I'm going to keep this write-up short because frankly, I still have only a basic understanding of the company and I have many more questions that I hope to uncover as time goes on. But based on the numbers and the story, it seems clear that Harvest represents a compelling valuation at current prices.
Harvest Natural Resources is an American company with oil production in Venezuela. Over the past few years, the stock price has been hit because of fears over the possibility of nationalization. Today however, the revised contract is very near implementation on the terms that the Venezuelan government has wanted. The terms were very stiff: 33% royalties, reduced ownership in the properties to 40%, and 50% tax rate. But if we accept this as final, then the risk reward situation as follows:
Price: 12.21
Market Cap: 460 million
At end of 2nd Quarter, 115 million in net cash.
Reimbursement payment: 60 million cash(*)
= approximately 175 million adjusted net cash.
The company also provides you with a discounted valuation of their reserves, after-tax and at 10%, as follows:
Proved reserves: 308 million
Probable reserves: 158 million
Possible Reserves: 396 million
Play around with the scenarios and you can see the range of values can be exciting, at 175 million - 1037 million. A few things to note:
*First, with regards to the reimbursement payment- this is the money the company is supposed to get reimbursed for operating their oil wells during the past year and a half without a contract. I believe the number I came up with is approximately right based on the terms in the new contract, although I will be double checking my methodology some more. See the comments below for further discussion.
Second, with regards to the valuation of the properties. These NPV's were done using a recovery rate(the amount of oil you recover out of the total in the field) of 13% on their reserves. The company showed how they have historically done much better than this, and they see their new fields having the same characteristics as their past successes. So, if you assume their 13% recovery rate is conservative, that means you would value the properties all the way to 3P (Possible), because that would be 13% recovery. Every subsequent 1% improvement in rate adds about 100-125 million in value to HNR, implying another huge upside in the stock based on exploration potential.
With regards to the fears over Venezuela, it seems like Venezuela has already "done its worst", so to speak. They have gotten the terms they have wanted, and to ask for anything stiffer would send the companies packing. Harvest and the other companies have shown how they can add plenty of value by exploring and operating these oil assets, so Venezuela doesn't want to see them go. So I think it might be fair for now to consider these terms as final.
I do have plenty of questions; (for example, what is the price of oil used in the NPV calculations?) Plus, I have also always been sort of an oil bear, thinking that most the rise in oil prices has been due to speculation rather than fundamentals. But add up the numbers for Harvest and you have a stock price backed by a lot of cash, along with a high quality oil asset with very low operating costs (Currently about $5-6 per barrel of oil). It was enough for me to buy a position today. Look forward to more on this in the future.
Update on 10/4/07
Sunday, September 30, 2007
Friday, September 28, 2007
"Estimating the Stock/Bond Risk Premium" (My Notes)
The folks at Hoisington Investment Management did some great research into the performances of stocks versus risk-free treasuries. Unfortunately I can not post a direct link, but below are my notes on their report, published in the 2002 Journal of Portfolio Management.
"This study sheds new light on the risk premium of stocks over US Treasury bonds, which indicates most research overstates the advantages of stocks over bonds. Our research also indicates long periods when bonds actually outperformed stocks and the conditions that produce these results."
With regard to the first point with the comparison of returns of stocks against bonds, the report goes all the way back to the creation of the S&P500 in 1871. From 1871 to 2001, stocks returned 9.3%,versus bond returns of 5.0%, much lower than most calculations on the matter.
More important for us is the second point- the scenarios under which bonds or stocks outperform. They concluded that the relative performances are most affected by three considerations: the inflation rate; dividend yield of stocks versus treasuries; and the P/E ratio. The following chart shows the 4 best 10 and 20 year periods for stocks and bonds:
The overriding factor has been price change, with deflation good for bonds and inflation good for stocks. But in periods where dividend yields have been excessively more than treasuries, stocks have tended to outperform. And in periods where treasury yields are higher than dividend yields, bonds tend to outperform. Also, a third factor has been the P/E yield. The report goes on to mention the implications of these findings in 2002's environment, and how they expected bonds to outperform .
And, they have been right so far. One problem I do have though is that in the examples they give, dividend yields are exceeding treasury yields. This is something that hasn't happened since the 1960's. But anyways, looking at these factors in today's environment:
1. Inflation rate:
This is the most important factor, and also the hardest for most people to predict. My opinion has been we have too much capacity if anything, because we have been requiring debt and assets to pay for our spending, rather than just income. And it's hard to see people spending considerably more from their already highly indebted levels. But these things are notoriously hard to predict, and who knows whether I'll be right or not.
2. Relative yields
Currently, the yield on a 10-year treasury is 4.57%. Meanwhile, the dividend yield of the S&P500 for 2006 was 1.77%, leaving a spread of 2.80% in favor of treasuries. As I mentioned before though, the dividend yield has not exceeded the treasury yield since the 1960's. It is difficult to say what to make of the fact that the dividend yield has been so low for so long. The common response is companies are reinvesting capital at favorable returns, or they have also been buying back shares. But dividends are money in the pocket today for investors, whereas the benefits of capital expenditures will only show over the long term and have usually been marginal at best.
3. P/E Ratio
The ratio for the S&P500 in 2006 was 17.3, above average but not by much. Still, it is nowhere near the low levels seen before the greatest stock advances.
The report concludes with the following:
We know that over very long terms stocks must outperform bonds, because investors must be rewarded for riskier assets, and we will experience again in the future conditions that warrant higher prospective returns. First, the baseline conditions must change, a process that may result in an extended period when bond returns will equal, or even exceed, returns on stocks.
"This study sheds new light on the risk premium of stocks over US Treasury bonds, which indicates most research overstates the advantages of stocks over bonds. Our research also indicates long periods when bonds actually outperformed stocks and the conditions that produce these results."
With regard to the first point with the comparison of returns of stocks against bonds, the report goes all the way back to the creation of the S&P500 in 1871. From 1871 to 2001, stocks returned 9.3%,versus bond returns of 5.0%, much lower than most calculations on the matter.
More important for us is the second point- the scenarios under which bonds or stocks outperform. They concluded that the relative performances are most affected by three considerations: the inflation rate; dividend yield of stocks versus treasuries; and the P/E ratio. The following chart shows the 4 best 10 and 20 year periods for stocks and bonds:
The overriding factor has been price change, with deflation good for bonds and inflation good for stocks. But in periods where dividend yields have been excessively more than treasuries, stocks have tended to outperform. And in periods where treasury yields are higher than dividend yields, bonds tend to outperform. Also, a third factor has been the P/E yield. The report goes on to mention the implications of these findings in 2002's environment, and how they expected bonds to outperform .
And, they have been right so far. One problem I do have though is that in the examples they give, dividend yields are exceeding treasury yields. This is something that hasn't happened since the 1960's. But anyways, looking at these factors in today's environment:
1. Inflation rate:
This is the most important factor, and also the hardest for most people to predict. My opinion has been we have too much capacity if anything, because we have been requiring debt and assets to pay for our spending, rather than just income. And it's hard to see people spending considerably more from their already highly indebted levels. But these things are notoriously hard to predict, and who knows whether I'll be right or not.
2. Relative yields
Currently, the yield on a 10-year treasury is 4.57%. Meanwhile, the dividend yield of the S&P500 for 2006 was 1.77%, leaving a spread of 2.80% in favor of treasuries. As I mentioned before though, the dividend yield has not exceeded the treasury yield since the 1960's. It is difficult to say what to make of the fact that the dividend yield has been so low for so long. The common response is companies are reinvesting capital at favorable returns, or they have also been buying back shares. But dividends are money in the pocket today for investors, whereas the benefits of capital expenditures will only show over the long term and have usually been marginal at best.
3. P/E Ratio
The ratio for the S&P500 in 2006 was 17.3, above average but not by much. Still, it is nowhere near the low levels seen before the greatest stock advances.
The report concludes with the following:
We know that over very long terms stocks must outperform bonds, because investors must be rewarded for riskier assets, and we will experience again in the future conditions that warrant higher prospective returns. First, the baseline conditions must change, a process that may result in an extended period when bond returns will equal, or even exceed, returns on stocks.
Wednesday, September 26, 2007
Rubin, Robert. Commencement Speech at Harvard, 2001.
Added to Online Library.
"I doubt if Kant or Spinoza viewed themselves as offering the best and more important preparation for risk arbitrage or for intervention in the dollar/yen foreign exchange market or for the many other activities of a finance minister. But, in my view, they did. Looking back on all my years in the private and public sectors, in the most important issues, certainties were almost always illusory and misleading, as were the simple answers or opinions that often were the response to the complicated issues in both political discourse and the private sector. Reality is complex, and recognizing complexity and engaging with complexity was the path to best decision-making."
...
"An important corollary to recognizing that decisions are about probabilities is that decisions should not be judged by outcomes but by the quality of the decision-making, though outcomes are certainly one useful input in that evaluation.. Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome. In managing trading rooms, I always focused on evaluating and promoting traders not on their results alone, but also and very importantly, on the thinking that underlay their decisions. Unfortunately, this approach is not widely taken, much to the detriment of decision-making in both the private and public sectors."
"I doubt if Kant or Spinoza viewed themselves as offering the best and more important preparation for risk arbitrage or for intervention in the dollar/yen foreign exchange market or for the many other activities of a finance minister. But, in my view, they did. Looking back on all my years in the private and public sectors, in the most important issues, certainties were almost always illusory and misleading, as were the simple answers or opinions that often were the response to the complicated issues in both political discourse and the private sector. Reality is complex, and recognizing complexity and engaging with complexity was the path to best decision-making."
...
"An important corollary to recognizing that decisions are about probabilities is that decisions should not be judged by outcomes but by the quality of the decision-making, though outcomes are certainly one useful input in that evaluation.. Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome. In managing trading rooms, I always focused on evaluating and promoting traders not on their results alone, but also and very importantly, on the thinking that underlay their decisions. Unfortunately, this approach is not widely taken, much to the detriment of decision-making in both the private and public sectors."
Railroads: Following Buffett's Latest Move
The Texas Hedge Report has come out with a new letter discussing the railroad industry, and what has changed, in some detail. Thanks to Lincoln Minor for bringing it to my attention.
Monday, September 24, 2007
Keynes on Cyclical Bottoms
While reading "Essays in Persuasion" by John Maynard Keynes, I came across this:
"The time which elapses before production ceases and unemployment reaches its maximum is, for several reasons, much longer in the case of the primary products than in the case of manufacture. (Note: by primary products, he means commodities) In most cases the productive units are smaller and less well organized amongst themselves for enforcing a process of orderly contraction; the length of the production period, especially in agriculture, is longer; the costs of a temporary shut-down are greater; men are often their own employers are so submit more readily to a contraction of the income for which they are willing to work; the social problems of throwing men out of employment are greater in more primitive communities; ..."
So when looking for cyclical bottoms, these are some additional factors that can help determine how long until an industry rationalizes. For the pulp industry and my investment in SFK Pulp Fund, the main problems which seem to apply are:
A. many small productive units that are not well organized
B. the costs of a temporary shut-down are great
C. the social problems of throwing men out of employment in primitive communities
I would also add my own problem: High leverage. Many pulp companies have taken on significant debt, which makes stopping operations and "giving up" not a viable option.
"The time which elapses before production ceases and unemployment reaches its maximum is, for several reasons, much longer in the case of the primary products than in the case of manufacture. (Note: by primary products, he means commodities) In most cases the productive units are smaller and less well organized amongst themselves for enforcing a process of orderly contraction; the length of the production period, especially in agriculture, is longer; the costs of a temporary shut-down are greater; men are often their own employers are so submit more readily to a contraction of the income for which they are willing to work; the social problems of throwing men out of employment are greater in more primitive communities; ..."
So when looking for cyclical bottoms, these are some additional factors that can help determine how long until an industry rationalizes. For the pulp industry and my investment in SFK Pulp Fund, the main problems which seem to apply are:
A. many small productive units that are not well organized
B. the costs of a temporary shut-down are great
C. the social problems of throwing men out of employment in primitive communities
I would also add my own problem: High leverage. Many pulp companies have taken on significant debt, which makes stopping operations and "giving up" not a viable option.
Sunday, September 23, 2007
Just Some Economic Charts: Part 2
Kudos to Prudent Bear for these. Click to expand.
And for those who continue to think of housing as a solid investment...
Here's the link to Just Some Economic Charts, Part 1.
And for those who continue to think of housing as a solid investment...
Here's the link to Just Some Economic Charts, Part 1.
Saturday, September 22, 2007
Warren Buffett Speaks- And I Expand
I recently got the opportunity to read a complementary copy of "Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor" by Janet Lowe. It is essentially a compilation of Warren Buffett quotes, categorized into an easy to read format. Overall, I really enjoyed reading it as a sort of refresher course in Buffett wisdom. And for someone who is new to investing or trying to understand who Warren really is, I think this is a great place to start. But I did want to share a few quotes that in particular struck out at me:
"We like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so. For example, the last time we bought Coca-Cola, it was selling at about 23 times earnings. Using our purchase price and today's earnings, that makes it about 5 times earnings. It's really the interaction of capital employed, the return on that capital, and future capital generated versus the purchase price today." (My emphasis added)
Well here is a quote that maybe I should put right smack there at the top of my blog because it's a point you hear and you think you understand only to disregard it the next time you're analyzing a business. Ben Graham built an entire investing philosophy based on looking at capital employed, albeit focusing only at that which could quickly be turned to cash. The reason being that it was A, simple, and B, there were plenty of these opportunities to exploit available. Unfortunately, B is no longer the case. Still, it is easy for many investors to want to summarize investing decisions based on something as easy as a Price to Book ratio- after all, if the company spent X million to build this business, it should be worth around X million. That philosophy gives too much credit to businessmen. Here's another way to look at it. Assets have costs - think shareholder equity, and they have market values- think of this as the price you are paying for a common stock investment. But using either as a indicator of true worth is faulty. When you get really down to it, the main determinant of value will always be future earnings, discounted of course.
Another thing regarding capital employed. I used to always just look at this as fairly straight forward- it is the amount the company has invested in its business. A look at a company's balance sheet can easily come to this figure. But then I got to thinking, what about future capital? If a company is going to continually invest all its earnings into the business just to stay competitive, doesn't that mean the real number will approach infinity? Inversely, if a company doesn't have to make any more investments into its business, well then the number would really be about the traditional figure.
And this is where moat comes along. Because if a company doesn't have to re-invest in its business, but it also has no moat, then competitors will quickly erode that return on capital, no matter how low that capital is. (Think, the staffing industry) And if a company has to constantly re-invest all its earnings into its business, then earnings might keep growing, but your return on total capital is always going to be meager. The sweet spot is obviously a company that doesn't have to worry much about putting in new capital, and can still keep growing earnings. Runner up would be a company that can keep growing by investing new capital at very nice rates of return. And also, a moat makes determining future cash flow much easier. So it's easy to see why Buffett has put so much emphasis on them.
"An irony of inflation-induced financial requirements is that the highly profitable companies- generally the best credits- require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago- and are correspondingly less willing to let capital-hungry, low profitability enterprises leverage themselves to the sky."
Here is something we've seen happen a lot in two categories. One being mortgage lenders, who have skipped the traditional bank model and came up with a new one that is leveraged to the sky. And the second group is investors as a whole. The bitter truth seems to be that future returns are going down. Again, the response by investors has been to jack up the leverage- examples include: private equity funds loading up buy-outs with debt; hedge funds using significant multiples of leverage; the universe of derivatives.
"The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And then GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing."
...
"In essence, one who spends less than he earns is accumulating 'claim checks' for future use. At some later date, he may reverse the procedure and consume more than he earns by cashing some of the accumulated claim checks. Or he may pass them on to others..."
The question today is are we the United States using up some of our 'claim checks' from the past wealth we built, or are we now going into 'claim debt'. It stands to reason that those accumulating 'claim debt' are spending more than they earn, and at some later date, may have to reverse the procedure and save more later. That is something to look deeper into.
"We like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so. For example, the last time we bought Coca-Cola, it was selling at about 23 times earnings. Using our purchase price and today's earnings, that makes it about 5 times earnings. It's really the interaction of capital employed, the return on that capital, and future capital generated versus the purchase price today." (My emphasis added)
Well here is a quote that maybe I should put right smack there at the top of my blog because it's a point you hear and you think you understand only to disregard it the next time you're analyzing a business. Ben Graham built an entire investing philosophy based on looking at capital employed, albeit focusing only at that which could quickly be turned to cash. The reason being that it was A, simple, and B, there were plenty of these opportunities to exploit available. Unfortunately, B is no longer the case. Still, it is easy for many investors to want to summarize investing decisions based on something as easy as a Price to Book ratio- after all, if the company spent X million to build this business, it should be worth around X million. That philosophy gives too much credit to businessmen. Here's another way to look at it. Assets have costs - think shareholder equity, and they have market values- think of this as the price you are paying for a common stock investment. But using either as a indicator of true worth is faulty. When you get really down to it, the main determinant of value will always be future earnings, discounted of course.
Another thing regarding capital employed. I used to always just look at this as fairly straight forward- it is the amount the company has invested in its business. A look at a company's balance sheet can easily come to this figure. But then I got to thinking, what about future capital? If a company is going to continually invest all its earnings into the business just to stay competitive, doesn't that mean the real number will approach infinity? Inversely, if a company doesn't have to make any more investments into its business, well then the number would really be about the traditional figure.
And this is where moat comes along. Because if a company doesn't have to re-invest in its business, but it also has no moat, then competitors will quickly erode that return on capital, no matter how low that capital is. (Think, the staffing industry) And if a company has to constantly re-invest all its earnings into its business, then earnings might keep growing, but your return on total capital is always going to be meager. The sweet spot is obviously a company that doesn't have to worry much about putting in new capital, and can still keep growing earnings. Runner up would be a company that can keep growing by investing new capital at very nice rates of return. And also, a moat makes determining future cash flow much easier. So it's easy to see why Buffett has put so much emphasis on them.
"An irony of inflation-induced financial requirements is that the highly profitable companies- generally the best credits- require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago- and are correspondingly less willing to let capital-hungry, low profitability enterprises leverage themselves to the sky."
Here is something we've seen happen a lot in two categories. One being mortgage lenders, who have skipped the traditional bank model and came up with a new one that is leveraged to the sky. And the second group is investors as a whole. The bitter truth seems to be that future returns are going down. Again, the response by investors has been to jack up the leverage- examples include: private equity funds loading up buy-outs with debt; hedge funds using significant multiples of leverage; the universe of derivatives.
"The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And then GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing."
...
"In essence, one who spends less than he earns is accumulating 'claim checks' for future use. At some later date, he may reverse the procedure and consume more than he earns by cashing some of the accumulated claim checks. Or he may pass them on to others..."
The question today is are we the United States using up some of our 'claim checks' from the past wealth we built, or are we now going into 'claim debt'. It stands to reason that those accumulating 'claim debt' are spending more than they earn, and at some later date, may have to reverse the procedure and save more later. That is something to look deeper into.
Thursday, September 20, 2007
Paul Volcker at Stanford. Feb. 11, 2005
Notes from the video:
- Past few years, most Anglo-Saxon economies have been growing fast
- China and India, with 40% of the world population, have been growing extraordinarily and lifting their people out of poverty.
-But underneath that, there are huge imbalances and risks; they seem as dangerous as I can remember, and I can remember a lot.
- The world is even more dependent on the United States as an engine of growth.
- With the free flow of capital there has emerged new benefits and risks.
- US and Europe have more room to maneuver than ever before, due to strong tradition of monetary stability. And there has been a vast accumulation of wealth- real, paper, housing.
- What's not to like? Let me suggest a few things:
- Boomers are spending like there is no tomorrow. Personal savings in the US have practically disappeared.
- True, businesses have started to rebuild their reserves, but at the same time federal deficit has come to offset this source of national savings.
- We're buying a lot of homes at rising prices, but homeownership is becoming a vehicle for borrowing and leveraging as much as a source for financial security.
- Businesses, particularly manufacturing, aren't investing much.
- At the heart of the problem, as a nation we are consuming and investing, that is to say spending, about 6% more than we are producing. What holds it all together- high consumption, high leverage, government deficits- is a really massive and growing flow of capital from abroad, at about 2 billion a day.
- The lesson I draw: there's a high premium to doing what we can to minimize the risks. We need a willingness to act even when everything on the surface seems placid. It boils down to the oldest lesson of financial policy... a strong sense of monetary and fiscal discipline.
- Past few years, most Anglo-Saxon economies have been growing fast
- China and India, with 40% of the world population, have been growing extraordinarily and lifting their people out of poverty.
-But underneath that, there are huge imbalances and risks; they seem as dangerous as I can remember, and I can remember a lot.
- The world is even more dependent on the United States as an engine of growth.
- With the free flow of capital there has emerged new benefits and risks.
- US and Europe have more room to maneuver than ever before, due to strong tradition of monetary stability. And there has been a vast accumulation of wealth- real, paper, housing.
- What's not to like? Let me suggest a few things:
- Boomers are spending like there is no tomorrow. Personal savings in the US have practically disappeared.
- True, businesses have started to rebuild their reserves, but at the same time federal deficit has come to offset this source of national savings.
- We're buying a lot of homes at rising prices, but homeownership is becoming a vehicle for borrowing and leveraging as much as a source for financial security.
- Businesses, particularly manufacturing, aren't investing much.
- At the heart of the problem, as a nation we are consuming and investing, that is to say spending, about 6% more than we are producing. What holds it all together- high consumption, high leverage, government deficits- is a really massive and growing flow of capital from abroad, at about 2 billion a day.
- The lesson I draw: there's a high premium to doing what we can to minimize the risks. We need a willingness to act even when everything on the surface seems placid. It boils down to the oldest lesson of financial policy... a strong sense of monetary and fiscal discipline.
Wednesday, September 19, 2007
Le Bon, Gustave. "The Crowd: A Study of the Popular Mind"
Added to Online Library. Here is a book I was about to buy, until I found the entire text for free online. To copy Amazon's description:
One of the greatest and most influential books of social psychology ever written, brilliantly instructive on the general characteristics and mental unity of a crowd, its sentiments and morality, ideas, reasoning power, imagination, opinions and much more. A must-read volume for students of history, sociology, law and psychology.
It is about 200 pages. I haven't had the chance to read it yet, but it seems like a worthwhile book.
One of the greatest and most influential books of social psychology ever written, brilliantly instructive on the general characteristics and mental unity of a crowd, its sentiments and morality, ideas, reasoning power, imagination, opinions and much more. A must-read volume for students of history, sociology, law and psychology.
It is about 200 pages. I haven't had the chance to read it yet, but it seems like a worthwhile book.
Tuesday, September 18, 2007
SFK Cuts Its Dividend
SFK Pulp Fund announced today a cut in its dividend to 2 cents per share from the previous 5 cents. In my 2nd Quarter Recap, i mentioned that at prevailing conditions, it seemed that a distribution cut was likely, and since then things got worse: the Canadian dollar continued to rise by another 3%. The fact still remains that 90% of NBSK pulp production is in Canada and Europe, so the fall in the US dollar is affecting everyone in the industry. In the short run, these currency changes can be devastating, but in the long term I have to believe economic forces will work themselves out. A friend of mine recently told me that things like these can take years to play out- for example, the refining industry was in turmoil for almost 20 years before finally correcting with a huge cyclical upswing. I am starting to understand what he means. But, I've always been long-term focused. My barometer for change relies on looking on 3 public competitors- Tembec, Catalyst Paper, and Pope & Talbot, who control, approximately 16% of the NBSK market. These companies have been generating negative EBITDA's (Earnings Before Interest, Tax, Depreciation & Amortization) for some time now, and I can only hope that the recent fall in the US dollar will be the nail in the coffin leading to industry rationalization. But I've been too optimistic in the past, and it could be some time before economic forces play out.
Sunday, September 16, 2007
Pabrai Funds Meeting
I had the pleasure of attending the Pabrai Funds Meeting yesterday, which was simply just amazing in terms of the type of people that were all gathered in one place. I also took notes of Pabrai's presentation and wanted to share a few of the things from the Q&A section. The words in italics are my own.
Q: On Ipsco, why were the analysts so wrong?
A: With Ipsco, it is difficult to forecast the cashflow going far out in a cyclical business like steel, and no one likes to deal with uncertainty. But we were able to take advantage of that.
For reference, Pabrai's thesis on Ipsco was simple. It was trading at a market cap of 2.5 billion. It had 900 million in excess capital, and was projected to earn 650 million in free cash flow over the next two years, meaning 2.2 billion in cash by the end of that period. Though steel is highly cyclical, one can relatively easily forecast an industry 2 years out just by researching new supply projects and usual demand trends. Afterwards a gray area exists, but at that point it was a true Dhando situation- heads you win, tails you don't lose much.
Q: Why were you in and out of RailCar America so quickly?
A: There was a lot to like about the business. Though it is very cyclical, odds were pretty good this would be fairly profitable. We sold because it was very narrow, with its only product being rail cars carrying coal. Second, there was environmental and union issues. Finally, there was a chance that the expected replacement for coal cars wouldn't come around for several years. Probably a mistake to sell- we will see.
Q: How do you assess political risk in your framework?
A: Sometimes there is inefficient markets in how to deal with political risk. An example is with our Embraer in Brazil. The company was very cheap based on concerns about the currency, but that was just noise. Underneath you had a business that was the best at what they do and in a duopoly. They were the icon of Brazil, so the talent of the country wanted to go there, giving them a competitive edge. Also, Brazil wouldn't want to screw up an export champion.
There are several things I took from this. First was the idea of talent attraction as a competitive advantage. It's something that I never really factored in but has a lot of merit. Most likely, the best in an industry will attract those that are most passionate about that sector. One obvious example is Google. A second example- me! I was recently telling my family that if I could work right now, I'd jump at the opportunity to work with Exchange Bank of Santa Rosa because they're the best at what they do. And I'd like to think I'd be worth the cost.
The other thing I took from this is very important for any international investor. A unconventional test I like to put on any investment is the value-added. Well, with a company like Embraer, who is the best at what they do, there is definitely a lot of value added. There is also only one other competitor, and they sell their products all around the world. In such a situation, currency risk is really "noise". Any rise or fall in currency can easily work through the business to conserve profitability. Alternatively, I was recently looking at another wide-moat Brazilian company, but they sold only to customers in Brazil. In such a situation, currency risk is much more present- a decline in their currency wouldn't be offset by higher profitability on exports for a US investor like me.
Third, I'm guessing this original question was being asked with reference to Harvest Natural Resources, an American oil company with production in Venezuela. Again, currency risk seems to be less of a worry here, because they have a global product (as long as the government allows them to export that production). They're producing barrels of oils- and the value being created by that is practically the same whether its coming from Venezuela or somewhere else. This is something I'll be looking into.
Finally, I see the same thing with SFK. The product is sold mostly in North America, Europe, Asia. The fall of the US dollar seems bad, until you recognize that 90% of NBSK production is from either Canada or Europe. And there is also offsetting forces because I am a US investor putting money to work in Canadian dollars.
I hope some of these concepts were helpful.
Q: On Ipsco, why were the analysts so wrong?
A: With Ipsco, it is difficult to forecast the cashflow going far out in a cyclical business like steel, and no one likes to deal with uncertainty. But we were able to take advantage of that.
For reference, Pabrai's thesis on Ipsco was simple. It was trading at a market cap of 2.5 billion. It had 900 million in excess capital, and was projected to earn 650 million in free cash flow over the next two years, meaning 2.2 billion in cash by the end of that period. Though steel is highly cyclical, one can relatively easily forecast an industry 2 years out just by researching new supply projects and usual demand trends. Afterwards a gray area exists, but at that point it was a true Dhando situation- heads you win, tails you don't lose much.
Q: Why were you in and out of RailCar America so quickly?
A: There was a lot to like about the business. Though it is very cyclical, odds were pretty good this would be fairly profitable. We sold because it was very narrow, with its only product being rail cars carrying coal. Second, there was environmental and union issues. Finally, there was a chance that the expected replacement for coal cars wouldn't come around for several years. Probably a mistake to sell- we will see.
Q: How do you assess political risk in your framework?
A: Sometimes there is inefficient markets in how to deal with political risk. An example is with our Embraer in Brazil. The company was very cheap based on concerns about the currency, but that was just noise. Underneath you had a business that was the best at what they do and in a duopoly. They were the icon of Brazil, so the talent of the country wanted to go there, giving them a competitive edge. Also, Brazil wouldn't want to screw up an export champion.
There are several things I took from this. First was the idea of talent attraction as a competitive advantage. It's something that I never really factored in but has a lot of merit. Most likely, the best in an industry will attract those that are most passionate about that sector. One obvious example is Google. A second example- me! I was recently telling my family that if I could work right now, I'd jump at the opportunity to work with Exchange Bank of Santa Rosa because they're the best at what they do. And I'd like to think I'd be worth the cost.
The other thing I took from this is very important for any international investor. A unconventional test I like to put on any investment is the value-added. Well, with a company like Embraer, who is the best at what they do, there is definitely a lot of value added. There is also only one other competitor, and they sell their products all around the world. In such a situation, currency risk is really "noise". Any rise or fall in currency can easily work through the business to conserve profitability. Alternatively, I was recently looking at another wide-moat Brazilian company, but they sold only to customers in Brazil. In such a situation, currency risk is much more present- a decline in their currency wouldn't be offset by higher profitability on exports for a US investor like me.
Third, I'm guessing this original question was being asked with reference to Harvest Natural Resources, an American oil company with production in Venezuela. Again, currency risk seems to be less of a worry here, because they have a global product (as long as the government allows them to export that production). They're producing barrels of oils- and the value being created by that is practically the same whether its coming from Venezuela or somewhere else. This is something I'll be looking into.
Finally, I see the same thing with SFK. The product is sold mostly in North America, Europe, Asia. The fall of the US dollar seems bad, until you recognize that 90% of NBSK production is from either Canada or Europe. And there is also offsetting forces because I am a US investor putting money to work in Canadian dollars.
I hope some of these concepts were helpful.
Calculated Risk: HMDA Data Analysis
Calculated Risk published a post which I nearly missed and I think has some very important facts for investors. To take some quotes from their summary which I thought were very important:
Although mortgage companies represented only 22 percent of the reporting institutions, they submitted information on more than 60 percent of all the reported loans and applications.
The most active lenders (those providing information on 5,000 or more loans or applications) accounted for about 5 percent of the reporting institutions and nearly 90 percent of all the reported loans and applications.
For 2006, lenders covered by HMDA reported information on 27.5 million applications for home loans. Almost all the applications were for loans to be secured by one- to four-family (so-called single-family) houses, as follows: 10.9 million applications to purchase a home, 2.5 million to make home improvements, and 14.0 million to refinance an existing home loan.
After declining in the early 1990s, the share of non-owner-occupant lending among first-lien loans to purchase one- to four-family site-built homes began rising in 1994, and it has risen in every year between 1996 (when it was 6.4 percent) and 2005, when it reached 17.3 percent (table 8). For 2006, the share fell somewhat, to 16.5 percent.
Although mortgage companies represented only 22 percent of the reporting institutions, they submitted information on more than 60 percent of all the reported loans and applications.
The most active lenders (those providing information on 5,000 or more loans or applications) accounted for about 5 percent of the reporting institutions and nearly 90 percent of all the reported loans and applications.
For 2006, lenders covered by HMDA reported information on 27.5 million applications for home loans. Almost all the applications were for loans to be secured by one- to four-family (so-called single-family) houses, as follows: 10.9 million applications to purchase a home, 2.5 million to make home improvements, and 14.0 million to refinance an existing home loan.
After declining in the early 1990s, the share of non-owner-occupant lending among first-lien loans to purchase one- to four-family site-built homes began rising in 1994, and it has risen in every year between 1996 (when it was 6.4 percent) and 2005, when it reached 17.3 percent (table 8). For 2006, the share fell somewhat, to 16.5 percent.
Saturday, September 15, 2007
A Few Tangents on Fairfax
Last night I went looking into a few things that I thought might affect Fairfax's value. The results are below.
1. Effect of a strengthening Canadian dollar
From the standpoint of a US investor, the overall strengthening of the Canadian dollar is a positive for US investors, in that it increases the value of Northbridge, their Canadian subsidiary. This is partially offset by an increase in corporate costs from the Toronto headquarters. Overall, the effect is pretty insignificant. Judging based on the market value of Northbridge, a 5% rise would add 88 million in value. If looking at earnings, a 5% rise would add approximately 9 million in operating income. (before tax) These are based off the table on pg. 53 which breaks down the overall business in terms of region.
2. Very Long-Tail Float from Run-off?
Under "Contractual Obligations", insurers include their loss reserves as well as a time-span for when they expect those to be paid out. I was hoping that perhaps Fairfax possessed a lot of super long-tail business from run-off which are reserved for today, but will not have to be paid until much, much later.
At the end of 2006, Fairfax had:
3-5 years 1.686 billion
5++ years 2.162 billion
Total reserves 10.658 billion
3 year++ reserves/ total reserves : 36.1%
5 years ++ reserves/ total reserves: 20%
Now in comparison, Allstate's property and casualty business had:
3 year++ reserves/ total reserves: 25.78%
5 years++ reserves/ total reserves: 14.23%
Which seems encouraging, but then I looked at Berkshire Hathaway, which only provides 3 years ++ numbers, and they were at 36.3%. So overall, I'd have to say that perhaps they have a slight edge in this respect, but not by much.
Also, some people have asked whether Fairfax's long term bond portfolio perhaps was a way to match assets with expected liabilities. Fairfax had over 6.7 billion in treasuries with a maturity greater than 5 years, far more in excess of the 2.1 billion they have reserved for. So the answer to that appears to be "No".
1. Effect of a strengthening Canadian dollar
From the standpoint of a US investor, the overall strengthening of the Canadian dollar is a positive for US investors, in that it increases the value of Northbridge, their Canadian subsidiary. This is partially offset by an increase in corporate costs from the Toronto headquarters. Overall, the effect is pretty insignificant. Judging based on the market value of Northbridge, a 5% rise would add 88 million in value. If looking at earnings, a 5% rise would add approximately 9 million in operating income. (before tax) These are based off the table on pg. 53 which breaks down the overall business in terms of region.
2. Very Long-Tail Float from Run-off?
Under "Contractual Obligations", insurers include their loss reserves as well as a time-span for when they expect those to be paid out. I was hoping that perhaps Fairfax possessed a lot of super long-tail business from run-off which are reserved for today, but will not have to be paid until much, much later.
At the end of 2006, Fairfax had:
3-5 years 1.686 billion
5++ years 2.162 billion
Total reserves 10.658 billion
3 year++ reserves/ total reserves : 36.1%
5 years ++ reserves/ total reserves: 20%
Now in comparison, Allstate's property and casualty business had:
3 year++ reserves/ total reserves: 25.78%
5 years++ reserves/ total reserves: 14.23%
Which seems encouraging, but then I looked at Berkshire Hathaway, which only provides 3 years ++ numbers, and they were at 36.3%. So overall, I'd have to say that perhaps they have a slight edge in this respect, but not by much.
Also, some people have asked whether Fairfax's long term bond portfolio perhaps was a way to match assets with expected liabilities. Fairfax had over 6.7 billion in treasuries with a maturity greater than 5 years, far more in excess of the 2.1 billion they have reserved for. So the answer to that appears to be "No".
Wednesday, September 12, 2007
Prem Watsa Presentation at Scotia Capital- Notes
Fairfax Today
- At end of march 2007, 700 millionUS
- Consolidated, about 4.8 billion premiums written, 60% orh and 60% northbridge
- Mostly, commercial line company
- 5 Yr Growth in book value adjusted for dividends
Northbridge (?)
Odyssey 18.7%
Crum forster 17.9%
- At end of march 2007, 700 million
- Consolidated, about 4.8 billion premiums written, 60% orh and 60% northbridge
- Mostly, commercial line company
- 5 Yr Growth in book value adjusted for dividends
Northbridge (?)
Odyssey 18.7%
Crum forster 17.9%
-
- 25% net debt to capital, soonest payment is 245 million due in 2012.
- We think property and casualty industry is on a downswing.
- Prices have come down in first half, we think it will continue to come down.
- Investment Side of business; 22% cash reserves, 55% in bonds, small corporate bond position. Went from 50% to 80% of equity portfolio hedged, plus 18 billion notional CDS portfolio.
- Conservatively structured for potential risks we see, not what we’ve seen over the last 6 months but worse, so we’re keeping our portfolio structure.
Why we’re concerned about the
- The 13 or 14 years from Nikkei peak in 1890, it went down. 40,000 to 7,500.
- even though interest rates fell from 8.00% to .50%, the stock market still fell down significantly.
- we like treasuries, 10 yr and above- if you look at it from a very long perspective, it is still a very high rate, 4.60%.
- High yield spread has been much higher, went down, going up again now.
- CDS for countrywide was about 150 basis when we bought, went to 50 basis points , now significantly higher.
- Q: whether you would sell CDS'? (Question doesn’t come up on call, my guess based on the answer given below)
Our view is it’s our judgment, and if we get sufficient spread we will take it. Some we think have a higher chance of having credit problems, but fair to say given an appropriate price we would sell it.
Counter-parties are Citibank, Duetsche bank, and Barclays, so major institutions, along with pledged collateral. People think Fed Reserve will drop rates and we will be back in business, we think that might not be the case, so we’re keeping treasuries and CDS portfolio.
Long, long term holding. Right now 6 billion premiums of
We focus on increasing book value by 15%, earnings may be volatile depending on when they realize capital gains, and we don’t give guidance. $1.50 book value in 1985 to $165 today.
No, still the case, we’re looking at approximately break even.
-Q: Long-tail claims of Runoff still stable?
There could be bumps, but we’re happy with reserves we have set.
I'll post Archive Link and Slides here as soon as available.
Tuesday, September 11, 2007
Mercer Investment Presentation
Monday, September 10, 2007
Technology Quarterly Summary
Every quarter, The Economist comes out with a special report on new and interesting technological innovations. I find it to be an important read for investors, in order to learn about what is going on in the world and also to know of trends that could affect investment decisions. But, it is also a very long read. Below is a summary of some of the noteworthy ideas mentioned.
1. The idea of transferring information through light (optical wireless) is being researched, promising better security and faster speeds than traditional radio-based communications. Advocates also like it for its convenience, and the cost to install is very low; the main drawback is that atmosphere conditions can affect the signal.
2. Researchers have developed an environmentally friendly light bulb that is cheap, uses very little energy and should last for decades. The traditional light bulb emits 5% of energy as light, fluorescent about 15%, and the new Ceravision lamp has efficiency greater than 50%. With lighting accounting for 20% of electricity use worldwide, this more efficient system could reduce energy demand as well as emissions. (Plus, reducing light bulb demand)
3. Using photosynthesis to capture exhaust gases from power plants could reduce the emissions produced by coal-fired stations, and could be re-used in the power plant as energy or converted to biodiesel. It is not yet commercialized, but a preliminary test suggested it can remove 75% of carbon dioxide from a power station’s exhaust. There stands the possibility that rather than paying for carbon emissions, power companies may soon be able to profit from them.
4. Offshore oil technology is becoming more efficient by outsourcing tasks off of rigs and by developing multiple fields from one platform, allowing for reduced levels of workers needed on rigs and resulting in lower production costs.
5.
6. German engineers have created the “SeaFalcon”, a ship that flies about two metres above water, allowing it to travel far faster than a ship (80-100 knots) and for cheaper than a plane of equivalent size.
7. A new 3-seater car named “The Aquada” has the ability to fold up its wheels and convert into a boat of sorts. It will go into production in 2008 and cost $85,000.
WaMu Chief Sees Perfect Storm
Washington Mutual today, after setting aside 500 million more for loan losses, said that they are amid what he called "a near perfect storm" in US housing. I wonder if he got the term from Prem Watsa, who has used the term often and is predicting a 1 in 50 or 1 in 100 year catastrophic event. Either way, it is good to know that the Fairfax team does hold CDS against Washington Mutual, among the many other mortgage names.
To see the list of other holdings in the Fairfax CDS portfolio, see this.
To see the list of other holdings in the Fairfax CDS portfolio, see this.
Sunday, September 09, 2007
It's Time for Quality
In a 1970's speech following Benjamin Graham, Robert G. Kirby made the following argument:
Economic analysis can be used to make investment decisions. In doing so, I would be inclined to concentrate my attention on two areas. The first would be in the determination of future, long-term interest rates. We have moved into an era where there are no longer two watertight compartments of "stock money " and "bond money." Equities and fixed income securities now compete for the same investment dollar. A critical factor in making good investment decisions is what the basic wage of capital is going to be in the future.
Today, there is a knowledgeable camp of people (Hoisington, Zell, Watsa) who believe that long term treasury rates will continue downwards. In such an environment, it is the high quality company, one with strong competitive advantages, that will prosper as an investment. This is because in the long run, the market value of companies will track their growth in earnings. In an environment where long term treasuries yield 3%, it is the marginal company that will feel the most pressure on its Return on Investment (ROI), and hence earnings. Meanwhile, the high quality company will be better able to maintain its ROI due to the moat surrounding its business. So, finding a company that can maintain 10% long run earnings growth becomes much more valuable in a 3% discount rate environment than in a 7% setting. Such companies are difficult to find at a meaningful discount, but you can bet I'll be watching closely for anything if further market turmoil continues.
It is also interesting to note the second economic factor Kirby mentioned to watch out for: whether the future will be one of saving or spending. With the consumer "tapped" out and heavily indebted, it would seem that our future is one of savings. Such a shift could have a major impact on earnings; but again, it is the high quality company that will least likely feel these effects.
Economic analysis can be used to make investment decisions. In doing so, I would be inclined to concentrate my attention on two areas. The first would be in the determination of future, long-term interest rates. We have moved into an era where there are no longer two watertight compartments of "stock money " and "bond money." Equities and fixed income securities now compete for the same investment dollar. A critical factor in making good investment decisions is what the basic wage of capital is going to be in the future.
Today, there is a knowledgeable camp of people (Hoisington, Zell, Watsa) who believe that long term treasury rates will continue downwards. In such an environment, it is the high quality company, one with strong competitive advantages, that will prosper as an investment. This is because in the long run, the market value of companies will track their growth in earnings. In an environment where long term treasuries yield 3%, it is the marginal company that will feel the most pressure on its Return on Investment (ROI), and hence earnings. Meanwhile, the high quality company will be better able to maintain its ROI due to the moat surrounding its business. So, finding a company that can maintain 10% long run earnings growth becomes much more valuable in a 3% discount rate environment than in a 7% setting. Such companies are difficult to find at a meaningful discount, but you can bet I'll be watching closely for anything if further market turmoil continues.
It is also interesting to note the second economic factor Kirby mentioned to watch out for: whether the future will be one of saving or spending. With the consumer "tapped" out and heavily indebted, it would seem that our future is one of savings. Such a shift could have a major impact on earnings; but again, it is the high quality company that will least likely feel these effects.
Friday, September 07, 2007
Domtar reports ABCP exposure
Something to watch out for- many companies might have unexpected exposure to financial market turmoil through their pensions. Domtar Corporation announced:
"In light of the current disruption of credit markets, particularly for third party asset-backed commercial paper ("ABCP"), Domtar Corporation is providing the following update.
Losses in the pension fund investments, if any, would result in future increased contributions by the Company or its Canadian subsidiaries. Additional contributions to theses pension funds would be required to be paid over a 5-year period. Losses, if any, would also impact operating earnings over a longer period of time and immediately increase liabilities and reduce equity."
"In light of the current disruption of credit markets, particularly for third party asset-backed commercial paper ("ABCP"), Domtar Corporation is providing the following update.
The Company and its subsidiaries, including Domtar Inc., have no holdings of ABCP.
Domtar Corporation's Canadian pension funds have approximately CDN $420 million (of which approximately $308 million is held by Domtar Inc.'s Canadian pension funds) invested in multiple ABCP conduits...Losses in the pension fund investments, if any, would result in future increased contributions by the Company or its Canadian subsidiaries. Additional contributions to theses pension funds would be required to be paid over a 5-year period. Losses, if any, would also impact operating earnings over a longer period of time and immediately increase liabilities and reduce equity."
Hayek, Friedrich. The Use Of Knowledge in Society
Added to Online Library.
"What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions."
...
"This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solution of the economic problem of society, does not yet provide an answer to it. The reason for this is that the "data" from which the economic calculus starts are never for the whole society "given" to a single mind which could work out the implications and can never be so given."
"What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions."
...
"This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solution of the economic problem of society, does not yet provide an answer to it. The reason for this is that the "data" from which the economic calculus starts are never for the whole society "given" to a single mind which could work out the implications and can never be so given."
New Info on the Mortgage Lender Bear Case
About a week ago, I posted my reasoning for avoiding most mortgage lenders, basically stating that they were adding very little value in the business- mainly, saving a person the trip to their local bank.
Well today on Calculated Risk, Tanta posted a new UberNerd on Mortgage Origination Channels, which I recommend you read from beginning to end. But the relevant part is the following:
In the old days, the depository lenders had “loan officers.” They were actually officers, and they actually decided whether to lend people money or not. In and around the 1980s, an idea arose that “loan officers” should primarily be “salespeople,” not credit underwriters, because they could reel in more borrowers that way. We took them off salary, put them on commission, and sent them to sales seminars in which everything they ever knew about evaluating credit risk was rinsed out of their brains in a deluge of sales tactics and lead generation and unspeakable “motivational” rhetoric. This resulted in a horrifying pile of terrible loans.
So we took the “officer” part out in reality, if not in name. “Loan officers” became pure salespeople, who turned over their applications to underwriters, who were salaried and paid a lot less, in most cases, than the loan officers. These underwriters were stuffed into cubicles in “back rooms” where they were expected to uphold the institution’s credit standards in the face of an aggressive sales force who didn’t get paid unless the underwriter caved in. Since loan officers were paid on volume, not profitability or loan quality, the LO just wanted to get to the closing table as often as possible. The underwriters got paid whether the loan closed or not, but they quite often didn’t get paid enough to want to be beaten to a bloody pulp by salespeople and branch managers and production vice presidents. Generally the underwriters reported up to the chief credit officer, who reported to the CEO. The loan officers reported up to the senior production manager who reported to the CEO. The CEO settled arguments based on either the good of the company or the bonus pool.
Having turned LOs into salespeople, it wasn’t much of a stretch to wonder why you needed to employ them at all. The RE market was already chock-full of real estate brokers and commercial loan brokers; why not mortgage brokers? Now, it seemed to some of us that the broker model made sense in the primary RE market, and in commercial lending, both of which are complex markets in which a buyer or borrower might need some real expert help finding a seller or lender, or vice versa. The earliest mortgage brokers were, exactly, in subprime or “hard money” lending, because those were also “illiquid” markets. Once you brought brokers into the very liquid, ubiquitous-bank-branch-on-every-corner residential mortgage market, you were, really, doing something weird.
So, he seems to be echoing what I was saying. Add into that another good point he brings up:
It is perfectly possible and even frequently the case that you have a loan that was brokered to Pissant Mortgage Company, who sold it on a correspondent flow basis to Medium Dog Bank, who sold it on a bulk servicing retained basis to Big Dog Bank, who sold it to Lehman, who securitized it. Everybody counted a loan in their own “originations” or production.
As an investor in one of these final securitizations, you must wonder how all these intermediaries are racking up fees while still selling you "a great investment opportunity." That's a great question that is unfortunately only being asked now.
Well today on Calculated Risk, Tanta posted a new UberNerd on Mortgage Origination Channels, which I recommend you read from beginning to end. But the relevant part is the following:
In the old days, the depository lenders had “loan officers.” They were actually officers, and they actually decided whether to lend people money or not. In and around the 1980s, an idea arose that “loan officers” should primarily be “salespeople,” not credit underwriters, because they could reel in more borrowers that way. We took them off salary, put them on commission, and sent them to sales seminars in which everything they ever knew about evaluating credit risk was rinsed out of their brains in a deluge of sales tactics and lead generation and unspeakable “motivational” rhetoric. This resulted in a horrifying pile of terrible loans.
So we took the “officer” part out in reality, if not in name. “Loan officers” became pure salespeople, who turned over their applications to underwriters, who were salaried and paid a lot less, in most cases, than the loan officers. These underwriters were stuffed into cubicles in “back rooms” where they were expected to uphold the institution’s credit standards in the face of an aggressive sales force who didn’t get paid unless the underwriter caved in. Since loan officers were paid on volume, not profitability or loan quality, the LO just wanted to get to the closing table as often as possible. The underwriters got paid whether the loan closed or not, but they quite often didn’t get paid enough to want to be beaten to a bloody pulp by salespeople and branch managers and production vice presidents. Generally the underwriters reported up to the chief credit officer, who reported to the CEO. The loan officers reported up to the senior production manager who reported to the CEO. The CEO settled arguments based on either the good of the company or the bonus pool.
Having turned LOs into salespeople, it wasn’t much of a stretch to wonder why you needed to employ them at all. The RE market was already chock-full of real estate brokers and commercial loan brokers; why not mortgage brokers? Now, it seemed to some of us that the broker model made sense in the primary RE market, and in commercial lending, both of which are complex markets in which a buyer or borrower might need some real expert help finding a seller or lender, or vice versa. The earliest mortgage brokers were, exactly, in subprime or “hard money” lending, because those were also “illiquid” markets. Once you brought brokers into the very liquid, ubiquitous-bank-branch-on-every-corner residential mortgage market, you were, really, doing something weird.
So, he seems to be echoing what I was saying. Add into that another good point he brings up:
It is perfectly possible and even frequently the case that you have a loan that was brokered to Pissant Mortgage Company, who sold it on a correspondent flow basis to Medium Dog Bank, who sold it on a bulk servicing retained basis to Big Dog Bank, who sold it to Lehman, who securitized it. Everybody counted a loan in their own “originations” or production.
As an investor in one of these final securitizations, you must wonder how all these intermediaries are racking up fees while still selling you "a great investment opportunity." That's a great question that is unfortunately only being asked now.
Thursday, September 06, 2007
Mortgage Banker's Survey
According to the group's quarterly delinquency survey, a seasonally adjusted 0.65% of loans on one- to four-unit residential properties entered the foreclosure process during the period, the highest level in the survey's 55-year history. In the first quarter, when the previous record was set, 0.58% of loans entered the process; a year ago, 0.43% entered the process.
According to the survey, 1.40% of all outstanding loans were somewhere in the foreclosure process during the second quarter, up from 1.28% in the first quarter and 0.99% a year ago.
The delinquency rate for mortgages on one- to four-unit proprieties was 5.12% in the second quarter, up from 4.84% in the first quarter and 4.39% a year ago.
According to the survey, 1.40% of all outstanding loans were somewhere in the foreclosure process during the second quarter, up from 1.28% in the first quarter and 0.99% a year ago.
The delinquency rate for mortgages on one- to four-unit proprieties was 5.12% in the second quarter, up from 4.84% in the first quarter and 4.39% a year ago.
Wednesday, September 05, 2007
Imperialism
While reading Imperialism, A Study by John Hobson, I stumbled across the following interesting passage. Although this was written over 100 years ago to describe the British Imperialism of the era, I had the distinct impression that the message has some value in our present-day. I'll let the reader decide.
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Tuesday, September 04, 2007
2007 Wesco Annual Meeting Notes
These notes are supposed to only be for people who have signed up for the upcoming Value Investors Congress, but since Vinvesting has published it on their site, I'll gladly relay the link below.
Monday, September 03, 2007
Fairfax Mentioned in Value Investor Insight
Fairfax Financial has a write-up in the August issue of VII by Whitney Tilson, with a price target of $365 (albeit, using some faulty numbers). Anyways, their thesis repeats what I've been saying here: Large CDS gain potential, and a hidden value in ICICI, combined with an overall very undervalued market price. I'd also add bond gains. Sorry, no direct link, as its subscription only.
Countrywide's Confidence turned to Crisis
"Countrywide also concedes that its vaunted proprietary system for estimating loss probabilities and delinquency rates was bamboozled by real-world conditions in 2006 and 2007"
Sunday, September 02, 2007
Critique on TFS Financial Corp. Write-Up
Hawkeye901 on Value Investors Club did an investment write-up on TFS Finacial (TFSL) stating that an 'MHC conversion' opportunity existed and the company, "at its current price of $11 per share, the company is trading at approximately 60% of its economic book value of $18 per share."
What is an MHC conversion opportunity? Well, MHC stands for mutual holding company, and it is a business structure available to banks in which the company's owners are its depositors. Some companies in the Northeast have chosen this structure, but these days you will rarely find new companies choosing this route. When MHC's want to go public and raise equity, things start to get very confusing. The company must hold more than 50% of its own shares, but the cash raised from the other shares sold goes straight to the company. Depositors, who were the original owners, get first rights to participate in the MHC's IPO. Now, the problem is how to treat the shares held by the company itself, because if and when these are eventually sold, the money for these will also go straight to the company. This means that looking at conventional shares outstanding and Price to Book or Earnings multiples would provide a very distorted figure, allowing for an opportunity for investors to profit from any misunderstanding.
This MHC opportunity has been well-covered, by me especially, and the opportunities have pretty much vanished as people caught on to the situation. This is why I was so surprised when I saw a VIC write-up with a 6.2 rating on such an opportunity, which claimed post-conversion it was trading at 60% book value. On further investigation, it appears that some optimistic assumptions were made to arrive at that figure.
I was first exposed to the MHC idea by a different VIC write-up done by jim77 on Service Bancorp, SERC. To copy a relevant paragraph from his write-up:
Now, to give some comparisons, when SERC IPO'd, it had 1.65 million shares outstanding, of which it sold 736,000 to the public at $10 a share. Post-IPO, it had 18.4 million in equity, meaning a book value per share of $11.15(counting all shares outstanding). Meanwhile, the share price was at $9.75 when he recommended it, and the benefit from any MHC conversion still hadn't taken place.
In comparison, TFSL currently has 332 million public shares, of which 105 million were sold to the public. Post-IPO, it has 1.9 billion in equity, and a book value per share of $5.72. Yet somehow, they claim that both trade at an adjusted price/book value of 60%, despite SERC's far superior valuations.
The difference is, jim77 is assuming the secondary sale of sells goes off at 75% Price to book value, assuming book value is calculated using all shares outstanding. Hawkeye is assuming 120% price to book value, and hes only using the public share count, meaning 105 million shares outstanding instead of 332 million that would be used in jim's analysis. In truth, jim was probably being too conservative with 75%, especially when he says the average second-step is done at 108%. But hawkeye is using 120%, and a seriously inflated book value number to come at his numbers. Hence my surprise that it received a 6.2 rating... but maybe I'm just behind on a new era in valuations.
What is an MHC conversion opportunity? Well, MHC stands for mutual holding company, and it is a business structure available to banks in which the company's owners are its depositors. Some companies in the Northeast have chosen this structure, but these days you will rarely find new companies choosing this route. When MHC's want to go public and raise equity, things start to get very confusing. The company must hold more than 50% of its own shares, but the cash raised from the other shares sold goes straight to the company. Depositors, who were the original owners, get first rights to participate in the MHC's IPO. Now, the problem is how to treat the shares held by the company itself, because if and when these are eventually sold, the money for these will also go straight to the company. This means that looking at conventional shares outstanding and Price to Book or Earnings multiples would provide a very distorted figure, allowing for an opportunity for investors to profit from any misunderstanding.
This MHC opportunity has been well-covered, by me especially, and the opportunities have pretty much vanished as people caught on to the situation. This is why I was so surprised when I saw a VIC write-up with a 6.2 rating on such an opportunity, which claimed post-conversion it was trading at 60% book value. On further investigation, it appears that some optimistic assumptions were made to arrive at that figure.
I was first exposed to the MHC idea by a different VIC write-up done by jim77 on Service Bancorp, SERC. To copy a relevant paragraph from his write-up:
First a few comments on the 'mutual holding company'(MHC) structure. GAAP 'understates' both the P/E and P/B ratios because they fully count the shares the MHC holds...but the shares have never been sold publicly. Others posters on VIC have commented that all the economic value of the enterprise should accrue to the public minority shares only...but I'm afraid that 'overstates' the true
economic reality in most cases. (There is a very large exception where this does hold true, however...and, is in fact, one of the reasons why I recently bought SERC). It's not difficult 'adjusting' P/B and P/E for a publicly traded sub of an MHC at the IPO...but it is a little trickier after it's been trading for a few years. The easiest way is to assume a second-stage conversion at a reasonable
P/B (second-stage conversions are primarily priced according to book). The Mass median P/B is 117% and the national average is 108%. Most recent second-stages have conservatively been priced to go off at a minimum of 75% P/B. Assuming SERC is priced at 75% in any second-stage, the current price is an adjusted 59% P/B (this asumes all the underwriting expenses and a realistic 8% ESOP and 4% MRP expense). SERC will not stay long at that 59% P/B mark with the average Mass thrift trading at twice those levels. But is there anything indicating that the bank would want to convert?
economic reality in most cases. (There is a very large exception where this does hold true, however...and, is in fact, one of the reasons why I recently bought SERC). It's not difficult 'adjusting' P/B and P/E for a publicly traded sub of an MHC at the IPO...but it is a little trickier after it's been trading for a few years. The easiest way is to assume a second-stage conversion at a reasonable
P/B (second-stage conversions are primarily priced according to book). The Mass median P/B is 117% and the national average is 108%. Most recent second-stages have conservatively been priced to go off at a minimum of 75% P/B. Assuming SERC is priced at 75% in any second-stage, the current price is an adjusted 59% P/B (this asumes all the underwriting expenses and a realistic 8% ESOP and 4% MRP expense). SERC will not stay long at that 59% P/B mark with the average Mass thrift trading at twice those levels. But is there anything indicating that the bank would want to convert?
In comparison, TFSL currently has 332 million public shares, of which 105 million were sold to the public. Post-IPO, it has 1.9 billion in equity, and a book value per share of $5.72. Yet somehow, they claim that both trade at an adjusted price/book value of 60%, despite SERC's far superior valuations.
The difference is, jim77 is assuming the secondary sale of sells goes off at 75% Price to book value, assuming book value is calculated using all shares outstanding. Hawkeye is assuming 120% price to book value, and hes only using the public share count, meaning 105 million shares outstanding instead of 332 million that would be used in jim's analysis. In truth, jim was probably being too conservative with 75%, especially when he says the average second-step is done at 108%. But hawkeye is using 120%, and a seriously inflated book value number to come at his numbers. Hence my surprise that it received a 6.2 rating... but maybe I'm just behind on a new era in valuations.
Saturday, September 01, 2007
The Compleat UberNerd
For anyone looking to get a very detailed understanding of the mortgage industry, I recommend checking out this section on the Calculated Risk blog entitled "The Compleat UberNerd". It offers a very comprehensive (and lengthy) write-up on several areas of the industry that many people misunderstand or just don't know much about. This probably isn't for everyone; in fact, they even go ahead and say:
an “UberNerd” is someone who is compelled to understand how things work in grim detail, even if the things in question are tedious in the extreme, like mortgage insurance policies. Not everyone who visits the blog is an UberNerd, or aspires to UberNerdity, but on the other hand those who display UberNerditude in the comment threads are treated with a respect bordering on lunacy.
I guess I would qualify, because I find all of these posts very interesting.
an “UberNerd” is someone who is compelled to understand how things work in grim detail, even if the things in question are tedious in the extreme, like mortgage insurance policies. Not everyone who visits the blog is an UberNerd, or aspires to UberNerdity, but on the other hand those who display UberNerditude in the comment threads are treated with a respect bordering on lunacy.
I guess I would qualify, because I find all of these posts very interesting.
Special Report: Heading For the Rocks
The Economist has a free special report on the turmoil in the financial markets. It can be viewed here.
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