Saturday, November 3, 2007

Why people lose money on fast growing companies.

Most people pick stocks like this. First they find what looks to be a "good company". A company that qualifies as a "good company" usually has a high growth rate.

For example people who call themselves "growth investors" will look for a company growing at 40% or so. Maybe it has only been around for two years but grew earnings at 40% both years. They say to themselves. "If it keeps growing at 40% for two more years (and why shouldn't it?) and retains the same valuation, then I will have doubled my money in two years."

Other people who would call themselves value investors or Warren Buffett inspired investors have read all the Buffett books. They take a variation on this. First of all, they look for high and stable return-on-equity, low debt, and a fairly high growth rate, say 20%. Then they look at valuation. They might be willing to pay P/E = 18 for a company growing at 20% and ROE=20% and no dividend. They might use DCF to get the "right" valuation.

Most of these "growth investors" and "value investors" don't beat the market.

The growth investor gets it wrong because they never really trust these growth predictions. They need to diversify into 25 growth companies because they have little faith in each one. Because of this, they do not know the companies very well. Sometimes there is not much to know. They may be speculative at best to begin with. Some do very well and keep growing quickly. Some slow down and lose their high valuation and some simply go bust. They get an average return over long time periods.

The "Buffett investor" gets it wrong as well. They also do not beat the market by much if anything. They may not get big losses because they avoid the speculative bubbles but may have some real dogs. Many of their "good companies" stop being good, drop in value and are sold. What went wrong? They read all the Buffett books. They made sure all had high ROE and therefore probably an economic moat.

What is wrong with the intrepid value investor? I first discovered it by reading this article over at Tweedy Brown, called "Great 10-year record = Great Future, Right?
(You might need to click around for it under research reports). It is a great article, a real eye opener for me. Many of these Tweedy Brown articles are great reads.

The gist of the story is that the earnings growth of companies over the proceeding 5-year period is uncorrelated with the earnings growth the preceeding 10 years. Similarly, the ROE is also uncorrelated. Companies with high ROEs over the 10-year period do not grow faster than the average company. And stock returns are not better for these high ROE companies.

What??!! You mean you can't turn Warren Buffett's performance into a simple formula based on high ROE? Sorry but no. Maybe that isn't surprising to you. After all, there are not many Warren Buffetts around despite everyone reading the books on how to emulate him.

Of course Warren never said it was that simple. He talks about many things including mangement, strong brands or economic moats. He talks a lot about fully understanding the business and being able to predict earnings. He talks about buying only cheap companies which he defines as companies selling below their intrinsic value.

I don't really think there is any great mystery to how Buffett does it. It is simply that he does it better than everyone else. When he says "really understand a business", he sets a higher threshold than most people. That is, he understands their competitors. He understands, whether their costs will likely rise or fall. He only buys companies for which he thinks he can undertstand what the demand for their products/services will be. He looks for companies that have little risk of underperforming his goals. It is these rare companies that he fully understands for which he can predict where they are going to be in 10 years. Once he knows this, he knows the value of the company and if it sells well below this value, it is a buy.

The bottom line is that Warren is hard to emulate because he does a lot of hard work that most people do not or will not do. It takes a long time to analyse an entire industry. Also, he has that rare constitution for investing. He doesn't get spooked out. He has confidence in what he is doing because he knows everything he needs to know. He doesn't get distracted. He doesn't violate his principles. He is of course the complete package, as Michael Jordan was the complete package in basketball. You can read books on how to be like Mike but that won't get you that far without talent.

One last thing about Buffett that I should point out. A rare quality he has is incredible patience. I see dozens of companies that I like and would invest in (and have invested in). Buffett aparently sees none. He has been sitting on $40B for several years and has invested very little of it. Clearly, his standards are much higher than most people. That kind of patience is incredibly rare among investors.

Monday, October 29, 2007

The Global Housing Crash

I am a believer in the global housing crash scenario. Normally, I don't put much faith in economic forecasts. I think it is almost impossible to do it well. Alan Greenspan agrees by the way. He recently said on the John Stewert Show (of all places) that he hadn't seen any improvement in economic forecasting over his entire life. However, the housing situation is different. It is a matter of common sense. Logically, real housing prices should not change very much. Houses and the land they sit on are stagnant things like commodities. They do not produce cashflows other than by renting them out. But renting them out for an amount that doesn't cover the mortgage payment is a negative carry. They are clearly overvalued and must come down one way or the other. I won't go over the argument why they are overpriced and why they must come down. Rather, I want to focus on the consequences.

Lets assume that the following dire scenario happens:

House sales and prices continue to drop over the next two years. The subprime buyers cannot be kept in their houses despite much government interference. It simply isn't in their interest to stay. They foreclose and/or declare bankruptcy. However they aren't the only ones. Other "prime" homeowners with negative equity, negative net worth but otherwise good credit realize that they also have no incentive to stay in their homes. Many of them also join the subprime crowd. The negative feedback is obvious. More foreclosures lead to more inventory which puts more pressure on prices. The deflationary psychology sets in. People put off buying because prices are dropping so quickly. The Fed will do its best but can't force people to buy houses. Washington will do its best to pass legislation with incentives to slow the crash but with only mild effects. Prices drop by 10% per year for four years, a total of 35% and then start to decline another 2% for the next six years. The total 10 year decline is 42%. With 2% inflation, real prices have dropped by a factor of 2.

What would the consequences be?

I don't really know. But I think this would lead to many different crises, certainly a long recession if not a depression. Some of the milestones would probably include

  • Lender failures
  • Home builder bankruptcies
  • Financial company impairments
  • Credit crunch
  • Failure of leveraged speculators
  • Major bank balance sheet impairments
  • Recession in countries with housing crashes
  • Recession spreads to most other countries
  • Failure of mortgage insurance companies requiring Government bailout
  • Near or complete insolvency of Fannie Mae, Freddy mac requiring Government bailout
  • Investment bank failures
  • Major bank failures
  • Currency devaluation arms race
  • Rise of protectionism
  • Major inventory/capacity overhang in manufacturing/export countries like China
  • Deflation in all major asset classes
  • Flight to safety, US dollar?, blue-chips, health care, high cash-flow, recession resistant companies, Treasuries
  • International goverment intervention in mortgage market and banking
  • Panic, crises, unforseeable events and eventually resolution and recovery

In the end (whenever that is), houses are no longer sexy "investments". They become more affordable and necessary "expenses". They are just the place where you live.

As I mention above. I don't know how it will end or what will go right or wrong along the way but many of these things could happen. Many will only happen if house price declines cross certain thresholds. A 10% decline will be manageable. A 20% decline will be major pain. Beyond that, my above scenario is (I think) quite likely and I don't see what could cause prices to stop decling at only 20%. They will still be very expensive for most people and still a negative carry for renting out in most markets. I don't think most companies have a plan for 30% price declines.

Wednesday, October 10, 2007

Westernbank versus Inyx Timeline

This is a timeline to keep track of developments concerning the Inyx , Westernbank interaction

Feb 2005, Irish High Court bars Kachkar and Carrigan from investment and directorship positions in Ireland. (source: Carrigan testimony doc 191)

March 31, 2005, Inyx and its wholly-owned subsidiary, Inyx USA Ltd. (“Inyx USA”), entered into a Loan and Security Agreement (as amended, the “USA Loan Agreement”) (attached Exhibit 1) with Westernbank. Fraud guarantees signed by "Inyx Operators" (source: RICO complaint)

May, 2005, Inyx Pharma Ltd. (“Inyx Pharma”), which is also a wholly owned subsidiary of Inyx, signed an amendment to the USA Loan Agreement (attached Exhibit 2), and became a co-borrower under that Agreement. Inyx, Inyx Pharma and Inyx USA are referred to hereinafter as the “USA Borrowers.” loan $46M ($10M revolving and $36M in 4 term loans) secured by all assets (source: RICO complaint).

July 2005 Jose Biaggi appointed CEO and President of Westernbank.

August 30, 2005, Kachkar, Green and Goldshmidt each executed similar guarantees covering fraud, deceit or criminal acts by Inyx, the EU Borrowers, or any officer, employee or agent of Inyx or the EU Borrowers. (source: RICO complaint).

On August 31, 2005, Inyx Europe Limited (“Inyx EU”) and Ashton Pharmaceuticals Limited, f/k/a Celltech Manufacturing Services Limited (“Ashton”), entered into a Loan and Security Agreement (as amended, the “EU Loan Agreement”) with Westernbank (attached Exhibit 9). Inyx EU and Ashton are referred to hereinafter as the “EU Borrowers.” Under the EU Loan Agreement, Westernbank agreed to lend up to $35.5 million, consisting of a revolving credit line of up to $11.7 million and term loans to Inyx EU in the aggregate amount of $24.8 million, pursuant to four promissory notes. Loans are now about $82M (source: RICO complaint also Montanez testimony).

October 24, 2005, Inyx sought and received a $5 million Secured Over Formula Advance Loan from WBC for working capital to purchase new inventory. The loan was to be guaranteed by inventory one of the Inyx Companies was to purchase pursuant to existing purchase orders. The Inyx Companies, however, never reported such inventory to WBC, and the underlying purchase orders were fraudulent. In addition, while the loan has long since been due and owing, the loan has never been repaid. Loans now $87M (source: RICO complaint).

Nov 2005, Another $10M in loans for revolver at Inyx Pharama Loans now $97.5M (source: Montanez).

On or about August 1, 2006, a conference call was conducted among Westernbank employees and Handley and Hunter. During this call, Handley and/or Hunter falsely represented to Westernbank that most of the Inyx past due accounts receivable discussed on the call would be collected over the coming months even though they knew that most of these
accounts receivable were fraudulent. This conference call took place over international wires (source: RICO complaint).

On or about August 11, 2006, Kachkar, Green, Goldshmidt and other Inyx Companies employees traveled to Puerto Rico to meet in person with Westernbank employees. Among the topics discussed were Inyx’s aging accounts receivable. Kachkar, Green and/or Goldshmidt told the Westernbank employees that they should direct their questions to Handley
and Hunter because they were the ones knowledgeable about the accounts receivable (source: RICO complaint).

Sep 2006, Loans are up to $110M. Accounts receivables increasing, need more working capital. Added to revolver (source: Montanez).

Starting in September 2006 and continuing through at least May 2007, the Inyx Operators repeatedly, misled Westernbank by advising it that the Inyx Companies and/or the Inyx Operators were finalizing arrangements with other sources of funding either to buy out or significantly pay down the Inyx Companies’ debt to Westernbank (source: RICO complaint).

Oct 2006, Auditors cannot complete audit in UK.

November, 10 2006 Jay Green says final stages of due dilligence with Goldman Sachs, Wachovia, Credit Suisse. Jay Green requests a waiver of financial covenants. They are writing off $37M in receivables and that they are pre-billings. "Raised a red flag". Contacted Kachkar who claims this is only GAAP accounting and that receivable are good (source: Montanez)

November 17, 2006 personal guarantee from Kachkar and Benkovitch in the amount of $10 million (source: RICO complaint).

November 20, 2006 Mike Vasquez sends letter acknowledging the $37M in pre-billings. (source: Montanez)

Jan 2007 Last WHI Conference call. Stipes says Inyx is current and that it is not a bad loan. Might be acquired.

Jan 17, 2007 Jack Kachkar offers $148.6 million to buy Marseille soccer team.

Feb 21, 2007, Skepticism grows over Kachkar's funds
Money laundering worries. . French Press says
he has 386M Euros (same link).

Mar 2, 2007
Jay Green sends Westernbank a letter of commitment for financing from Pareto Securities. The letter turns out to be a forgery.

Mar 5, 2007
French Paper reveals that
TRACFIN, the French agency that investigates money laudering is investigating Kachkar and Benkovitch.

March 7, 2007 personal guarantee from Kachkar and Benkovitch in the amount of $8 million (source: RICO complaint).
Loans at $120M (source: Montanez).

Mar 14, 2007 Kachkar's claims to have purchased Grimaldi Castle exposed in
Provence Paper .

Mar 24, 2007 Robert Louis-Dreyfus decided not to extend a payment deadline for Kachkar to buy Marseille team.

Apr 11, 2007 Jose Biaggi tenders his resignation as CEO and President of Westernbank and member of the BOD.

In May 2007, Westernbank learned of a collateral deficiency under the Loan Agreements in excess of $80 million because of uncollectible accounts receivable. Various Inyx officers, including Kachkar, Green and Goldshmidt, thereafter gave false assurances to Case 3:07-cv-01606-ADC Document 3 Filed 08/23/2007 Page 32 of 54 33 Westernbank in June 2006 that the collateral deficiency was substantially less than this sum, the accounts receivable identified as uncollectible were in fact collectible, and/or that the collateral deficiency would be covered by other assets (source: RICO complaint).

May 2007, David Zinn says receivables probably not collectable (source Montanez).

May 14, 2007, Sahara Bank replies by SWIFT saying that it has no letter of credit from Qadahfi for Westernbank.

May 31, 2007 Meeting with Kachkar. He says receivables are good (source Montanez).

June 7, 2007, Kachkar and Benkovitch executed an Amended and Restated Limited Guarantee (the “First Personal Guarantee”) (attached Exhibit 14) guaranteeing, with certain limits as detailed in the First Personal Guarantee, all obligations of the USA Borrowers and the EU Borrowers to Westernbank under both the USA and EU Loan Agreements (collectively, the “Loan Agreements”), up to $30.1 million. The First Personal Guarantee was given “in substitution” of earlier guarantees (source: RICO complaint).

June 19, 2007 According to 8-K filed June 25, 2007, WB decides that the Inyx loan is impaired.

June 20, 2007, Kachkar and Benkovitch executed an additional Limited Guarantee (the “Second Personal Guarantee”) (attached Exhibit 15) guaranteeing, with certain limits as detailed in the Second Personal Guarantee, all obligations of the USA and EU Borrowers to Westernbank under the Loan Agreements in an amount equal to the sum of $70 million plus the amount that the repayment obligations under the Loan Agreements exceeded $142.4 million. This Guarantee was “in addition to and not in substitution of” the First Personal Guarantee for $30.1 million, which remained “continuously in effect.” (source: RICO complaint).

June 20, 2007, Kachkar and Benkovitch executed a Collateral Deficiency Letter (attached Exhibit 16), through which Kachkar and Benkovitch agreed to Case 3:07-cv-01606-ADC Document 3 Filed 08/23/2007 Page 12 of 54 13 provide certain collateral (the “Mining Collateral,” as defined in the Collateral Deficiency Letter) sufficient to cover the amount of the collateral deficiency under the Loan Agreements (source: RICO complaint).

June 22, 2007 Montanez says "We became concerned on approximately June 22nd." because David Zinn reports missing $4.1M in receivables at Inyx USA and 28M sterling missing at Inyx Pharma and 51M sterling missing at Ashton. They contact Zinn who says they will never be collected. Zinn also says $14M in funds have been diverted from lock box (source: Montanez).

June 25,2007 WB files the
reporting the impairment. WHI stock falls.

As of June 28, 2007, Westernbank had made loans to the USA and EU Borrowers in the amount of $142,778,299.77 under the Loan Agreements. As of that date, numerous Events of Default under the Loan Agreements had occurred (source: RICO complaint).

June 28, 2007, administrators were appointed for Inyx Pharma and the EU Borrowers (source: RICO complaint).

June 29, 2007, Westernbank sent a demand letter to the USA Borrowers (attached Exhibit 17). In that demand letter, Westernbank informed the USA Borrowers that (i) the amount of the outstanding loans exceeded the amounts available under the lending formulas and (ii) Westernbank was demanding, as entitled under the Loan Agreements and the Cross-Default Agreement, for the immediate payment of such excess amounts, totaling $87,282,422. The demand letter also informed the USA Borrowers that all other “Obligations” as defined under the Loan Agreements had become due and payable (source: RICO complaint).

June 29, 2007, Westernbank sent a separate demand letter to Inyx Pharma and the EU Borrowers making the same demand as in the demand letter sent to the USA Borrowers but referring to the Obligations under the EU Loan Agreement that had become due and payable as a result of Event of Defaults under the EU Loan Agreement (attached Exhibit 18) (source: RICO complaint).

July 2, 2007, Inyx USA, as well as another Inyx subsidiary named Exearis, Inc., filed voluntary petitions for relief under chapter 11 of title 11 of the United States Code in the United States Bankruptcy Court for the District of Delaware (source: RICO complaint).

On or about July 3, 2007, Westernbank sent to Inyx, Inyx Pharma, Inyx EU and Ashton a “Notice of Default and Demand” (attached Exhibit 19). The Notice of Default and Demand stated that numerous defaults had occurred under the Loan Agreements (source: RICO complaint).

On or about July 3, 2007, Westernbank also issued letters to the Inyx Operators demanding payment under the Fraud Guarantees (attached Exhibit 20). By these letters, Westernbank demanded payment from the Inyx Operators of at least $80 million (source: RICO complaint).

On or about July 3, 2007 and on or about July 10, 2007, Westernbanki ssued letters to Kachkar and Benkovitch demanding payment under the Personal Guarantees and the furnishing of the Mining Collateral under the Collateral Deficiency Letter (attached Exhibits 21 and 22). Westernbank demanded from Kachkar and Benkovitch (a) payment in the amount of $30.1 million under the First Personal Guarantee, (b) payment in the amount of and $70,378,299.77 under the Second Personal Guarantee, (c) the furnishing of the Mining Collateral sufficient to cover the collateral deficiency under the Loan Agreements, and (d) compliance with and performance of their covenants under the Collateral Deficiency Letter (source: RICO complaint).

July 26,2007 The

Stipes Fights Back
article published in Caribbean Business

Sunday, October 7, 2007

A house is NOT an investment

People often get caught up in prevailing myths which provide a basis of belief which leads them to make poor financial decsisions. One of the biggest myths is the idea that buying a house is an investment. The way we talk about things often dictates the decisions we make. Investing money always seems more prudent than simply buying. Often it is said that buying a house is an investment. Is this true? That of course depends on what we mean by investment.

I think the best definition of investing is using ones savings to buy an asset which will provide real future returns in excess of the invested capital.

For example buying a factory with which you will produce marketable products is an investment. Even if you borrow most of the capital, you can pay the interest payments with the operating cash flows. If it is a good investment, you will have profits left over which you can put into savings. Over the long term, it is likely that you can pay off the mortgage and collect these cash profits. After say 30 years, you will have paid off the loan so that you own the factory, the cash flows that were produced as well as the future cash flows that will come in the future. If the real value of these things are greater than the real value of the invested capital, you have made a profitable investment.

I will use the term real value to mean inflation adjusted value. We can compare dollar amounts at different times by discounting them by the risk free return.

Other examples of investments are buying stock in a company, buying CDs from a bank, buying an apartment building which is producing cash flows in excess of the mortgage payment interest rates.

So, what about buying a house? Well, we all need a place to live. Our main choices are renting an apartment or buying a house (or condo). A similar decision to this is choosing what to eat. We all need food but we seldom talk about investing in our food. We consider it a necessary purchase not an investment. Buying a house should be considered the same.

It is possible to think of buying houses as investing. For example, if you buy a house for the purpose of renting it out, it can be an investment. If the rental payments are large enough to pay for the mortgage and also build equity in the house, this can be an investment. However this shows that it is only possible to make housing an investment if mortgage payments to rent are a low enough ratio. In fact this is the best way to value the price of houses. The price to rent ratio is similar to the price to earnings ratio for a stock.

During times of a speculative housing mania, the price of houses will be increasing. People buy houses with borrowed money and hope to make money simply from the increase in house price. If the house price is increasing faster than the interest rate of the borrowed funds then it may be the case that the rent is below the required mortgage payment but the appreciation of the house makes up for this negative cashflow.

However, this situation is unstable and cannot last for long. Eventually the house price will stop appreciating at these high rates and may even start deceasing. These people with negative cashflow will have to sell. This wave of selling will lead to higher inventories of houses for sale which will lower prices further. This kind of "investing" is better thought of as speculation. The profits depend on price appreciation and not positive cashflow. It is no different than speculating on the prices of gold, currencies or pork bellies.

Whether or not such housing speculators make money depends on when they got into the game. People who started early may come out with a profit. Those who started late will come out with a loss.

The housing industry is constantly promoting the idea that buying a house is an investment when this usually is not true. When you are buying a house to live in, this is simply a purchase to satisfy your housing needs. It is the main alternative to renting and often makes sense for people. If the payments on a traditional 30-year fixed mortgage are comparable to the payments that you would pay to rent the same house, then buying is probably a good idea. That is because you are paying a similar amount and are building equity in the house.

The housing prices in Los Angeles these days are so high that buying a house can only be thought of as irrational. Prices are way above any amount that is justifiable by rental cash flows. You will pay more on a interest only mortgage than you would pay to rent the same place. With an interest only mortgage, you are building no equity in the house. The no-money-down, interest-only-loan, which was so common these past few years can be thought of as renting money to speculate with infinite leverage on house prices. Most people would never borrow $20K and then buy pork belly futures but they actually undertaking something even riskier when they use these interest-only motgage products to buy a house. They are not actually buying a house- i.e they don't build equity-they are merely speculating on rates of appreciation. The only benefit over renting is that you get to profit from any appreciation of the house. However in a climate of falling home prices, this can only be a negative. Plus you need to pay all of the expenses associated with buying such as taxes, repairs and insurance. In such an environment prices have to go down since there is practically no financial incentive to buy at current prices. People who got in late may forclose and these forclosed homes will add to the inventory driving prices down further.

Sunday, September 16, 2007

Valuation of W Holding (WHI)

I have constructed a model for valuation of the W Holding company, a Puerto Rican bank (ticker: WHI). They are likely to suffer a one time loss over one or more bad loans this year. This model will assume that they have a fixed return-on-assets (ROA) over the immediate future. It assumes a fixed leverage, Assets/Equity. They have preferred shares and so pay a fixed dividend to preferred share holders. They also pay a common dividend. I will assume that this common dividend is a fixed percentage of net earnings (prior to preferred payments, common dividend and one time loss). I assume that common shareholders compound their dividends in a money market account. The following tables show the constants, the key variables, the expected yearly data and finally the results which include a valuation. We discount this to the present to get a Net Present Value which we can compare to today's stock price. All dollar amounts and share counts are in Millions.


Fixed Constants
Name Value Description
NSHARES 164.897 Number of shares
ASSETS 17894.0 Beginning Assets
EQUITY 1147.00 Beginning Equity
PREF 36.9120 Annual preferred payments
LEVERAGE 15.6000 Leverage ratio, Assets/Equity
PREF_EQ 530.800 Preferred Equity
PRICE_NOW 2.11000 Today's Price per share
PE 10.0000
Price-to-earnings ratio for final valuation
PCB 1.50000
Price-to-common-book-value ratio for final valuation
DISC_RATE 0.100000
Discount rate to convert final value to present value

Name Value Description
ROA 0.00800000
Return on Assets
DIV_PAYR 0.200000
Dividend Payout Ratio, fraction of Net Income before one time loss and dividends
LOSS1 170.000
One time after tax loss due to this years bad loans
BB_EQ 50.0000
Equity used to buy back stock in first year
PRICE_BB 2.60000 Average stock price for buy-back

Per Year Data
Year Earnings E. Growth % Dividend Assets (end) Equity Com. Eq. /share ROE ROCE
2007 -26.8480 -126.848 28.6304
15671.9 1004.61 3.25271 -2.34071
2008 125.375 NA 25.0751
16660.8 1068.00 3.68787 12.4800
2009 133.286 6.30974 26.6572
17748.3 1137.71 4.16648 12.4800
2010 141.987 6.52782 28.3974
18944.5 1214.39 4.69287 12.4800
2011 151.556 6.73962 30.3112
20260.1 1298.73 5.27181 12.4800
2012 162.081 6.94444 32.4162
21707.1 1391.48 5.90856 12.4800

Description Value
Final number of shares 145.666
Ending common equity per share 5.90856
Total dividends received per share 1.17726
Total dividends compounded per share 1.32790
Price based on PE = 10.0000 11.1269
Price based on PCB = 1.50000 8.86284
Final Value/share = Av. Price + Total comp. dividend
Net Present Value (discounted at rate = 10.0000%)

The key variable is ROA. I have assumed 0.8% in the example above which is quite conservative. The average ROA for W Holding since 1996 is 1.15%. The max was 1.147% (in 1997) and the min is 0.59% (in 2006). A more optimistic value for ROA would be 1% which would increase the Net Present Value to $9.5/share.

The main thing that I left out was share dilution from stock options which may be considerable. I would guess that there may be about 10 million shares created for management. This would lead to a dillution of 6%.

Saturday, July 7, 2007

W Holding and the Yield Curve

Here I will explain a bit about the yield curve and how it affects the profitability of banks with the focus on Puerto Rican banks and W Holding in particular.

The long term rates such as the 10 year or 30 year yields are determined by SUPPLY of savings and the DEMAND for long term loans. Essentially this is determined by the bond market and essentially is affected by everything that goes on in the world including the growth of the world economy, the savings rates, the inflationary expectations and world politics (i.e everything).

The curve defined by the yield of similar secutites (say US Treasuries) as a function of maturity is called the yield curve. Here is a webpage which will show you the shape of the yield curve at various points of time. You can check it daily as well as get some of the most insightful bond market commentary from PIMCO .

I won't go into the gory details of the yield curve and what it means in detail. It is quite a fascinating creature actually. It not only tells you about the present supply versus demand of loanable funds of various maturities but also tells you about the future expectation of changes in itself. In short, if you want to borrow (or lend) money for 10 years, you can do it in several different ways: one fixed 10-year loan or two 5-year loans or five 2-year loans. Global arbitrage will result in making the expected cost the same. This will presume the market assumption of what the 5-year yield will be in five years from now or what the 2-year will be at various points in the future. I like the quote from financial writer and former derivatives trader Frank Partnoy, "If you don't understand the forward yield curve, you're probably losing money to someone who does". Pardon the digression.

Generally banks borrow short term funds. For example they receive checking and savings deposits or issue CDs. They also borrow from each other at the Fed funds rate and if necessary can roll over these short term loans. Similar short term loans between banks are called repurchase agreements or repos. These are loans where the borrowing bank sends some collateral to the other bank such as bonds or some financial security. Funds from checking and savings accounts are the preferable way to borrow money since the interest expected on these is minimal. CD rates and in general the short term lending rates are largely determined by the Federal reserve. The Fed directly controls the overnight lending rate, the Fed funds rate, and all other short term instruments compete with this rate and so do not differ much from the Fed funds rate.

The difference between the long end (say 10-year yield) and the short end (the 3-month yield) is called the yield curve spread or simply the spread. This number is crucially important to the profitability of banks. This is because they typically borrow short and lend long. For example they issue CDs and take these funds and offer mortgages or business loans. When this spread is large, they can make a lot more money than when the spread is small. When the spread is negative, they are actually losing money by lending. This is one reason why the spread is typically positive. There is no incentive for banks to lend at rates that are lower than their borrowing costs. So they will refrain from doing so which will reduce the supply of loans and drive up the interest rate. Like all market rates, it is all determined by supply and demand. There is also the issue of risk spreads. Riskier loans require higher interest rates over the risk-free US treasuries. When these risk spreads are higher banks make more money. When they are tight (like now), banks have to take on risk without as much compensating profitability. These periods of low risk premiums do not usually last very long and frequently end in turmoil. As Greenspan put it, "...history has not dealt kindly with the aftermath of protracted periods of low risk premiums." Often they end in too many bad loans and not enough profit on the surviving loans to make up for it. In short, there is too much money and not enough good investments to make with it.

Let's get back to our bank in question, W Holding (ticker WHI), parent holding company to Westernbank of Puerto Rico. The defining feature of Puerto Rican banks is the lack of low cost deposits. Puerto Rico is quite poor. Although part of the US, they are as about as poor as Mississippi, the poorest US state. There is not a lot of money hanging around in checking and savings accounts. Instead these banks mostly rely on brokered deposits. In essense they have to buy their funds in the money market through CDs and repos and other similar short term instruments. Although this is usualy thought of as a dissadvantage, they have other advantages that can make up for it. The main one is the low tax rates. PR banks can register as an International Banking Entity (IBE). Because PR is not a state and doesn't have full representation, they are not taxed by the US government. Remember the whole "No taxation with representation" thing?. We take that pretty serious in the US (except for Washington DC). PR banks thus have lower tax rates and can offer slightly higher rate CDs and repos because they can earn slightly higher after tax returns by investing in US treasury securities.

These IBEs are typically divisions within the bank and when the yield curve spread is positive they become incredible cash machines with very little risk involved. The only risk is that the yield curve will flatten or invert, making them unprofitable or even loss producing. However these periods are usually not long lasting. If the flattening is due to rising treasury prices (falling yields) then they have made a capital gain on those bonds which make up for the fact that yields going forward are smaller. Rising Fed funds however are simply bad for IBEs and make this business difficult. Happily, these times do not last forever. The natural state for the yield curve is to have positive slope and so the natural state of IBEs is profitability.
There can be maturity mismatch. Much of this can be handled with derivative instruments such as interest rate swaps. Generally speaking, there are short term risks but over the long term they are great businesses. They can be run with very few employees and so are extremely efficient. WHI is one of the most efficient banks in the US.

This brings us to a rather simple point. The profitability of WHI is affected by the spread. The stock price is also affected by their profitability and so one would expect a correlation between the spread and the stock price. Lets look at a chart

The red is the yield curve spread with the scale on the left. The black is the stock price (scaled arbitrarily). One can see that there is a pretty good correlation. The stock price has a bit of a lag as investors don't seem to react until reported earinngs begin to decline. You don't want to be in WHI when the spread is huge (say 2004), profitability is large and investors think this will go on forever. However buying in the 2000 recession, before the fed cut, would have made you a four-bagger in three years. You want to be contrarian. You want to get in when things are bleak and the bank is simply skating by with low profit margins. The market is short term oriented. They won't wait for things to change. However a long term investor can simply buy in here and wait. Someday, things will change. The Fed will lower rates and the yield curve will steepen. The IBEs of Puerto Rican banks will become cash machines again and the banks will grow at growth rates of 20%+. The stock price will rise and continue to rise for years as the economy recovers until the Fed decides that it is time for a slowdown. You want to get out while the gettin' is good before a new crop of investors learn their lesson about the yield curve the hard way.

Saturday, June 2, 2007

Where I get financial data

If I had lots of money I would pay Standard and Poor lots of money and I would get their Compustat database with some visualization software. However I don't so I have rolled my own. Here is a brain dump.

Where do you get financial data? Here is where I get mine.

1) Yahoo finance.
This is a pretty good site. I won't go into it in detail but you can find lots of financial data here as well as stock price charts and a message board (alas with too much spam). The problem with yahoo is that you can't get much for financial data from more than two year ago. It is good for short term info but not so good if your looking for 10 years worth of earnings data. You can also look up historical prices here. Other info you can find here are short ratios, EV/EBITA, Analyst estimates etc.

2) MSN Money
A good place for a 10-year history of profitability is MSN Money. For example, go here to get the 10 year profile for IBM.
The key things to note on here are the 10-year, net profit margins, return on equiy and assets.
When I want to look into a company that I know nothing about, I go here first. One glance at this table and I can see whether the company is profitable and stable or otherwise.

3) Morningstar
This is a great site for info about stocks. I pay $9/month or so for the premium membership. Here you can find loads of info about the companies. One of the best things are the analyst reports where you can learn a lot about the companies. They also gives recommendations for whatever that is worth as well as rate the management and tell you whether they believe the company has an economic moat (i.e. barrier to entry). Unlike bank analysts, they don't have conflicted interests. The other great thing is the stock screener. This is the best that I have seen. There are hundreds of parameters to screen on. You can even screene on things like their Morningstar management grade. You can also get 10-year financial data from the three financial statements. Highly recommended.

4) Scottrade
This is the discount broker that I use. One of the things that I like about it is the access to Standard & Poor Stock Reports which are similar to Value Line reports. You can also buy these in book format from your bookstore . Obviously, I prefer the electronic PDF format. I can also save these to my laptop and use them as a database. They have 10 financial data and in a more useful format then most other places. Again, if I were more savy (or had more time), I would write some software to extract the data from the PSF files and store them in a more structured way. What I have been able to do is write a piece of code which prompts the user to highlight the table of 10-year financial data and cut and paste it into a file. Then it stores this into a simple text file and makes the following plot using Bed Bath and Beyond (BBBY) as an example.

I know that is a lot to take in at once but by looking at this, I get to see every financial aspect of a company in a single glance. Every box shows a 10 year history of some financial quantity. The top three (left to right) book value per share, earnings per share and cahsflow per share. In the sixth row you see the Returns on : assets, equity, invested capital, total capital, capital and tangible capital. I won't go into the details here about what the differences are. The three on the left of the bottom row are P/E, pretax earnings yield and free-cash flow yield. I can click on any box to see the growth rate calculations. I can also see the number of shares to see if the company has been buying back shares or diluting. This is extremely useful. I don't know of any other way to visualize this data without paying someone a lot of money to write some kind of software to do this. S&P also gives the stocks a rating 1-5 stars and over the past decade, this has proven to be market beating advice. Whether that will continue is anyone's guess.

5) National Association of Investment Clubs
I decided to pony up $49/year to join this. I haven't explored here too much. I joined only to get a hold off their compustat database. You don't get the whole data base but you can search by ticker and get a complete financial history of a company. For example I can get the earnings for JNJ or GE all the way back to 1950. Pretty cool. I can save these html files with a simply keystroke. I wrote some software which then reads these html files. That way I can make a little database of companies that I haved looked up. If I were a bit more savy, I would be able to write a program which fetches this info without having to use a web browser. Maybe in the future. I also have written some code which makes plots of this data and calculates growth trends. For example this is one for JNJ.

This is very useful when you want to know the long term picture of the company. Unfortunately, this only gives you the long term picture of the PAST. The version which calculates the future earnings is still in development ;)

6) Insider trades.
You will want to keep track of insider trading (the legal kind). This is especially important with small obscure, out of favor or ignored companies.

7) SEC Edgar
Sometimes you need to get your hands dirty and read through anual reports like 10-K or the quarterly 10-Qs or other SEC filings. Go directly to the SEC page and search by ticker.

Enough with financial data. There is more about companies than the numbers. I have mentioned two places already to get qualitative info. The morningstar and S&P analyst reports. But what if you want to read about the history of a company. You can find these at They are written by I find these excellent places to read about the long term history of a company especially if they are not too well know. For example if the company is Bank of America, then there are many places to get info. For a company like this, you will find multiple books written on the company. However, for a less well know company like Graco (GGG) might be the best place to go. Wikipedia usally just has the same Hoover's histories.

9) Guru Focus
This is a good site to find out where some of the world's best investors are putting their money. For example you might find out that Warren Buffet and Bill Miller both bought some stock which is now 20% lower than they paid. This may not lead you directly to riches but is still very useful info. If I am casually looking at a stock and I find out that a couple of these guys is buying it, then I might look into it in more detail. For example, seven of these value investing guru's have bough UPS. About 10 have bought Wal-Mart.

Wednesday, May 30, 2007

Valuation of RGFC.PK

The valuation of R&G Financial (RGFC.PK) which just sold its Florida Bank to Fifth-Third bancorp. I estimate it is selling at half its value and will probably double if/when it return to the NYSE from the pinksheets.

21,559,584 Class A
29,561,190 Class B
51,120,774 Common shares

Liquidation value of Preferred stock

Series A 50,000,000
Series B 25,000,000
Series C 69,000,000
Series D 69,000,000
total 213,000,000

Equity (based on Bank Holding Company data, after restatement)
544,945,000 As stated on BHC form
- 213,000,000 Preferred
331,945,000 Equity for Common shares
- 118,569,000 Non-tangible servicing asset (though not worthless)
213,376,000 Tangible Book Value

6.49335 Book value per share
4.17396 Tangible book value per share
3.02 Cohen (former analyst) estimate of Tangible book value per share

211,685,000 Other assets, probably mostly derivatives included in book value
Interest rate derivatives, probably OK

723,721,000 Listed on BHC as intangible and other assets
255,816,000 Listed on BHC as other liabilities
467,905,000 Diff between these two

------------------Changes with sale of Crown bank--------
Price payed
288,000,000 For crown bank
50,000,000 Paying off preferred shares
16,000,000 Real estate
354,000,000 total payed

226,000,000 tangible assets of Crown bank
128,000,000 Gain in tangible assets for RGF common stock holders

213,376,000 Old Tangible Book Value
+128,000,000 Gain in tangible BV
341,376,000 New tangible BV

6.67783 New Tangible BV per share

If Cohen's number is right
285,451,984 New tangible BV
5.58387 New tangible BV per share

3.90 Price per share on May 30
69.84% Fraction of tangible BV

Even a poor bank is worth about 1.5x tangible book value per share
Using TBV=5.58387
This is
Value = 8.3758
which is over twice the current price

Other scenarios:
The deal falls through. It needs to sell out like Doral to obtain cash. Value = 1.5 /share. Probability 10%
The deal goes through but tangible equity declines by $50M. Value = 6.0/share Probability 10%
The deal falls through and they fail. Value =0 Probability 5%
Value = 0.75*8.4 + 0.1*1.5+ 0.1*6 = $7.05/share

I will take as my value 7.0/share which makes it a buy at 3.90 however with the risk involved I can only put a small amout of my money into it.

############## UPDATE #####################
RGF announces that the think the restatement will be about $240 million after taxes. They had figured $185-$200M previously. On their BHC form they listed -$264,637,000 as accounting restatement which is probably pretax.

So I think we subtract about $50M which gives us about 230-280 of tangible book or $4.5-$5.5/share. It is selling at
$3.95/share today. Still pretty cheap but worth the risk? Investors did seem to like Doral once it got an infusion. Maybe RGFC.PK is worth a few bucks. I think the chance of doubling is still very good and chance of failure small.

Also the $16M is not for RGF sharholders

8-K about FHA license being taken away. Hopefully temporary.

Price on July 23, $2.60/share WOW!!!

##################### Update ###########################

12/2007 Holding company report out

Common book value down to $125MM. There is $523MM in either 30 days late or non-accrual. They have recently said that they are probably not going to pay any more preferred dividends. They are now deteriorating quickly. It could be the end for RGF. They will likely need to sell the bank in order to avoid being seized by regulators. Yikes.

Friday, May 18, 2007

Home builder earnings

I made this plot of earnings and book value for two of the oldest buiders Pulte Homes (PHM) and Centex (CTX). Black is PHM and red is CTX. The solid lines are book value per share (BV) and the dashed line is earnings (E), multiplied by 10.

They have grown BV by a factor of about 1000 since 1968. Pretty impressive. That is a 19.9% annualized growth rate for PHM and 17.8% for CTX.

You can also see how volatile the earnings are. Earnings are the change in BV from year to year: the derivative of the BV curve. The ratio of the two E/BV is the return on equity (ROE). You can see that the average ROE is roughly 10%. For the past 10 years, the ROE has been much higher. The dotted lines are about twice the solid so ROE is about 20% similar to the late 1970s.

You can also see the major recessions in 1973-1974 (the OPEC oil crisis) , 1980-1981 (Volcker's recession), and the 1991 Bush recession. The 1973-1974 recession appears to have been the worst for these builders. PHM nearly lost all of its earnings but still managed to avoid a loss. For both companies, BV has never declined in nearly 40 years. They have never had a loss.

Despite these terrible recessions, builders have managed to recover after a couple of bad one or two years. I think they will do likewise after this recession. Will the profitability of builders return to ROE=10 like they did in the 80s? Perhaps. However, the future may not resemble the past. What really matters in terms of growth for the builders is population growth. It appears that the government is passing immigration "reform" which should allow not only higher than average population growth but also plenty of cheap labor which will add to builder profitability. I think it is true that the long term picture is still rosey for home building in the US. However in the shorter term, we are likely to see a recession and the housing slump is likely to get worse before it gets better. There are still lots of uncertainty over how this will all play out. I think we are likely to see massive intervention on the part of the government aided by the Fed to prevent a full blown deflationary collapse. As an investor, my job is to decide whether builders will survive, whether they will grow thereafter and to decide when all this bad news is sufficiently priced in to create a good entry point in the stocks. I like Meritage Homes (MTH) best at this point although they are probably not the most conservative pick. Still, they seem to have the most long term potential and seem to be most feared by market participants presumeably because they only build in the southwest. They are trading at 0.88 BV and may go a bit lower. I have some shares, purchased at around this valuation and may acquire more if they drift lower towards half book and I see a rise on the Fear Meter which is now registering only Medium-High.

Of course one should be prepared for some volatility in prices. In the 1973-1974 recession, CTX tumbled in price from 2.78 to 0.3 (split corrected) which is a factor of 9.3,Yikes! Of course, they started off that priced 4.8 times book (way overvalued)and bottomed at half book (way undervalued). It seems half book is about the maximum fear point. MTH may not be there yet.

Thursday, March 29, 2007

Monday, March 26, 2007

The Chinese problem

Everyone in the investing world needs to have a basic understanding of our trade situation with China. It boils down to this. We buy stuff from Walmart,Target etc who buys their inventory largely from China. So essentially China is sending us stuff and we are sending them dollars. What can a manufacturer in China do with dollars? Well, they can buy US imports, they can buy US financial assets (stocks and bonds or real estate) or they can trade them for Yuan or other currency on the Forex market. As most people know, we have a significant trade deficit with China which means that the Chinese typically do not use their dollars to buy US goods and services. They typically buy US treasury bonds which is essentially saving in the US dollar currency.

This dollar build-up should have a natural brake on itself. Eventually, the excess amount of dollars should cause the dollar to drop (via supply and demand). This makes Chinese goods more expensive to Americans and so should decrease their buying. However, it hasn't exactly worked out that way. The Chinese central banks has been inflating their currency by printing as many Yuan and trading them for dollars as it takes to keep the Yuan from appreciating so that Americans do not stop buying and the Chinese can grow their export-led economy at a very fast pace.

Can this go on forever? Can the Chinese keep growing their factory base at 10% if US consumption only grows at 4%? Not unless the Chinese or someone picks up their consumption. It is unlikely that the Chinese and the rest of the world are going to change that quickly. The Chinese are new to this capitalism thing. They still lack basic property rights, a solid sytem of business law, a strong financial system. Most importantly, the Chinese lack a basic sense of political and economic security. Without this security, they will opt to save rather than consume.

This should lead to dire consequences for China. Eventually they will develop excess capacity. This means they will have too many factories making too many products and not enough Americans or anyone else to buy them. This is the classic economic problem which leads to recession. When the excess is large enough, it leads to a depression. Whether or not this is a mild to medium recession or a more severe depression (like the Great Depression) may depend on the stability of the Chinese financial system. I don't have much knowledge about this but the general concensus is that the Chinese banks are plagued by corruption and nearly insolvent. So you can easily see what could go wrong for the Chinese. They need to support their growing economy with growing consumption but don't seem to be able to do so.

What can the Chinese do to prevent this? I would argue very little. I think it is enevitable that they undergo a recession. They can further inflate their currency which lowers prices for Americans. However this doesn't work out as planned. They still need to buy oil, energy and commodities from outside of China. Cheapening the currency just makes these more expensive. That is, inflation is never a solution. It can add a temporary stimulus but cannot really benefit the real economy.

A better way to look at all of this is without the use of currencies. Currencies can add another layer of complexity that act to obscure the real issues. Basically the real issue is this. As global markets have opened up over the last few decaded, poor people (like the Chinese) have been able to get jobs servicing the people in the more developed nations (like the US). Since they were poor, and had little access to jobs, they were willing to work for less pay. It is just supply and demand. There are lots of skilled but jobless Chinese willing to work all day to pay for their rent and dinners and the global economy has found a way to allow these people to service the richer American people. As long as there are more Chinese people (or in general poor people anywhere) than jobs, their wages will remain low. They simply have no bargaining power to ask for higher wages if their employers (ultimately the rich consumers) can go elsewhere for work.

This will end when we run out of poor unemployed people. Once that happens, they will demand higher wages and they will get them. This will cause higher prices for the rich Americans. In the mean time, the poor will have been saving their money and will be less poor. Ultimately, they will be as rich as the Americans. Overall, this is good for everybody. That is the whole point of the field of Economics. Trade is good for everybody. Isn't this great how trade solves all problems? Well...

Friday, March 23, 2007

Fab Five

Sometimes when we are diligently searching for wonderful ideas, we miss what is right in front of our noses. There are times when the best investment ideas are not found by digging through the 10-Ks of obscure pinksheet companies but rather are found right out in the open among the largest, most prominant companies. This may be one of those times.

Which five Dow stocks have negative returns over the last year as well as the last five years?

Ticker Full Name PE 10-y Ann. Growth Div. Yield Div. Growth
JNJ Johnson & Johnson 16.2 13% 2.5% 16.5
PFE Pfizer 10.0 9% 4.5% 14.4
WMT Wal-Mart 17.8 17% 1.8% 24.6
AIG AIG 12.7 12% 1.0% 24.7
HD Home Depot 13.7 21% 2.3% 23.7
Average 14.1 14.4% 2.42% 20.8

All five are considered to be among the highest quality companies in the world (nearly all Dow stocks are). Companies like this are what the financial writer George Goodman (aka "Adam Smith") has termed super-currency. They are more reliable than any currency, resistant to inflation and accepted everywhere as a store of value. When the world is caught up in panic over the next crisis, these kind of stocks hold up the best. JNJ PFE and AIG are practically recession proof and this five stock portfolio is fairly well diversified across a few major industries: health care, retail and insurance/financials.

Their growing dividends are very attractive to income investors (i.e. the massive wave of retiring boomers) and their recognition factor will be attractive to all the new foreign investors (like in Asia) looking for an alternative to their less established stocks and overall turbulent markets. They have little real downside risk from here. All should have a sustainable long term growth rate above 10% (for at least 15 years). All of these are suffering from the fact that they were incredibly over-valued when the 90's bull market came to an end.

What would the expected return be over the next ten years for this five stock portfolio?

Let's assume the average growth rate slows from the 10 year average of 14.4% to G=12.0%. The average dividend yield is 2.42%. We will assume that dividend grows at the same rate as earnings (despite the fact that dividends are growing a lot faster at 20.8%). The annual return will then be R=G+Y = 14.42% assuming that the valuations don't change. That is a pretty good return for no-hastle investing. If the valuation grows from the average PE of 14.1 to 17.0. This might be expected as they become more favored. This is ΔV =20% expansion of valuation. If it comes over ten years that adds another 2% to the annual return. For the mathematically challenged, the annual change is ΔVA = [1+&DeltaV]^(1/N) -1 where N is the number of years it takes to expand.

This gives us a ten-year expected return of R=G + Y + ΔVA = 16.4%. If this valuation expansion happens faster; say in three years (not unrealistic) , then the return is R(3-year) = 21% which would be spectacular. You can fiddle with the numbers and get different results either better or worse. However, It seems almost impossible (short of a depression happening) that this portfolio wouldn't return at least 9% over 5-10 year times scales. Since dividends are growing at 20.8% and these stocks are buying back shares, it would not be surprising for these stocks to return more like 25%.

I own the first three JNJ PFE WMT and may soon buy the other two. I have a few other good investing ideas but feel that there aren't too many good places to invest in this market. In the meantime I will put money into the Fab Five and keep some cash around in case things change.

Tuesday, March 20, 2007

Mortgage Insurers

I am completely convinced that we have a housing bubble in the US that will bust and cause havov for the US economy. Still, I would like to keep my cool and invest somewhere at some time in the real estate sector when fear of the crash is overdone. So where to invest? The usual places would be homebuilders, banks, furniture makers, home furnhing like Home Depot etc or title insurance.

Another place is private mortgage insurance (PMI). Mortgage insurance is an interesting business. Basically they insure against banks losses for the top 10-20% or so of loans for people who don't pay a full down payment. Some notable mortgage insurers are (tickers) MTG, RDN, PMI and TGIC. All of these are down somewhat and hovering near book value. These companies have typically grown about 15% over the past decade or so and investors have had good returns despite significant volatility. Buying them at the right time typically gave you a 40% one year return.

The bussiness model is fairly simple. They get paid a premium by the borrower. If they forclose and the bank takes a loss, they pass on this loss to the PMI which either pays the bank or takes over the title. Like any insurance company, it makes sense to talk about the loss ratio (losses over revenue) and expense ratio (operating expenses over revenue) and the sum of the two which is called the combined ratio. When the combined ratio is less than 100%, the PMI makes an underwriting profit. It can also invest the float for investment income. The net operating income is the sum of the underwriting profit (or loss) and the investment income. Most regular insurance companies have a combined ratio near 100%, usually a few points higher. Thus they take a small loss to be able to invest the float at a higher return (mostly in bonds). They make a profit on the spread. A combined ratio of 100% means they are getting an interest free loan which they can invest at say 5% in bonds. There is generally a limit of float-to-equity which is considered safe but they can thus leverage their return on assets by this ratio to make a reasonably high return-on-equity of 12-20% or so for a good insurance company. Generally they grow at about the same rate as ROE.

Mortgage insurance is quite different. In good years the combined ratio is very small. For example MTG (company name is MGIC) has a combined ratio of between 45% and 70% for the past 5 years. Wow! What a bonanza! Even if it just buried their money in the backyard they are making a net profit margin between 30-50% just for signing pieces of paper. Unlike most insurance companies, they make more money from underwriting profits (in good years) than they do from investments.

Figuring out the future of this industry is complicated and requires a good understanding of the whole mortgage industry. (I don't claim to understand it well enough but I am working on it).

For example these companies are at the mercy of :
1) the Federal government which competes with them through the FHA.
2) Fannie Mae and Freddie Mac who make a lot of the rules of what is conforming etc.
3) Strengthening/consolidating lenders who siphoning off premiums through captive reinsurance.
4) Lenders offering piggyback loans and other PMI alternatives.

I won't go into the details of the these issues. Another important things is the shape of the yield curve, the persistenacy of premiums, tax deductability, pricing pressures etc.

What I want to focus on is loss ratios. I have mentioned above that combined ratios over the past 5 years are in the range 45-70%. Expense ratios are typically in the range 20-30% which leaves loss ratios in the range 20-40%. Are these typical numbers? Are there typical numbers? Would we expect losses to increase significantly?

That is difficult for me to estimate. Surely they will rise, but will they rise enough to make combined ratios much above 100% where the PMIs would start reporting losses and decreasing book value? I don't think anybody knows for sure which makes it quite a gamble.

Lets look at the past for examples. First of all there is the Great Depression. There were actually PMI around during the 1920s. None of them survived. All went bankrupt in the collapse of the financial system. MGIC (MTG) started up in 1957 to compete against the FHA which was a "New Deal" program to restart the mortgage market during the Depresssion. You can read about the history of MGIC HERE .

Ok, well you might not want to count the Great Depression. Hopefully that won't happen any time soon. What about more recent history.

Here is a plot that I made of Book Value Per share (BV), Earnings (E), Dividends (D) and Return on Equity (ROE) since 1990.

Basically BV has grown at 20% and you can now get a 2% dividend yield. On top of that they are selling for P/B of about 1 which very low. If they continue growing at this rate and get back to P/B of say 1.5 in 3 years, your getting a return of 36% anualized for the next three years, maybe even better. Sounds great right?

I have my doubts. Let look further back into the 80s. The 2002
for PMI group shows the loss ratios back to 1981.

The bottom line is that loss ratios in the 1980s were terrible. They attributed these to the real estate decline in the oil patch. When inflation was reigned in by Paul Volker's Fed, oil prices collapsed and so did all the business in Texas and other oil patch locations. Loss ratios were in the range 200-265% for contracts written in years 1981 and 1982 and these losses carried on for twenty years for contracts written in those two years. That is PMI was still paying out losses (probably small ones) in 2002 for bad decisions made in 1981. I am not sure how all of this works its ways into yearly earnings. I would like to see a chart of common equity for PMI through all of these years. I am guessing it decreased significantly in the mid 80s but don't know sure since PMI was not a public company then.

How does this relate to today? Surely the oil-patch real estate bust was more acute than todays national/international housing bubble. However todays bubble is more wide spread and I don't see any reason why losses couldn't be worse than the 1980-1983 debaucle. Will these companies even survive? I don't know. Hopefully they are reinsured well enough to handle a national housing crash but I don't have the expertise to figure that out. I have seen a quote in the 10-K of MTG that says that because they are regionally diversified, they don't expect major losses. However that seems to rely on the idea that house prices can't crash everywhere at once. What if they do? Are they still prepared to weather the storm if house prices decline by 20-30% nationally like some bears (i.e. Gary Shilling, Jim Rogers) are predicting?

I don't want to make that bet. I am staying away from investing in these companies until I start seeing them handling severe losses gracefully. Which means I might miss them entirely. That's fine. I will stick to more transparent businesses. I think that if hell gets cut loose on these companies the stock prices will collapse to something like 1/4 of book (see for example the subprime lenders). In that situation you might be getting the right odds to make a bet on these companies. In fact, you might be better off to invest through LEAPS (long term options) since they would either go bankrupt or survive and prosper. If they go bankrupt you lose it all with either common stock or LEAPS but with LEAPS you get more leverage on the upside. I don't think your getting good odds to invest in the common stock now.

Sunday, March 18, 2007

The LA Housing Bubble

This is an example of a house in my neighborhood, the Silverlake neighborhood of Los Angeles. This plot is from Zillow. Can anyone really believe that this rediculous price expansion is not a price asset bubble? In 1997 this was worth $115K. By 2004 it had appeciated to about $200K. That is an 8% annualized price appeciation which is pretty good, about 6% more than the inflation rate of 2%. Then things went crazy. The bubble mentality set in. People decided that prices in this neighborhood were going to accelerate. They were right. Over the next three years the price would increase from $200K to $900K at a 65% annulaized rate. During this time houses became not places to live but things to invest in for short term gains. Failed traders from the dot-com days decided that real estate was the place to be. This house below was traded three times in these three years. The original owner sold in in 2005 for $450K and probably walked away with $350K in profit. It was bought by someone looking for a short term profit. They probably invested no more $10K by buying with an interest only, low or no down payment loan. It would go from $450K to $650K in two months. That is, they multiplied their $10K investment by 20 in two months. That annulized rate of return is over 6 billion percent!!!! By this standard the next owner was down right conservative. This person held it for a whole year and only made a $150K profit. The poor sucker that bought next for $800K may have watched this zillow chart and seen $100K of equity appear about thin air. Unfortunately it is clear to all that this bubble is busting. The poor owner probably has this house sitting on the market at inflated prices and has to bear the horror of watching the prices drop like the hapless NASDAQ in 2000.

Now consider the effects of all of this home equity appearing out of nowhere for millions of people in Los Angeles. How much money was created? Well if there are one million households in LA and if each house recieved $300K of new equity, that is 300 billion dollars. The total amount of new equity created in the US is a few trillion dollars. The effects of a few trillion dollars introduced into the economy can't be ignored. Many of people would pull money out of their homes though a home equity loan. They would use this money for home repairs, new expansions, to buy cars or pay off loans or credit card debt to free up these cards for new purchases. All this new money flooded into the economy. Much of it ended up in bank accounts which helped fuel new lending. As prices rose further and further, houses became unaffordable to most with traditional loans. But banks would not allow the party to stop. New products were dreamed up that allowed anyone to buy a house regardless of credit quality or lack of down payment. These were the interest only loans, the adjustible rate mortgage (ARMs), the negative amortization loans, the option ARM, stated income loans etc. As long as prices were rising, even poor credit buyers could sell at a profit if they couldn't keep up with payments. Banks themselves were not at risk as long as prices rose even if they put their own capital at risk through second mortgages (piggyback loans). Non-bank subprime lenders would originate multitudes of loans to poor credit buyers and sell these loans off to Wall Street banks who would send them along to hedge funds looking for high yield products where they could could make huge profits by buying these with large amounts of leverage, some of which was generated by borrowing yen at near zero rates, selling yen for dollars and buying high yield US mortgage loans. When the bust started, the Wall Street banks stopped providing capital to these risky subprime lenders who collapsed due to this liquidity crisis. This reluctance of banks and non-bank lenders to lend would further add pressure to the collapsing housing market. The end game is now obvious. This housing collapse will be the worst since the 1930s. The bubble is bigger than previous bubbles in the 70s,80s and 90s. The collapse will therefore be worse. Some people still hope that Washington or the Fed can still save housing and save the economy. Unfortunately, the only solution is for prices to come way down. In the meantime this will lead to a miserable economy, higher unemployment and probably a severe banking crisis. The Fed can probably bail out banks if it chooses to to prevent a deflation like the 1930s by lowering rates close to zero which would allow banks to make large enough profits on the spread to cover real estate losses. However it can't make people spend like they did before. It can't restart the boom. It is time finally to face the music and deal with the fact that our economy cannot grow at these unsustainable rates of past years.

Thursday, February 15, 2007

The mystery of mean reversion

One of the things I find fascinating about markets and the economy is the tendency towards mean reversion. Rather than taking a random-walk, markets seem to shuffle back in forth, contained within a tight range of possibilities. One of the places you see this is with the stock market averages. In Jeremy Siegel's book, "Stocks for the Long Run", he shows a plot (need a link) of the stock market average from 1830 to the present. Amazingly, it is nearly a straight line (on a log-axis) when corrected for inflation which indicates a steady 6.9% return over long periods of 30 years or so. In the shorter term, there are "wiggles" like the great crash of 1929 and the great bull market of the 1990s but over long periods you see it return to the trend. Other investments like bonds or real estate or gold do not show any kind of regularity. Stocks do not behave as a random walk, where the next move is simply random. Even though the country has changed dramatically from a agricultural economy to an industrial economy and then finally a service economy, the stock market returns have not changed a bit. Over 30 year periods, you simply get a 6.9% real return just like you always have.

Well, this isn't a history class. What does this mean for investors? There are a number of useful things to take away from this. Lets stick with the stock market averages for now. For one, it means that the current prices of stocks are not really the best predictor of where they will likely be in the future. This contradicts the Efficient Market Hypothesis (EMH) which says that the current price of stocks is really the best predictor: the price tells you everything and the trend tells you nothing. Mean reversion says the best predictor is really the trend itself. If your below trend, then your most likely to move upward back to the trend. If your above the trend then the opposite is more likely to happen. The long term data clearly indicates that mean reversion and not random walks is a better description of the stock market averages. In other words, in times like 1980 when stocks were well below the trend, we should have known better and simply loaded up on stocks. It should have been a no brainer and of course it is in hindsight. We were way below trend and they were practically giving stocks away. Of course most people hated stocks then. Business Week had their famous "Death of Equities" cover. In the opposite extreme was 1929 and 1999 when we were way above trend but crazy about equities. Using the insight of mean reversion should have convinced people to pull out and ignore stocks for a while. Of course we know what happened. The bubble bursted and we heading back to the trend. Surprise, surprise.

Other places that you see mean reversion is with whole industries. Banking for example goes through periods of high profits and periods of low profits. Same with insurance companies. Real estate also has these cycles. By understanding that these cycles are temporary and actually acting on this insight, you can out-perform the indices. Of course, not everyone can do this anymore than everyone can be taller than average. There seems to be some principle that keeps the average person at a 6.9% return. The goal of the stock picker to be better than average. But clearly only a few of us can do this. Others need to underperform and most will simply cling to the average by buying index funds.

The value investor is someone who tries to appreciate this principle of mean reversion. They seek to buy things that are out of favor and probably performing below average. The hope is that, as usual, things will change and this company's fortunes will change for the better. If the company is selling for a cheap enough price, then it will appreciate quickly when things begin to change. In my opinion, the best places to do this are with older companies that have survived many such cycles. For example, buy high quality and conservative insurance companies when profits are lower than usual. This is usually when there is a soft market and many companies are jumping into insurance and fighting for market share and so lowering prices. This eventaully will change when there is a crisis and these new companies become unprofitable and start to pull their capital from the insurance business. This allows prices to rise and the old stalwart insurance company becomes more profitable again. Other examples. Buy home builders during a housing crash (like now). Buy industrials during a recession.

The key is that you may have to wait a a while to get good returns. It is very difficult to forcast accurately when things will change. In fact it is probably almost useless to try to guess since the Market is a great discounting machine that is trying to determine this before you do. Marty Whitman has said that you should try to buy at the point of maximum fear. Of course you never know that you have reached this point. Buffett has said to "be feraful when others are greedy and greedy when others are fearful". However getting the timing right is difficult at best. Buffett has made the point that what you really do is simply try to figure out how much the company is worth as the total discounted cash flow (DCF) over its lifetime. This is the long view and to do this you need to assume that things will revert to the mean. You should not simply extrapolate the present situation because that is what the Market does. To beat the market, you should use the principle of mean reversion.

Why do things revert to the mean? That is the great mystery and we will leave that one to the philosophers and the social scientists. What an investor needs to know is that for whatever reason it is simply a proprerty of the markets. To beat the market averages you should work it into your investment scheme. If everyone did this and we had a market of DCF robots then maybe this wouldn't work. But Markets are controlled by people and people are afraid to lose money and get more afraid as security prices drop. This makes them ignore mean reversion and miss opportunities that value investors take advantage of. This is unlikely to change anytime soon as it appears to be simply a part if human nature. If we can resist these human emotions and invest more objectively, we have a chance at above average returns.

Saturday, January 27, 2007

Road to Serfdom - cartoon version

Great Cartoon for your socialist friends