Saturday, July 28, 2007

"Black Swan" Event for AHM

Earlier this month, I shared my thoughs about the underwriting at American Home Mortgage (copied below for your convenience):

And finally, some food for thought: American Home Mortgage, an Alt-A loan originator, recently withdrew its guidance for the year and said it expects a loss because of a large influx of warranty penalties. To clarify, when most loan originators sell a loan to an investor, they usually include a warranty that the loan will not go delinquent within the first three months, or otherwise the company will buy back the loan. Those following the subprime fiasco know that this was the cause of the downfall of New Century and several other lenders. (Delta Financial, on the other hand, has so far avoided this) The question is, if loan underwriting has gotten so bad that many loans are going bad in three months, how much better could the loans be that they wrote 6 months, a year, two years ago? The question is important considering subprime and Alt-A combined made up 40% of 2006 loan originations, and many loans written in the last few years are set to reset in the 07-09 period.

Well, late Friday afternoon American Home decided to delay dividend payments on their common and preferred shares in order to preserve liquidity. "The disruption in the credit markets in the past few weeks has been unprecedented in the company's experience and has caused major write-downs of its loan and security portfolios and consequently has caused significant margin calls with respect to its credit facilities."(my italics) So in other words, they were hit by one of Nassim Taleb's black swans: a rare, large-impact event that is beyond normal expectations. It's not that this credit tightening was unpredictable- anyone following the matter could have seen how poor loan standards had become and the future instability to come. But because the good times have been rolling for so long for the financial industry, many choose to ignore the possibility of a credit crunch. Now, those same firms are getting hit hard. I'm starting a new label entitled "Black Swan" that will keep track of the firms that will claim to have been struck by unprecendent, black swan type events
. My guess is the list will soon be pretty long.

Thursday, July 26, 2007

Wall Street: The World's Biggest Casino

As I was reading a Businessweek article entitled "Profiting from Mortality", I couldnt help but think that this is more of the same: gambling. Let me try to explain why these death bonds are just that, and how they differ from true investing. The new asset is life settlements, arrangements that offer people the chance to cash-out their life insurance policy early to investors, who keep paying the premiums until the sellers die and then collect the payout. Basically, the earlier the people in the pool die, the greater the profit. "Now, Wall Street sees huge profits in buying policies, throwing them into a pool, dividing the pool into bonds, and selling the bonds to pension funds, college endowments, and other professional investors... There's big potential." The truth is, this is just another Wall Street concoction to dope investors.

There are several reasons why these death bonds make terrible investments. The first reason is the all-important competition. The process of making a death bond has many self-interested parties along the way. First, there is the life insurance holder. He or she is looking for the best possible cash-out value for his policy, driving up the initial cost of the investment. Also note the inherent dilemma: A policy holder looking to cash out is more likely feeling healthier than average, meaning lower returns for the investor. But the process doesnt end here, because the settlement on a death bond isnt just between the policyholder and the investor- there are the middlemen. In this case, there is 1) the life settlement providers, who call and arrange the settlement for the policyholder, and 2) the investment banks, which package these settlements together into a securitization pool. Both of these industries are looking to take their share of fees in the process before finally selling the death bond, taking away much of the potential gains from the investor.

Why do investors bite for these esoteric products? Gullibility. Investors are going to be told the sales-pitch that these death bonds should return 8% a year and be uncorrelated to other markets. Most people just accept that right there, without digging further. Why 8% a year? What are those assumptions based on? What do the underlying life arrangements in the securitizations look like? These are questions rarely asked. Because the investor doesn't realize that he got the bad-end of the deal until much later, Wall Street can continue this scheme for some time. For a recent example, just look at the sub-prime market. Years of poorly underwritten loans made into securitizations are now being uncovered for what they really are, and many investors who 6 months ago felt like they were in on a great investment have all of a sudden been wiped out completely. But not before Wall Street and loan originators took their fair share of fees.

A real investment, on the other hand, is backed by solid logic and conservative assumptions. You need to dig to the core of the matter, research into what really matters, and uncover the underlying prospects. Even better is when you can find an investment whos intrinsic value will grow over time, such as stocks. Ben Graham's words ring true: "An investment operation is one, which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

As I've been thinking about this, I couldn't help but also think of two things: First was Sam Zell's Christmas Card, seen here. The other is John Bogle's recent speech entitled "A Tale of Two Markets" (Added to the new "Favorite Readings" tab on the right):

As professional institutional investors moved their focus from the wisdom of long-term investment to the folly of short-term speculation, “the capital development of the country [became] a by-product of the activities of a casino.” Just as he warned, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism is likely to be ill-done.”

Tuesday, July 24, 2007

Psychology of Intelligence Analysis

I highly recommend everyone to read all the chapters of this publication, entitled The Psychology of Intelligence Analysis, posted for free on the CIA website. As I have been reading through this, I have learned a lot more about the way the mind works and the limitations it can put on ourselves. There are a lot of parallels between the recommendations this book makes and the characteristics needed for successful value investing.

Friday, July 20, 2007

Be Careful

Anyone picking up a newspaper recently has read about the quick turn of events unfolding in the sub-prime market. Two leveraged Bear Stern funds have wiped out all their investors capital, while the ABX index tracking sub-prime loans has fallen sharply and keeps hitting record lows. With every new low the market keeps trying to shrug it off as the new "bottom", yet I believe this is just the beginning of things to come. Here are two things that haven't been mentioned frequently that you should know about.

1. Accounting Tricks
There was a recent change in accounting rules that allows companies to mask investment losses and keep them out of their earnings statements, even though the balance sheet and equity will still be negatively impacted. Well, we are beginning to see the first signs of companies using this policy. In my opinion, investors should look unfavorably on any company that tries to hide their true results using an accounting rule which makes no sense. But this isn't the first accounting rule that has seemed illogical.. remember the time when options didn't need to be treated as an expense?

2. Inverted Yield Curves
We've all heard about the recent inverted yield curve in the United States and its usual indication of recession. Well, what you might not have known is that it is a common phenomenon worldwide. A look at the Economist's interest rate statistics shows that 13 other countries (of the ones listed) currently have inverted yield curves, also.

So, in short, be careful.

Monday, July 16, 2007

Updated Write-up on Bancinsurance

I wanted to do an updated write-up on Bancinsurance now that I have a greater understanding of the company and hence the investing situation. You can find a link to the original write-up at the bottom.

The Company
Bancinsurance is a small insurance company(market cap of 30 million) that focuses mostly on two small niche lines of business. 53% of their premiums are from Ultimate Loss Insurance(ULI). ULI covers physical damage to collateral in cases where it has been repossessed and is not insured, up to the lesser of fair market value or the remaining loan balance. The 2nd biggest line is GAP insurance, which makes up 23% of premiums. When a car is damaged beyond repair or stolen, GAP insurance pays the difference between the amount left owed on the lease and the insurance on the car. (Generally, the fair market value falls much faster than the amortization of the loan or lease.)

The Situation
In 2001, Bancinsurance expanded into a new line of insurance in a bid to grow their business. This ended up being a huge disaster- In 2004, huge losses came up, the auditors left, an investigation began, and the company took the company who managed the new line of business to court for missrepresentation.

Bancinsurance Today
The investigation concluded with no wrongdoing, the company hired a new auditor and became up to date with their filings, and most the claims have been handled and the rest have been reserved for on a practically worst-case basis. The last court arbitration should finish by this year and with it, take away a huge legal expense which cost Bancinsurance approximately 4 million in '06.

Valuation - Safety
Bancinsurance's losses in their lines of business are fairly predictable and stable. GAP relies on a car being either stolen or damaged beyond repair, while ULI covers physical damage on car's that are being repossessed. A recession would lead to more repossessions, but the combination of recession and physical damage is needed for bancinsurance to pay anything. Hence, I think book value is the safety net, especially considering that the company is still making healthy profits. The book value as of last quarter was $7.54, compared to a current price of $6.05. (24.6% return)

Upside Potential
Bancinsurance is in small niche lines of insurance and has been able to earn nice returns on capital throughout its history. And although growth has stagnated recently, over a longer time horizon they have done an excellent job running the business.
The following numbers are the results from 2006 to 2000. (numbers in millions)

Premiums: 49.1, 51.7, 50, 50, 42.6, 33, 25
Net Inc: 5.5, 6.3, -8.5, 3.9, .9, 3 , 3.9
One time
expenses: -1.8, -.4, -20.2, 0, -1.5, 0 , 0
(included in
net inc)
From 2004 to 2006, these one-time expenses consisted of reserves for the discontinued bond program, while in 2002 it was from the affect of an accounting change. Also, keep in mind that expenses were inflated in 2005 and 2006 due to approximately 4 million in yearly legal expenses. Put it all together and there is considerable upside potential for the company.

The company operates in niche lines of insurance, keeping many competitors away due to the small size. Also, the company sells its products mostly to lending institutions and car dealers, and there is some efficiency gained by having Bancinsurance operate a centralized claims management.

The main risks revolve around the discontinued bond program and the SEC investigation, but I believe these are accounted for because they are reserved for it and the SEC investigation has been open for a long time without any prosecution. (Usually, it takes a long time for the SEC to formally close an investigation, but if nothing happens within the first two years it diminishes the risk of the situation greatly) There is also a risk that premiums and business will continue to decline.
Given the price, I believe these risks are more than accounted for.

Original Write-Up on Bancinsurance on 9/19/06

Disclosure: I own shares in BCIS. This is neither a recommendation to buy or sell any of these securities. All information provided believed to be reliable and presented for information purposes only.

Thursday, July 12, 2007

Too Much Information

"AT 13.16 British Summer Time on July 11th, traders watching the “All News” page on their Reuters screen would have seen 21 headlines flash up. That would have given them less than three seconds to absorb each item—always assuming, of course, that they had finished reading the 16 stories that appeared at 13.15.

So when one starts to wonder why investors were so slow to wake up to the problems of the subprime mortgage market, information overload has to be a factor. An economist, Fischer Black, described this information as “noise”; investors trade on the back of it even though it has no value. The trouble is that it is very hard to distinguish noise from useful pieces of data.


All this confirms what most investors who lived through the dotcom bubble must feel: investors are not always rational and markets are not always efficient. But, judging by the subprime saga, spotting those irrational moments is no easier than it ever was."

Direct Link

Tuesday, July 10, 2007

The Black Swan

One of the greatest books I have come across is The Black Swan by Nassim Taleb, which discusses our attempt to generalize and oversimplify a world that is really chaotic in nature. (The book was originally recommended by Charlie Munger at the Berkshire annual meeting) We can see this everyday in the stock market- as Chris Anderson put it:

Four hundred years ago, Francis Bacon warned that our minds are wired to deceive us. "Beware the fallacies into which undisciplined thinkers most easily fall--they are the real distorting prisms of human nature." Chief among them: "Assuming more order than exists in chaotic nature." Now consider the typical stock market report: "Today investors bid shares down out of concern over Iranian oil production." Sigh. We're still doing it.

Our brains are wired for narrative, not statistical uncertainty. And so we tell ourselves simple stories to explain complex thing we don't--and, most importantly, can't--know. The truth is that we have no idea why stock markets go up or down on any given day, and whatever reason we give is sure to be grossly simplified, if not flat out wrong.

Even more importantly though, is that none of us want to consider the possibility of a truly shaking event, such as a market crash. As the Economist put it:

Betting on a black swan does not offer attractive odds. If a catastrophe only happens 1% of the time, then 99 times out of 100, betting on such an event will lose money. The investor will underperform the benchmark and lose clients.

Staying fully invested, and waiting to get sandbagged by events, makes more business sense. After all, if a catastrophe does happen, the investor has the perfect excuse: nobody saw it coming. The chances are that everybody's portfolios will suffer in tandem.

Needless to say, Warren Buffett would disagree with this type of thinking. In his 2006 Letter to shareholders, Buffett discussed his criteria for a new Chief Investment Officer. He commented:

"But there is far more to successful long term investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."

How does someone avoid getting blindsighted? Keep your mind open, keep asking questions, and avoid over-generalization.

Saturday, July 07, 2007

Heads Up versus Chou

In 2006, Francis Chou gave a presentation in which he outlined his investment in BMTC Group, a large Canadian retailer of furniture, mattresses, and appliances. He discusses his rationale for betting big on the company in 2002. The company was generating extraordinary returns on capital, and it was trading at a very cheap valuation: 8.9 times earnings, and 5.5 times EV/EBITDA. Since that time, the company has appreciated from $9 to $23 per share, allowing us to now say that it was clearly an excellent investment.

I'm mentioning this because one of my company's, The Brick Group, is in direct competition with BMTC in the Canadian retail space. Both companies earn high returns on capital and distribute a bulk of their earnings back to shareholders. But my purchase was made at 8.1x EV/EBITDA compared to the 5.5x purchase made by Chou. Some of this difference is justified- since Brick is an income trust, it does not have to pay taxes for 4 more years, allowing it to keep more of its EBITDA. But, earnings in 2002 were a lot more stable than today. The massive liquidity of the last five years has inflated corporate earnings and made it difficult to figure out what true earnings power is for most companies. So, kudos to Francis Chou for taking advantage of the great opportunity presented to him at the time.

Key terms:
Ebitda- Earnings before interest, taxes, depreciation and amortization
EV- Enterprise value, which is market capitalization plus net debt.

Friday, July 06, 2007

A Closer Look at Prem Watsa's Portfolio

Prem Watsa, CEO and Chairman of Fairfax Financial, is a person I would term "a superinvestor". Over the last 15 years, he has returned 17.2% in common stocks, compared to 10.6% for the S&P500. Through news releases, it is known he owns large stakes in both SFK Pulp and Torstar. By digging through some insurance filings, I was able to find some of the other stocks in his portfolio, which include:
*As of 12/31/06
Marsh and Mclennan
Takefuji Co
International Coal Group
Eastman Chemical
Citizens Communications

This is as good a place as any to start researching from.

Tuesday, July 03, 2007

Francis Chou

I have great respect for the deep-value investing style of fund manager Francis Chou. In addition, he has been publishing great annual letters for several years that I think everyone should read from front to end. Here are some notable statements that stood out for me as I was reading through them. (Note: Words in bold are my own)

“Those whom the gods wish to destroy, they first blind them with greed.”

As for what’s new, we are finding pockets of bargains in commodities, commodities-related industries, and companies that have business interests in Eastern Europe and Asia. A proviso, however: because the economics of these types of businesses are not as clear cut, they have to be compellingly cheap before we buy them. We have invested in such companies in the past and have done well with them. -April 15, 1999
This was amazing call given what has happened in the 8 years since this statement. Note his warning about the economics of these businesses.

The Fund is not invested in technology stocks. Their current inflated prices make them unattractive and unsuitable to the investment philosophy of the Fund, which is: 1) To buy above-average to excellent companies run by skilful managers, at a price far lower than what a knowledgeable and rational acquirer would pay for cash; and 2) To buy at deep discount to liquid book value for companies with average prospects.
See my posts on
Marginal Company Investing and the self-test on my own portfolio.

Over time I have sifted through thousands of bargains which have come in different shapes and flavours
such as discount to net-net working capital, discount to book value and low P/E ratio. When all is said and
done, those which continue to give me the greatest satisfaction are the ones which display the following
1) Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
2) Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
3) Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
4) A stock price which is far lower than what a knowledgeable and rational buyer would pay.

If there is a secret to the Buffett/Munger success story, it is their willingness to be brutally honest and realistic in their analyses and assessments. They are highly introspective, always checking and rechecking their assumptions and premises against reality. Executives who sugarcoat business realities and embellish results, downplay issues and disguise potential problems to investors may well fool even themselves. They start believing in their own world of make-believe. Buffett/Munger’s formidable powers of analysis would be worth nothing if they looked at problems with rose colored glasses.
Take this to heart.

Seven questions to be answered for any investment operation:
1) How favorable are the economics of the business and where does the company rank in terms of market share?
2) How sustainable are its earnings stream?
3) How skilful have management been in deploying capital?
4) What is the appropriate discount rate to take?
5) Is the capital structure too leveraged?
6) What would an acquirer pay for in cash?
7) And most important of all, what is the appropriate price to pay for such a company that would give an investor more than adequate margin of safety? Margin of safety is simply paying far less for a company than what it is worth, measured by sustainable earning power and/or hard assets that are not depreciating in value. This concept, while unappreciated and ignored by many at the moment, is what distinguishes investment from speculation.

Monday, July 02, 2007

Recent Events

It's been a relatively slow week with not much to post about. Here are a few updates to keep in mind. First, I've been invited as a guest contributor to Reflections on Value Investing, a daily blog dedicated to collecting and posting great reading material relevant to value investing. So rather than post every good article I come across here, I encourage you to make a daily stop at Reflections and read the posts from me and the other great contributors on the site.

Second, back in January I mentioned that the Value Investors Club report on Interoil was a great example of investment analysis. It spelled out various reasons why the company was worth considerably less than its stock price of $23. Well, since that time, the stock has appreciated to a high of $44, before dropping precipitously in three days to $19. Today, the stock is up 26% on news realeased by the company that the price drop is "an overreaction". As Buffett has said, shorting is never really a fun sport. It is difficult to get shares (i was never able to sell it short through my broker), the interest can be high, and the stock can stay irrational longer than you can stay solvent. And to top it off, you are going against insiders that are doing what they can to inflate their stock price. So if you are going to be short a company, be prepared for an emotional roller coaster.

And finally, some food for thought: American Home Mortgage, an Alt-A loan originator, recently withdrew its guidance for the year and said it expects a loss because of a large influx of warranty penalties. To clarify, when most loan originators sell a loan to an investor, they usually include a warranty that the loan will not go delinquent within the first three months, or otherwise the company will buy back the loan. Those following the subprime fiasco know that this was the cause of the downfall of New Century and several other lenders. (Delta Financial, on the other hand, has so far avoided this) The question is, if loan underwriting has gotten so bad that many loans are going bad in three months, how much better could the loans be that they wrote 6 months, a year, two years ago? The question is important considering subprime and Alt-A combined made up 40% of 2006 loan originations, and many loans written in the last few years are set to reset in the 07-09 period.

I am adding to an old position, and there will be a more detailed write-up on the company soon.