Thursday, February 28, 2008

Fantasy Land

In the streets there's no wrong and no right
So forget all that you see
It's not reality
It's just a fantasy
--Aldo Nova

The debt markets largely depend on two rating agencies, Moody's and S&P, to rate the creditworthiness of borrowers. Ratings range from AAA (excellent ability to pay back lenders) to junk (very questionable capacity for payback).

Bond issuers (i.e., borrowers) want to score higher ratings, because higher ratings mean borrowers pay less to borrow funds. Moreover, many institutions (e.g., pensions funds) are by charter only permitted to invest in 'investment' grade debt; they can't buy the riskier 'speculative' grade stuff.

Recently, eyes have focused on the credit ratings of MBIA (MBI), the largest insurer of municipal bonds. Oddly, MBI has historically enjoyed the top AAA rating, despite being a highly leveraged entity. For comparison, the other half dozen companies garnering the AAA rating include some of the most hisorically solid large companies out there including General Electric (GE), Johnson & Johnson (JNJ), and Berkshire Hathaway (BRK.A).

MBI's AAA rating has been vital to its success on a number of fronts. Since they borrow so much money, their top shelf credit rating drastically reduces their cost of borrowing. Morever, those insured by MBI, primarily cities and other locales issuing 'municipal bonds', enjoy lower costs of borrowing because MBI guarantees payback of the debt that they insure. Buyers of the debt are willing to settle for a lower interest rate in exchange for the guaranteed payback.

The concern right now is that, due to the credit crunch and general economic slowdown, many municipalities are closer to defaulting on their positions than they have been in years. If they default enmasse, there is no way MBI will be able to cover all claims by muni bond holders. Some folks think that MBI is currently insolvent. In these types of situations, the bond rating agencies would typically look at the numbers and downgrade MBI's ratings. The consequences of doing so, however, would be significant. Muni bond markets might freeze up, and MBI would be rendered insolvent as municipalities defaulted.

So, lo and behold, the rating agencies came out this week and reaffirmed MBI's AAA credit rating. MBI just closed their FY2007 books with $3.1B in revenues, a -61% profit margin, and about $3 in debt for each $1 in cash. For comparison, Pfizer (PFE), a company that just LOST their AAA rating a couple months back, sported FY2007 results $48.6B in revs, 17% profit margin, and $22B in cash on the balance sheet (about $3 cash for each $1 debt).

Does something seem out of whack to you?

Why MBI ever earned the AAA rating to start with is easy to speculate about. Pessimists suggest that below-board deals were struck (and continue to be struck) to preserve MBI's rating.

The question, of course, is whether any rating shennanigans will continue to be effective, or whether the market ultimately wakes up, and finally recognizes that the emperor wears no clothes.

position in PFE

Tuesday, February 26, 2008

Silence of the Lambs

So hold on here we go
Hold on to nothin' we know
I feel so lonely way up here

Toddo was speaking to Cody Willard on FBN's Happy Hour tonite, and Cody proposed that although the various government sponsored bailouts currently in motion may be 'legal,' they are unconstitutional since they essentially appropriate citizen property for the benefit of a special interest group.

What's that? You don't think you're getting poorer as a result of these bailouts? Consider the 3 ways that governments procure resources at citizenry's expense. They can walk into your house and say, 'we own it.' They can appropriate your property in a slightly less direct manner through coercive taxation.

Finally, they can print money by fiat. Government spends the new currency for whatever purpose, and bids up prices in the process. Plus the money supply has increased. Your wealth, defined in terms of what your money buys, goes down.

What evidence of wealth appropriation can we observe? Well, today crude closed above $100/barrel for the first time ever, gold is near all time highs at $948/oz, and silver closed at a multidecade high of $18.72/oz. Simply said, our dollars buy less today.

Make no mistake. You're being robbed.

The question is whether we have the wherewithal to put a stop to this. Do you know the measures necessary to prohibit government sponsored theft? (hint: we used to do all of these things)

position in gold, silver

Monday, February 18, 2008

Fading Away

So glad we've almost made it
So sad they had to fade it
Everybody wants to rule the world
--Tears for Fears

Contrarians love to fade conventional wisdom and trends. Let me offer three market-related situations that currently seem quite crowded. One is the general movement towards a shorter term trading posture. Whether you're looking at increasing volume on the NYSE, steadily rising individual issue turnover, or at the median mindset of the professors at Minyanville, it seems clear that folks are less prone to hold positions for a long time. In a trading mindset, behavior is driven by technical, psychological and event factors.

Secondly, the last few years have been marked by increased risk-taking with no directional bias. Traders are more reactive than ever before. If the market goes up, they get long. If prices are going down, they quickly turn their hats around and go short. Folks have been willing to take risk regardless of direction.

Finally, the world is short cash. Yes, central banks have been 'printing money' over the past few years, but the lion's share has been 'credit money' (i.e., debt). As such, much of the risk taking in financial assets has been driven by leverage. If you want a snapshot of the tiny cash:debt ratios on the average individual's balance sheet, peruse some profiles on networthiq.

How to fade these trends? Elongate time horizon and assume more of an investment posture. Seek opportunities that possess attractive fundamentals and valuations (I believe fundies will reassert their primary influence in the years ahead). Look for payoffs that may take 5 years or more before they are realized. Because this is the road less travelled, opportunities are likely less picked over. Consistent with Mr Practical's advice, reduce risk, pay down debt, and raise cash. Should debt deflate, unlevered cash will buy more in the wake of a general price decline.

These actions position a market participant radically different than the crowd, which, of course, suits a contrarian just fine.

Friday, February 15, 2008

To Plan or Plan Not

I stuck around St Petersburg
When I saw it was a time for a change
Killed the czar and his ministers
Anastasia screamed in vain
--Rolling Stones

Every now and then it's useful to remind ourselves of the basic economic problem that all societies face. Individuals have needs. Some of these needs are fundamental to human existance, such as food and drink. Other needs promote a more interesting existence, such as transportation and high definition TVs.

Production of goods and services to fulfull these needs requires conversion of society's resources into tangible and intangible outputs. A few issues complicate production, however. Resources are scarce--they exist in limited quantities. Productive capacity for converting resources into outputs varies among individuals in a society. Finally, the needs of individuals are constantly changing.

The basic economic problem, then, is how to allocate scarce resources to meet society's needs given the dynamics of the situation.

One approach for solving the problem is to put a small group of individuals in charge of making all these decisions. These 'central planners' determine types and quantities of resources needed for production, who will be involved in production, and types and quantities of output obtained. Although central planners may make this determination directly through production scheduling, they can also influence the economic process indirectly by fixing prices or by some other monetary or fiscal policy mechanism.

If the central planners are all knowing and if economies are simple and stable, then this approach could efficiently solve the problem. These are big ifs, however. It has long been recognized that, even under favorable circumstances, decision-makers are 'boundedly rational' and constrained by their cognitive capacities (March & Simon, 1958). The planners may also be less than benevolent in their motivations. Desire for power, influence, or greed may create an agency problem (Jensen & Meckling, 1976) between the planners and the constituencies dependent on the planners' judgement.

Complex, dynamic economic contexts only magnify these issues. Even if the planners correctly make all decisions in one period, they have to keep getting things right as the economy evolves. Unfortunately, evidence suggests that bureaucrats are often incapable of modifying courses of action even in the face of evidence that they should do so (Staw, 1981).

Yet, despite a large body of both theoretical and practice evidence suggesting the inadequacies, societies continue to lean on central planning for solving economic problems. And, lest US citizens be tempted to think that central planning is something that is done somewhere else, they would be wise to consider domestic institutions like the Federal Reserve. The Fed governors essentially represent a group of bureaucrats charged with determining the 'correct' price of money and credit. Central planning personified.

Despite arguments to the contrary presented by many politicians, the growing size and complexity of our global economic situation suggests that the timing could not be worse for a central planning mindset.


Jensen, M.C. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 304-360.

March, J.G. & Simon, H.A. 1958. Organizations. New York: Wiley.

Staw, B.M. 1981. The escalation of commitment to a course of action. Academy of Management Review, 6: 577-587.

Tuesday, February 12, 2008

Buying Cash

I'm the kind of guy who laughs at a funeral
Can't understand what I mean? You soon will
I have a tendency to wear my mind on my sleeve
I have a history of losing my shirt
--Barenaked Ladies

A friend offers you a dollar bill right now. How much should you pay for it today? Assuming there's nothing special about the bill, such as it being a rare silver certificate, then you should pay face value of $1.00. Simple enough.

Suppose this same person offers to give you a dollar bill exactly one year from now in exchange for a cash payment today. How much is that future dollar worth today? If you pay face value today you're likely overpaying, since there's opportunity cost associated with the dollar you currently have. At the very least, that buck could be earning interest in at a bank account somewhere. Plus, inflation may eat away at its purchasing power.

You estimate that the buck in your pocket will net you 5% over the next 365 days. If so, then you'll need to pay your buddy 1/(1+.05) = $.95 in order to be indifferent on the deal. If you pay something less, then this transaction should be a good deal for you. If you pay more than 95 cents, then you're better off keeping that dollar in your pocket.

Now, let's say your friend proposes a longer term deal. Exactly one year from now, he/she will pay you one dollar on this day for each of the next 10 calendar years.

Assuming the same 5% 'discount rate' you employed earlier, how much is this stream of future dollars worth today?

We'll look at this in a future missive.

Friday, February 8, 2008

Inside Out

A king may move a man, a father may claim a son. But remember that, even when those who move you be kings or men of power, your soul is in your keeping alone. When you stand before God you cannot say, 'but I was told by others to do thus' or that 'virtue was not convenient at the time.' That will not suffice. Remember that.
--King Baldwin IV (Kingdom of Heaven)

Is liberty not grounded in the value of personal accountability? What happens to a society where individuals do not hold themselves accountable for their actions?

Or to an economy where personal accountability, once valued, has diminished in importance?

Tuesday, February 5, 2008

Beta Blocker

I wish that I could fly
Into the sky
So very high
Just like a dragonfly
--Lenny Kravitz

MV profs frequently observe that traders are 'chasing beta.' Beta is a measure of the change in the price of a security compared to the change in the price of a index (such as the S&P 500 Index). When general markets increase, a high beta stock such as Google (GOOG) or Research In Motion (RIMM) tends to move up more than the general trend.

The downside is that, when markets move down, high beta stocks tend to go down more.

As such, you'll typically observe traders piling into beta when markets move higher, and shedding them during market declines.

Cash is King

Confusion that never stops
The closing walls and the ticking clocks
Gonna come back and take you home
I could not stop, that you now know

There are many ways to value securities, but I'm biased towards those based on free cash flow. Free cash flow (FCF) is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital (Jensen, 1986: 323). Stated another way, it's the cash that is 'free' for distribution to shareholders after all investments have been financed (Stewart, 1991: xvii).

FCF is what should matter to an investor. The investor's essential question should be, "Based on the capital that must go into an enterprise, how much can I get out?"

Truly, a 'fundamental' investment question...

A FCF approach can be handy for valuing stocks of publicly traded companies--particularly well established enterprises. However, valuing companies like General Electric (GE), Exxon (XOM), or even Google (GOOG) on a FCF basis seems to be a dying (or at least dormant) practice.

Perhaps we can kickstart the process in future missives.


Jensen, M.C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. Amercian Economic Review, 76: 323-329.

Stewart, G.B., III (1991). The quest for value. New York: HarperCollins.

Monday, February 4, 2008

Striking Out

Here comes the rain again
Falling on my head like a memory
Falling on my head like a new emotion

After 125 bips of Fed love and an election year government tripping over themselves with fiscal stimulus, it's easy to conclude that the worst is over w.r.t. the credit markets. After all, notes Jeff Saut, this kind of intervention has worked time and time again in the past.

However, Minyan Peter thinks we have lots more work to do. Financial institutions current face gross risk that are almost incalcuable. Awareness of this risk appears to by seeping into lending behavior as the cost of credit is going up.

I continue to ponder the possibility of a broad deflation driven more by a seller's strike (lenders not wanting to lend) than a buyer's strike (borrowers not willing to borrow).