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.
----------------
Shares
------------------------------------
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)
http://www.chicagofed.org/economic_research_and_data/bhc_data_2001_2006.cfm
-----------------------------------
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
-------------------------------------
-------------Valuation----------------
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.
Wednesday, May 30, 2007
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.
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...
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?
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.
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.
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
10-K
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.
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.
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
Friday, December 22, 2006
Two value strategies
I believe that all good investing involves buying something below it real value. Up until now I have been concentrating on what may be called a Buffett strategy. This is essentially investing in good business at prices below their value. For example you can buy companies with high return on equity (ROE) and low P/E. You can make guesses about their probable future growth and so estimate their fair value P/E and buy if the market P/E is below that.
There is another way where you buy companies at low price to book value, P/B, regardless of whether they are good or bad. These strategies are connected because of the identity
P/B = P/E * ROE
This is true simply because ROE = E/B. So you can't really have low P/E , low P/B AND high ROE. You need to choose whether you want to go with high ROE and low P/E or low ROE and low P/B. With good companies like Coke or Walmart your going to get stable and predictable earnings, high ROE and high P/B. Generally you care about getting them at low P/E.
The other strategy is buying companies with low P/B. In the extreme you want to get things where the Current Assets - Liabilities is less than the market cap. This is tangible book value and is what you would get (hopefully) if the company was liquidated right away.
The main difference is that for the growth companies, you are valuing the companies based on the earnings that will come in the future. For the low P/B companies you are simply looking at what is there already. In some ways these low P/B companies are a more conservative bet. You don't need to project far in the future. You just look at what is there. The trick for these is to figure out whether your actually going to be able to extract that value.
Things can go wrong. The management can piss away stockholder value by trying to save the company with hair-brained schemes or outright fraud. When tangible book value is substantially more than market cap, the stockholders would usually be happy if the company simply liquidated and paid out a final dividend. However often this doesn't happen. If the CEO is getting a high salary he is often happy bleeding the company for years and simply collecting salary. He need to look for management with interests alligned with shareholders. You also need to look out for other liabilities that may arise such as pending lawsuits or other fishy things on the balance sheet or 10Qs.
Combining these two strategies is probably a good idea since they should be uncorrelated. In fact the low P/B stocks themselves should have practically no correlation and so is good for diversification. The diversification thing is more than just reducing volatility. Value investors shouldn't fear that. It has more to do with the fact that some of these companies will blow up and could cost you everything you put in. However most will return above book value. Some of these will more than triple in a few years and should make up for the occasional loss. It is not short term volatility that matters but rather volatility of long term portfolio growth. If you lose it all your done. This relates to the Kelly formula from gambling theory. Never bet your whole payroll on one bet. Figure out the right amount to bet on each based in your edge and the odds your getting.
Also with these low P/B companies you have low expectations of earnings growth. Generally you just want them to quit losing money, stablize their business and generate postive earnings with below average ROE. Then they return to above book value and you sell them. This could be considered more conservative than expecting an already good company to get even better and grow even faster. It is these low expectations that make them a reasonably good investment.
There is another way where you buy companies at low price to book value, P/B, regardless of whether they are good or bad. These strategies are connected because of the identity
P/B = P/E * ROE
This is true simply because ROE = E/B. So you can't really have low P/E , low P/B AND high ROE. You need to choose whether you want to go with high ROE and low P/E or low ROE and low P/B. With good companies like Coke or Walmart your going to get stable and predictable earnings, high ROE and high P/B. Generally you care about getting them at low P/E.
The other strategy is buying companies with low P/B. In the extreme you want to get things where the Current Assets - Liabilities is less than the market cap. This is tangible book value and is what you would get (hopefully) if the company was liquidated right away.
The main difference is that for the growth companies, you are valuing the companies based on the earnings that will come in the future. For the low P/B companies you are simply looking at what is there already. In some ways these low P/B companies are a more conservative bet. You don't need to project far in the future. You just look at what is there. The trick for these is to figure out whether your actually going to be able to extract that value.
Things can go wrong. The management can piss away stockholder value by trying to save the company with hair-brained schemes or outright fraud. When tangible book value is substantially more than market cap, the stockholders would usually be happy if the company simply liquidated and paid out a final dividend. However often this doesn't happen. If the CEO is getting a high salary he is often happy bleeding the company for years and simply collecting salary. He need to look for management with interests alligned with shareholders. You also need to look out for other liabilities that may arise such as pending lawsuits or other fishy things on the balance sheet or 10Qs.
Combining these two strategies is probably a good idea since they should be uncorrelated. In fact the low P/B stocks themselves should have practically no correlation and so is good for diversification. The diversification thing is more than just reducing volatility. Value investors shouldn't fear that. It has more to do with the fact that some of these companies will blow up and could cost you everything you put in. However most will return above book value. Some of these will more than triple in a few years and should make up for the occasional loss. It is not short term volatility that matters but rather volatility of long term portfolio growth. If you lose it all your done. This relates to the Kelly formula from gambling theory. Never bet your whole payroll on one bet. Figure out the right amount to bet on each based in your edge and the odds your getting.
Also with these low P/B companies you have low expectations of earnings growth. Generally you just want them to quit losing money, stablize their business and generate postive earnings with below average ROE. Then they return to above book value and you sell them. This could be considered more conservative than expecting an already good company to get even better and grow even faster. It is these low expectations that make them a reasonably good investment.
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