which means that they will always have adequate funding for attractive investment opportunities. He says:

[W]hat if there were lots of wonderful loan opportunities, but banks today are unable to take advantage of them because of impaired capital? Well, they could then raise some more capital, which is exactly what they are doing. "We need capital to take advantage of this wonderful situation. If you buy an equity stake in our bank, we are sure you will enjoy a wonderful return on equity." … This is also an argument behind the sovereign wealth funds' recent investments in big US banks. "Well, they're having a hard time now, but they have fantastic franchises and have proven to be very profitable in the past. We'll bet on a winning horse, and when the situation turns around and there are more lending opportunities, the bank will make good money again."

This is true, so far as it goes. I for one believe that many large banks will probably be on sale (though smaller banks that rely more heavily on specific kinds of lending will continue to suffer). But the idea that there is plenty of capital outside of the US is belied by the fact that so many global banks are suffering in this crisis. Capital is being wiped out all over the world. (IKB a small German bank that focuses on real estate lending in Germany – IKB stands for Immobilien Kredit Bank, German for Real Estate Credit Bank) has become insolvent due to its exposure.

Of course, capital can always be raised on some terms. The question is, are those terms attractive? Thus when he concludes

[L]ending is not driven by capital, rather capital is driven by opportunities in the lending business

He elides over the fact that “attractive” opportunities are partially defined by the terms upon which one can obtain financing. A project that returns 15% might be attractive, but surely it is not if financing cannot be had for less than 20%.

The point he wants to make is that it is the absence of attractive opportunities that lead to a collapse of borrowing. Without borrowing banks lose out on two major income streams: interest margins and origination fees. He details how this happened in Japan. A collapse in asset prices led to a lack of interest in borrowing and indeed to a general monetary deflation in which aggregate demand failed to match the existing supply capacity in the economy.

Since monetary deflation makes borrowed money extremely expensive and since capacity was already sufficient to meet demand, there was no incentive to borrow. (Actually, operating cash flow is the normal source of investment income under monetary deflation, which is on reason why IT firms tend to hoard cash and not borrow. This is the world they face every day). Even interest rates near zero were insufficient. But this BEGS the question he doesn’t ask: how are banks approaching lending opportunities today?

The answer is not reassuring.

Banks are calling in and reducing all sorts of outstanding financing arrangements, particularly if those arrangements are linked to real estate. There are several examples. This means that many borrowers who have been using home equity as a crutch to maintain spending levels and lifestyle will find fewer options to do so. This suggests that aggregate demand will drop and as that happens, many firms will find that investing is simply unnecessary. Instead the focus will actually be on reducing financial and operating leverage so that supply can be matched to demand. Doing so takes time, so in the short run output is likely to exceed demand and prices will have to fall to clear the market. Monetary deflation is likely to result. Yes, I know that central banks and governments are falling all over themselves to create inflation, but I return to the BoJ and its experience in Japan. Low rates do not guarantee attractive terms.

Why will banks do this? Contrary to Mr Lewis’ thesis, banks do not like to float new capital, even if they can. They much prefer increasing the balance sheet through retained earnings. Having to tap the general markets or strategic investors like sovereign wealth funds, is expensive. Those investors are in a position to demand high returns on their capital. It is the benefit of having capital to offer when no one else does. Beggars cannot be choosers.

This is why my approach has been, and continues to be, to keep cash on hand and scour the markets for attractive opportunities. They need not be stocks. I am myself looking at a few possibilities in common stocks (more on this in anther post). Because of some decisions that I made in 2006, I am not looking at real estate right now, but I will be before long. I see this market as a real buying opportunity – but only for selective purchases.

Mr Lewis is making an argument against a massive federal bank bailout. I support his thesis: banks and investors cannot go to the casino and then only keep the winning bets. They pocketed the fees and got the dividends and the buybacks. Why should taxpayers share the burden (unless the financial system becomes so ossified that the payment system breaks down. This is not impossible. In such a case, taxpayers should be glad to pay the price to prevent the complete implosion of credit markets). But he supposes that the markets and the pundits are being too pessimistic (and that the banks, looking for the losing bet insurance, are the source). Credit markets are indeed becoming much tighter, however, and this means that it is wrong to assume that investors aren’t being rational in their perception of heightened risk.

This credit cycle is going to produce a great deal of pain. No one knows exactly how it will turn out. We have never had so many alternative financial products with various risk profiles as we have today. The models aren’t working, so irrationality is coming to the fore. I continue to maintain large cash balances – and believe me it is no fun earning peanuts on those balances. But I am willing to be patient and selective and purchase from Mr Market those assets about which he is unnecessarily pessimistic.

Monday, February 25, 2008

Lowest existing home sales in years

Yahoo! Finance is reporting that existing home sales have fallen to a nine year low. This means that sales have returned to the level of 1999. Seasonally adjusted sales remained below 5 million for the first time this decade. You can get the data from the National Association of realtors as a PDF here and as an MS Excel sheet here. One way to look at this is that, after now reaching multi-year lows, housing must be do to reach a bottom soon. The other view is to view 1999 as a pretty good year in the housing market (it was) and to argue that even with the long fall, housing has only just returned to long-term trend sales figures. This view holds that while we may have returned to “normal” conditions, we have not yet begun to work off the excesses of the boom. Thus, housing is likely to continue to head lower and underperform other assets, likely for years with yet lower prices required to clear the market.

Naturally, the irrepressible Lawrence Yun and the National Association of Realtors take the first (more optimistic) view. They have chosen to spin the numbers and call yet another bottom to the housing market. They do this by simultaneously focusing on the (un-annualized) month over month decline, which is less than ½ of 1 percent and simultaneously talking up phantom demand that is simply waiting for a “catalyst” – in this case the increase in the ceiling of conforming mortgages, which will enable homeowners with mortgages larger that $417.000 to obtain a mortgage backed by Fannie Mae or Freddic Mac.

In fact, if anything this report confirms that housing will continue to decline for the foreseeable future. The 0.4% decline over December represents a pretty steep decline year over year. And, in the datasheets provided, it becomes clear that housing is now much slower than last January: the year-over-year comparison (the only one which matters) shows a 23% decline in the number of homes sold and a 4.6% decline in median home prices (with a smaller decline in average home prices).

What the data say in clear terms is that even significant price discounts (a 5% fall is huge: final prices exclude other incentives like closing costs paid by the seller or upgrades to kitchens, bathrooms and the like) buyers are simply unwilling to do deals. Inventory remains extremely high. After dropping over the holidays, units on the market have increased and inventory again surged above 10 months supply. More houses are likely to come on the market in the next few months as the foreclosures mount. More inventory and more sales by banks rather than homeowners, suggest that prices will continue to fall and sales will continue to decline.

Buyers will naturally be reluctant to purchase for the same reason that they were so desperate to purchase during the boom: the effect of leverage. If one is able to put down 10% on a home and experience 5% appreciation per year, the leverage provides the buyer with a 50% gain. During the boom, prices regularly increased by 11-15% per year providing an annual gain of 100% or more. With even an even lower or no down payment returns became magnified to even greater extent.

But let us return to that same buyer today. A buyer who can qualify for a conforming mortgage, and who has 20% down is staring at a first year loss of 25%. If the trend continues for two years that same buyer is out 9.75% of the purchase price and has succeeded in wiping out nearly half his capital. Better to keep renting and hold onto the principal. A buyer with 10% or less to put down would have his entire equity wiped out in the first year. The NAR is hoping that buyers who already own homes and who are looking to trade up to a substantial home, $500k or more, will return to the market and generate more sales at the high end. If this were to happen the owner would likely list his current home, which means that no inventory would be removed. The problem remains without first time homebuyers there is no one to clear the inventory and right now there are no first time buyers.

Going inside of the numbers

Let’s move beyond theory and see what the numbers suggest.

This chart (created by the Center for Economic Policy Research using data from the US Census Bureau) shows the vacancy rate for home (both rentals and owned homes) is a clear indication of the source and magnitude of the current problem: there are too many residences and not enough families to occupy them. With a sharp reduction of interest rates in 2001-2003, rental vacancies soared.

The vacancy rate, which had remained fairly stable between 7.5 and 8% decade, leaped to 11% in two years. The decline was both so strong and so sudden that rents actually declined (lower rents suggested deflation in the CPI calculation, which reinforced the argument to keep rates low!). At the same time, home vacancies remained quite stable, virtually a flat line. With many renters shifting to being homeowners, we might expect home vacancies to be falling. That this did not happen shows how rapidly new home construction was running. By 2004, the rush was on to condo convert every apartment building in America. This finally brought rental vacancies down (by eliminating rental stock from the market - not by finding new renters) and the rise in vacant homes began. Many of these units were purchased in anticipation of future price increases and, as we can now see, nearly 3% of owned homes are vacant. But selling or renting these homes will not fix the basic problem: the surplus of residences. We may see arbitrage back and forth between rental units and owned units (condo conversions or rental of purchased condos). It doesn't matter because vacancy rates in both rented and owned homes are much higher than in 2000. This problem will not be resolved until positive absorption can be restored. Even then, the process will take years.

So how low can housing go?

This is the big question. Let's see if we can get inside some of the numbers to make a sensible projection. Before we do, I want to point out that housing corrections are slow to unfold and resolve. The negative impact of leverge and the stress that the losses put on the banking system require years to resolve and sometimes decades. Japan has yet to recover from the property boom of the 1980s.

I take as a principle that housing sales is a mean reverting series with a bias toward a long term rise. Population and household creation in the US are growing, albeit slowly, which leads to a rise in the need for homes (and generally, though not necessarily, owned homes). If the series is mean reverting however, we should expect that a series that experiences a spike outside of the normal range to experience an offsetting dip. So, where is the market now? That depends on how far back you look.

There are two basic series of housing data. The first is existing home sales. (These are the numbers reported by the NAR above). Unfortunately, the NAR charges for data beyond 12 months. (If anyone has the data series going back a ways and is willing to share, please contact me). The second series is the New Home Sales, which is available from the US Census Bureau. I used the publicly available dataseries from Economagic. The publicly available information is excellent and there are some free chart generators (gif and pdf) There is also a premium subscription available which allows for more data series and more customization of the charts and a direct export of the data series to MS Excel for analysis.

Back to the data. If I were the realtors, I would want to use this chart. Yes, it paints an extremely grim picture of new home sales since the middle of 2006. However, the chart suggests that we have returned to the level of home construction prevalent before the housing bull market started around 1995. Furthermore, new home sales are well below the long germ trend presented here. Given the weakness of new home building in the early 1990s, it could be reasoned that we are now sopping up excess demand and are poised to make a comeback.

The problem with this chart is that the long-term trend is broken, but there is no comparable data series to use to estimate how far this knife is going to fall. Let's take a longer term view with a goal of establishing a) how long housing markets stay down and b) how much of a decline in sales activity we tend to experience and how much of a decline in prices we tend to experience. With that, let us see if we can figure out where we are in the housing cycle.

The data series are available back as far as 1964. If you import the data to Excel and run an Ordinary Least Squares (OLS) regression, you find that the best fit is a polynomial (i.e. not a linear) trendline. Excel proposes this graph:

I find this graph amazing because it shows two things. First, that the housing boom of the 1980s, which peaks in 1987, only represented a return to trend (the peak falls right on the trend line). The impact of the financing crisis that resulted from the aftermath the rapid surge in sales (an increase of about 62%) led to a 10 year period where sales failed to re-attain the volumes at the peak. The trendline also suggests that we have only just returned to the trend line. To put it another way, the decline from 2005 to late 2007 was only the return to long-term trend activity. As a mean-reverting series, it can be seen that we are only at the beginning of the backing and filling necessary to work off the excess.

In fact this peak seems to show more similarity to the 1970s boom, which was driven primarily by the massive growth in household expansion from the Baby Boomers. There has been some discussion of the potential for new sales from the “Echo Boom”, but as noted above, first time buyers have no incentive to enter the market.

One further point, this trend line is quite distorted because the data series is short. If we had more historical data, we would likely see a flatter and more linear curve. This would serve to reduce the amount that sales in the 1970s were “above trend” but would also INCREASE the amount that recent sales are above trend. It is possible that we have YET to return to trend, though I think we are probably close. That chart would look more like this:

So how long are we likely to wait?

I believe that sales are likely to continue to decline over the next 18-24 months. Prices will likewise continue to decline, but that by 2010-2011 we are likely to reach bottom. Most of the earlier peaks and troughs are 4-5 years apart. This would put the bottom somewhere in 2009-2010. This boom is larger than the previous ones, so the down-cycle could be longer. However, the data seem to suggest that the decline is likely to be much sharper. In other words, the fall will be much greater, but will occur over the same time period so the curve will be much steeper.

What can we expect on prices?

Here the news is even more sobering than on volumes. Home prices soared very, very far about the long-term trend. Ironically, one of the usual appeals of real estate investing is that price levels tend to increase at very consistent rates, about in line with wages (which are the big limiter on the amount people can borrow). Even the surge in prices of the 1980s is a comparable mild and look at how long prices remained below trend thereafter. After 1997, however prices began accelerating.

This chart suggests that prices must continue to decline, at least another 5% just to return to trend, but that prices are unlikely to begin rising again once the trend is reached. In fact, it is quite likely that prices will undershoot similarly to overshooting. If that were to happen, prices would have to fall 20-25% below trend and remain below trend until 2012-2013 at a minimum. From here, then, we should expect a 25%-30% decline from here. This means that unless you can get a deal, or have more than 25% to put down, or you can be quite sure that you will not need to move in the next 6-7 years, or you have the ability to ensure adequate cash flow (including a cushion should rents begin falling again) investing in real estate is a losing proposition.

If you already own, but have adequate cash flow and don’t mind just collecting rent checks, you don’t need to sell. If you need to sell, it might be better to do it now rather than risk braving the market 12-24 months from now.

I know many people think the market will come back soon. I still believe that the only true analog to this housing phenomenon is Japan from 1989-2004. After a similarly foolish bubble in asset prices, asset prices declined for 15 years. It probably won’t be that bad: regulators in Japan were painfully slow to force banks to clean up their balance sheets and most banks in the US seem to be moving with reasonable speed. But it is worth noting that every quarter involves yet another massive charge from UBS, Citi, JP Morgan and now Credit Suisse.

If you have cash and credit, you can start looking, but you MUST focus on cash flow. Capital appreciation will not happen for years. A 10-year IRR calculation should assume NEGATIVE capital gain. Thus, cash flow returns must be quite adequate. This is also necessary to ensure that you will not be forced to sell the property in the event of a decline in rental prices (which may happen if many other investors follow similar bottom-feeding strategies). Finally, consider if you have the resources to upgrade and remodel in the event that you find your neighborhood becomes competitive.

Sunday, February 24, 2008

Will Suburbs be the Slums of the 21st Century?

Christopher Lineburger writes for the Atlantic that the huge rise in foreclosures, particularly in those expensive developments where 4000 sq ft of house is shoehorned onto half an acre of land, is leading to a massive crime wave in suburbia.

"At Windy Ridge, a recently built starter-home development seven miles northwest of Charlotte, North Carolina, 81 of the community’s 132 small, vinyl-sided houses were in foreclosure as of late last year. Vandals have kicked in doors and stripped the copper wire from vacant houses; drug users and homeless people have furtively moved in."

And again

In the Franklin Reserve neighborhood of Elk Grove, California, south of Sacramento, the houses are nicer than those at Windy Ridge—many once sold for well over $500,000—but the phenomenon is the same. At the height of the boom, 10,000 new homes were built there in just four years. Now many are empty; renters of dubious character occupy others. Graffiti, broken windows, and other markers of decay have multiplied.

Massive amounts of building, heavily focused on a specific type of house (large, SFR, suburban or exurban) are creating huge vacancies. Worse, the article goes on to suggest that there may never be enough demand for these houses, because lifestyles are changing. People are increasingly interested in living in urban communities with walkable centers. This trend has been building since "regentrification" of several urban communities in the 1980s (think projects like Boston's Quincy Market). The trend is likely to accelerate because now the primary consumers of large homes, Boomers, are interested in scaling down. If energy costs continue to remain at these levels, or even move higher, the costs of heating, lighting, cooling and commuting will further tip the balance in favor of cities.

To me, this story demonstrates the why an owned home is not an asset in the normal sense, but rather a lifestyle choice and should be seen as such by the prospective home buyer. For decades, people chose to pay much higher prices to live in the suburbs, generally inconvenient out-of-the-way places, than they were willing to pay to live in cities, which almost always had better infrastructure and convenience. Of course, homes in cities were often old and small. People wanted new appliances, modern kitchens, more bedrooms than people and more televisions than bedrooms. Mostly, though, I think what they really wanted was to live near people like themselves. This meant that they would go to church with people like themselves, go to Little League games and PTA meetings with people like themselves and be able to assess their success and status against their peers. It's a biological impulse, but it doesn't mean that it's investing.

In order to accomodate this inconvenient location, people began to take on large additional "operating" expense - lawn/garden services, paid cleaning services, heating and the like. The biggest cost, in time and treasure, were the capital expenditure for private transportion and the related operating expenses (insurance, gas, repairs, etc).

I don't mean to suggest that somehow living in the suburbs is wrong. I don't really get my jollies off of trying to manage or constrain other people's lifestyle choices. I see nothing wrong with making the decision - so long as one is aware that it is a lifestyle choice and not an investment that one is making. The problem that I see is that many fail to see that realizing their "investmetn gains" from their home will necessitate a major lifestyle change. That is all well and good, if that is the goal. But why not instead pursue an investing strategy that doesn't FORCE a lifestyle change?

In any event, the trend toward suburbanization is changing, which suggests that there is more money to be made in urban real estate. Purchasing foreclosures and rehabbing or doing flat-out knockdowns to speculate in urban land may be extremely profitable. This invites much opportunity to rethink one's real estate strategy in cities. Most people I know are doing modest rehabs with a goal of renting to students or lower income folks. Might make more sense to go more upscale. Or to look for some knockdowns and hold the land: even better if one can get contiguous properties that can really be redeveloped.

On a macro level, what I find interesting is the impact that the move toward reurbanization will have on these large home prices - and how that will affect near-retirees' behavior. Contrary to their plan, which was to sell their (expensive) suburban McMansion and move to an (inexpensive) urban setting, realizing a tax free capital gain and freeing equity to provide income, they may find that they are stuck with a large home, or that the price at which they can sell it is comparable to that small 2 bedroom condo near the shops and city center that they were planning to move to.

Your thoughts?

Friday, February 22, 2008

More on the Bond Insurer Mess

Nicole Galinas of the New York Post elaborates the point about the dual role of borrower and regulator that the State of New York represents. She rightly notes that NY State would benefit from the separation of the mortgage and muni insurance business. I pointed out yesterday that Spitzer’s biggest concern was maintaining NY State’s borrowing capacity.

But I find it hard to believe that municipal borrowers were really paying 20%. I would not be surprised if some of the bonds declined in value to the point where the offered yield was 20% - but I cannot imagine any government borrower seriously willing to float paper at this rate. Maybe the indentures carried variable rates? If so, this can only be described as asinine, since rates have been quite modest over the past seven years. In any event if otherwise solid municipalities are paying penalty rates, they can refinance (albeit, without insurance and with new investment banking fees).

The bottom line is that this entire effort to rewrite the rules of underwriting AFTER the contract goes into force is unethical. Worse, it is not even a positive development, since it will ultimately reduce access to credit in the real estate markets (by making investors less willing to finance MBS-insurance firms, knowing that the rules can be tweaked at any time by populist politicians). And, since municipal finance in the United States is primarily driven by real estate taxes, NY State is only serving to reduce its future income streams.

UPDATE: I miss wrote earlier - the Port Authority of NY and NJ paid 20% annualized rates to rollover an existing issue. HOWEVER, they will only pay this for one week. Apparently, the proximate cause was a failure of the major market participants, who chose not to participate. Usually, these firms make significant buys because of their ability to resell the bonds to their clients. For whatever reasons, they let this auction fail - which naturally spooks the rest of the market. The attractive rates for a financially strong institution like the Port Authority will undoubtedly bring in a host of smaller firms to buy up the next issuance of paper. Presumably rates will be much lower.

Book Review: The Intelligent Investor

Synopsis: This book is a true investment classic. It relates in simple, plain English the key concepts behind investing. Graham artfully distinguishes between investing and speculating (the presence of a “margin of safety” against loss) and explains the essence of “intrinsic value” and shares his famous depiction of “Mr Market”. While not a “reference” book or a textbook (for that, one needs to read his other seminal work, Security Analysis, written with David Dodd in 1934), it is a book to which one can return many times, as there are always new nuggets and perspective to consider. This book is simply a must read for anyone who intends to make money investing.

My take on Graham is that he believes that investing is about knowing what one is looking for: this, I think is the true sense of “businesslike investing”. Different investors, facing different circumstances with different strengths and weaknesses must think about how they want to approach the market. The key is to understand clearly what one is looking for and then seek to exploit the opportunities the market offers, when it offers them. This is very much like a firm must approach the market for its goods and services. The firm must be selective and targeted. So must the investor. Picking a good target is important, but then the investor must train his ability to see and to be patient if that which he seeks is not readily available. What many (un)intelligent investors choose to do is change their strategy to fit the market, making them slaves to Mr Market and his whims.

Full version: When Warren Buffett was 19 he read a book published by Columbia University professor and money-manager Benjamin Graham. Buffett was so impressed, he decided to attend business school at Columbia and subsequently to work for Professor Graham at his hedge fund, the Graham-Newman Company. Buffett, of course, was no ordinary student. In fact, Graham later remarked that Buffett was the best student he ever had. Certainly, he is the most successful. The book is titled “The Intelligent Investor” and it has recently been republished with commentary by Jason Zweig and an introduction by none other than Graham’s famous student.

Graham’s views of investing were heavily informed by his experience in the Great Depression. Graham had been a successful speculator in the late 1920’s boom, before losing his entire fortune. That experience was an eye-opener, though. He came to realize that his purchase decisions had been driven by entirely the wrong set of measures. He resolved to revise his principles and make investing based only on the “fundamental” value of a business. This was a fortuitous decision for two reasons: a major change in the information available to investors in securities and an extremely inexpensive market. Just at the time that he resolved to make decisions based on the financial condition of a company, the US government was passing landmark securities legislation, the Securities Act of 1933 and Securities Exchange Act of 1934. These two laws dramatically increased the amount and quality of information that public companies were forced to share with outsiders and investors. At the same time, stocks were trading at multi-decade lows. Many stocks were not only trading at significant discounts to book value but were actually trading below liquidation value.

Graham seized this opportunity to begin purchasing stocks at bargain basement prices. Together with his textbook, which was the first systematic approach to using the newly standardized financial statements required by the SEC, his professorship at Columbia and his success as an investor led to the creation of his hedge fund.

By the early 1950s Graham was again a wealthy man and was something of a legend. He decided to write a book that would encapsulate his investing philosophy. Graham’s philosophy is often distilled into two basic concepts: Margin of Safety and the irrationality of the Market in short term price decisions. In spite of the efficient market hypothesis and its heralds (many of whom are professors at my alma mater on the shores of Lake Michigan), the Intelligent Investor takes both of these factors into consideration in order to maximize his returns.

In my opinion, his system can be boiled down to two factors: know your strategy and exploit market conditions to when they are favourable to your strategy (either in the purchasing or selling). This would be good enough advice (it is often not followed), but he broke down the elements of these two investing rules into more practical factors

  • Know what you are looking for. “Value” does not inhere exclusively in an investment. Aninvestment’s value is also based on the objectives and skills of the investor
  • ·Leave room for error. Investing is too uncertain to haggle over small differentials. The amount of time some firms spend determining (and arguing) about small changes in discount rates never fails to amaze me. Technical wizardry often trumps common sense, with disastrous results (think LTCM). Better to be approximately correct than precisely wrong, as Buffett says.
  • Use market error in your favour. If you know what you are looking for, and you can distinguish value from irrational swings, you can have the confidence necessary to make significant capital allocation (or significant reduction of capital allocation) and achieve fantastic returns.

In short, this is one of my favourite books on the topic. It is readable, enjoyable, sensible and practical, which is more than one has a right to expect from most books on finance. It is available for $9.99 from Amazon.

Thursday, February 21, 2008

CDOs - Humor

Asset-backed-securities (ABS) are at the center of the financial crisis in which the banking industry finds itself. Nevertheless, enterprising bankers haven't lost their sense of humor. (This was sent to me by a private banker friend).

This is a fairly concise synopsis for the layman of how the crisis is playing out.

Is this a sign that the crisis is coming to an end, or a sign that there is no end in sight?

Eliot Spitzer and the Mortgage Insurance Crisis

The Wall Street Journal, that most indispensable of newspapers, has this editorial suggesting that the credit crisis may be reaching bottom, noting that Warren Buffett seems keen to begin buying choice assets at rock-bottom prices and noting that Elliot Spitzer, the governor of New York and former Attorney General of the same is now demanding a breakup of the mortgage insurers.

The recent posturing by both men is a lesson in investment strategy. Buffett is demonstrating that liquidity is the most important weapon an investor has. Many times in his annual letters to shareholders over the past several years, he has noted that Berkshire holds enormous cash reserves and that it does so at minimal rates of return. He describes this situation as “no fun” since every investor wants to bag the big, return accelerating prize. But he has also presciently noted that it is often difficult to raise cash when you need it most and so Berkshire chooses to raise it at favourable rates when it is possible to do so, in order to ensure that the funds are available when needed (to pay super-cat insurance claims and still make major purchases). The bond insurance business is a classic example of an industry with players who appear to be undercapitalized (though comparing the company equity with the face value of the bonds they insure is hardly as significant as the press makes it appear – even defaults will not result in total losses in most cases). Buffett is offering them liquidity to ensure that they can meet payments (and avoid a credit downgrade in the short term) in return for collecting large premia on assets unlikely to default.

It is important to understand that Buffett is not offering to take the troublesome mortgage backed paper, but rather the quite solid municipal bond paper, of the hands of the insurance firms. These are assets likely to keep earning steady premia for years for these companies. But, if you cannot wait for those premia to come in because you need cash now, you may have no choice but to sell. This unfortunately is like having to sell the family heirloom to the pawnshop to meet the rent. While it puts off the day of reckoning, possibly forever, it more often leads to insolvency.

This is why it is so disheartening to see Eliot Spitzer recommend the breakup of the insurers in this way (unless they could recapitalize). Notionally, what Spitzer is suggesting is a prophylactic for the municipal bond holders (and issuers). Since they, through no fault of their own (they were trafficking not in shaky mortgages supported by questionable assets and incomes, but in solid municipal projects supported by reliable municipal taxes) they may lose protection because they chose the wrong insurer. Insurers actually favour a breakup which would allow the healthy municipal business to be insulated from the unhealthy mortgage business. But, as Cecilie Glutcher from Bloomerg quotes Tom Mercer of Musashi Capital, this is “like going to the casino and keeping only the winning bets”.

In fact, this is the worst possible outcome for bond insurance. It defeats the very CONCEPT of insurance. As we know, insurance is based on the empirical evidence that it is easier to predict outcomes for an entire population than for an individual member of that population. Since the risk (as measured by the standard deviation of the outcome) faced by the individual (early death, dismemberment, etc) is higher than that of the population, it is possible to make money arbitraging the difference. This is called underwriting. Everyone wins.

Furthermore, there is another well-known principle in investing, which is diversification. Diversification of risk tends to reduce the overall risks of a portfolio, even when the risks show some correlation. Thus, even if mortgage trouble is correlated with municipal default (because both mortgage collateral and municipal taxes are tied to real estate values) holding both types of mortgages should improve the quality of the balance sheet of the insurer. Insisting that an insurer would be better off taking on only one kind of risk is the same stupid anti-business/anti-management/anti-capitalist views that insisted that banks couldn’t have multiple branches, lest they become monetary overlords.

As I have noted before, this is exactly the sort of foolishness that led to the banking crisis of the 1930s. Spitzer thinks that if insurers of municipal bonds can be forced to only take this sort of business, which has historically been prone to high levels of repayment, that he can preserve cheap borrowing for cities and states. But he makes these insurers substantially more prone to risks unique to municipal borrowers (such as meeting large pension obligations). Worse, he prevents the beneficial diversification effects for mortgages and commercial paper that provide the source of the tax revenue that the cities need. Making real estate financing harder to obtain in the midst of a major downturn will lead to lower assessed values and the need to raise tax rates in order to meet budget shortfalls.

Not a pretty picture at all.

Certainly, the bond insurers need to find a solution. The most like is a recapitalization by large investors – hedge funds, private equity or possible state pension funds (now that would be ironic). The solution is not to weaken them, but rather to strengthen them.

A Note About the „New“ Blogger

If you are returning to The Strategic Investor, you will have noticed the change in the format of the blog. When I started blogging, I had to decide which blog application to use. At the time, Blogger was the most primitive of the blog options (I looked at WordPress, TypePad and several others) and I seriously considered using one of the other packages. I decided to stick with Blogger for most of the same reasons cited here.

The key factor for me was my decision that a good investor can create an asset and learns how to monetize that asset. Thus, my strategy was always to be able to have a no-cost blog (which meant getting free hosting, which, at the time was only available from Blogger and that could also run ads. Blogger was the best fit.

This meant that I would have to have a .blogspot URL (which has been fine). It also meant using fairly standard templates and worst of all, it meant not having labels (though I found a solution care of another Blogspot blogger who developed a clever search function that effectively performed the same role). While it appears that he has stopped blogging, I would like to say, “thanks,” by asking you to check out his blog here.

I am pleased that I made the decision as the beta of Blogger has added several features that make publishing much easier (including labels), even if you aren’t an XML or CSS.

I look forward to taking full advantage. I hope you will join me by subscribing.

Wednesday, February 20, 2008

Valuing a Website

We've all seen the incredible valuations offered for social networking sites like MySpace and Facebook, but Dale Carlson decided to use that information and establish an individual site value meter.

He took the price paid for one of the sites (I think it was MySpace) and calculated the value of an inbound link (using the link counter from Technorati). Based on that he wrote a script to lookup the number of inbound links to a site and calculate the value.

At the time of relaunch this site was worth $2,258.16 -- but I'm not selling. Besides, networks follow the power rule which means that the value of the sight grows exponentially with the number of links, whereas this is a simple linear extrapolation. Still, it is a way to think about the added value of the site.

You can get the script for your own blog by clicking on the icon.

My blog is worth $2,258.16.
How much is your blog worth?

Google's Options

Christian who writes for both Investor Geeks and his own blog BloggerJacks, writes some of the most thought provoking articles I have come across in the blogosphere. I always make a point of stopping by to read what he writes. While I was in Thailand he had a post and a reference that, in my opinion, takes the last of the shine off of Google.

You may recall that there have been many Googlenistas who, in addition to talking about the rapid growth of earnings at the company, also like to suggest that managment has a similar attitude towards capital structure as Berkshire Hathaway. Mostly I think they do this, because their target audience are small retail investors who are reluctant to lay out the cash for the shares at these nominal prices. They need retail investors to keep buying the stock, however, so they don't want anyone to wait for a stock split and sit on the sidelines (stock splits have no impact on the value of an investment, nominal prices are almost meaningless), however most people like to purchase round lots).

Apparently, Google has decided to allow employees to sell (trade) their options on the open market. This is a good thing for the employees, as it allows for rapid diversification, but not good for investors. Google, undoubtedly will argue that this is good for investors, as this change in policy *may* enable them to issue fewer options. Fewer options should mean less dilution which is positive as far as it goes. But the real reason that this is a bad idea is that it severs any link of risk and reward between employees and owners.

Allowing employees to sell options means that a significant portion of their compensation no longer comes from changes in the fundamental earning power of the company and is instead based on price movements of the stock - specifically, employees are now rewarded for encouraging additional volatility in the stock and for the length of the insurance contract that they can offer investors.

To understand this one must realize the the value of a stock option is based on several criteria: The strike price, the market price, the length of time to expiration, interest rates, volatility of the price of the underlying asset and (in the case of put options), dividends and whether the stock is European or American.

To understand why volatility is so important, one need only think of the insurance aspect of an option. It allows for a one-way bet that prices will rise or fall, and locks in a different price, protecting the holder against adverse movements. The larger the volatility, the more likely it is that that insurance will pay off (ditto for long periods of time).

This was NOT what options were intended to do. Options were a means of rewarding management for increasing the value of a firm. The problem was that salary was always paid based on short term (usually annual) performance, whereas real value creation by top management often took years to emerge, since many decisions were far-reaching and the actual wisdom or folly of those decisions might not be known for years. Indeed, if only short-term metrics were used, management had an incentive to under invest and instead prop up short term numbers to collect on bonuses, while actually destroying long-term value. (A good example was Chrysler Corp under Bob Eaton, which chose financial engineering over product development in the mid 1990's necessitating the sale to Daimler-Benz).

Options, with long holding periods were a means of tying management performance to long-term value creation. By issuing options at the current value, management participated in the upside gain that they created. Because (unlike the stockholders) they did not participate in the downward losses, it became necessary to ensure that options and the potential payoff were enormous to "guarantee" that management would go to any length to increase firm value.

With this system, however, employees can cash-in during periods of high volatility. In fact, there is an INCENTIVE to make decisions that enhance current volatility at the expense of long-term value. This is the exact opposite of Buffett's dictum that a Berkshire manager should "run the business like it is the only asset that his family will have for the next 100 years". Employees of Google who receive stock options should be looking at the company as a life-long investment. That long-term perspective is the REASON to award stock options. Otherwise, the firm could simply pay cash and employees who want to can purchase shares or options on the open market.

Resuming life as a "Strategic Investor“

Well, I have decided to return to blogging. Last year, I believed that life as a student would permit adequate time to research investments and to write about what I was learning and how it was influencing my thinking. While I certainly did a great deal of writing, I found that there was no time to do the in-depth, fundamentals-oriented style of investing that I do. It became painfully clear that I was suffering from the problems that most independent investors face: lack of time.

However, I have wanted to return to the fray, particularly in light of the very difficult and confusing investment climate which materialized in 2007 and which continues to this day. I have written before about my belief that the housing market would implode in 2007 (see posts here and here) and that this would have profound impact for the US economy and by extension that of the world. I continue to hold this view and it informs my holdings, which are almost entirely in cash.

With that in mind, I will resume posting as of today. You will notice several changes – starting with the template of this blog itself. I am now using the Beta version of Blogger, which makes changing features of the blog much easier. I am also taking this opportunity to overhaul my categories/labels to make finding material easier. In addition, I will look to add a “Strategic Investor’s Bookshelf” – which will keep you up-to-date on what I am reading and what I think about it. I will look to add more linking and to point readers to important financial news.

What has not changed is my desire to provoke, explain and inform a sophisticated audience that aspires to superior returns. I will look always to bring a unique and well-reasoned perspective and aim for the “big picture”, while not losing sight of the fact that every investment is a “special case” (though some are more special than others).

Finally, it should be noted that this blog is an exploration of ideas and that I observe and comment and will share what I am doing – but no strategy should ever become the slave to tactical moves. Even if we are faced with the same market circumstances, we approach them from different positions and – far more important – with different objectives. Many strategies are possible within the same market. The reader must decide for himself what strategy he wishes to pursue.