With the price of many mortgage lenders hitting record lows, many people are wondering if now is the time to get into this sector. I am going to spell out my reasoning against investing in this area. To clarify, I am talking about the mortgage lenders which skipped traditional banking and instead focused on originating and selling large volumes of loans.
The basis of my argument revolves around the idea that the "value-added" from this industry is minimal at best. I summarize the mortgage lending business model as this: borrow at market rates from banks, hire a staff dedicated to finding and originating loans, and then sell them to other investors for a profit, and repeat. The whole process uses heavy leverage to make the returns worthwhile. Basically, they're aim is to add value in the originating process by making more profitable loans, whether through higher interest and/or more security (For sub-prime and Alt-A, it was higher rates while hopefully maintaining security) The mortgage lenders could have gone three routes:
A) originate loans to good borrowers that banks would also lend to.
B) Loan to good borrowers that banks would not lend to.
C) originate loans to bad borrowers.
In C there is no viable long-term business model. In Situation A, the "value-added" is minimal- you save the borrower the time from visiting their local bank, and in return add another layer of frictional costs. On average, the mortgage lenders total cost to originate are about 2% of loan value, so you can make a rough estimate of $4,000 per loan in additional costs.
Only in B does there exist a niche market which appears worthwhile. But the market will always occupy only a small niche outside bank lending criteria. If the non-conforming business grew large and the loans being made were truly good loans, then banks could simply loosen their criteria and add new competition, forcing it back to a situation A.
So when the market for Sub-prime and Alt-A grew to 40% of loans originated in 2006, either things got out of hand, or banks fell behind a new shift in acceptable lending. I choose to believe in the former.
Wednesday, August 29, 2007
Monday, August 27, 2007
Chou Funds Semi-Annual Report
Francis Chou's 2007 Semi-Annual Report is out along with some interesting commentary. He also made some purchases during the semester, which as far as I could tell were mostly:
(Numbers based on $ cost)
NEW* Alpha Natural Resources 6.3 mil
NEW* Sprint-Nextel 9.4 mil
NEW* Media General 4.3 mil
Sun-Times Media Group Increased from 4.2 mil to 13.9 mil
Watson Pharmaceuticals Increased from 1.4 mil to 11.9 mil
NEW* IDT Corp. 1 mil
NEW* Primus Telecom Debt 25 mil
For reference, Chou manages a total portfolio of 420 million. Overstock continues to be one of his significant holdings, with 36 million invested into it. The new position in Primus debt is also a very large position by Chou's standards.
(Numbers based on $ cost)
NEW* Alpha Natural Resources 6.3 mil
NEW* Sprint-Nextel 9.4 mil
NEW* Media General 4.3 mil
Sun-Times Media Group Increased from 4.2 mil to 13.9 mil
Watson Pharmaceuticals Increased from 1.4 mil to 11.9 mil
NEW* IDT Corp. 1 mil
NEW* Primus Telecom Debt 25 mil
For reference, Chou manages a total portfolio of 420 million. Overstock continues to be one of his significant holdings, with 36 million invested into it. The new position in Primus debt is also a very large position by Chou's standards.
Saturday, August 25, 2007
Delving into Investing Theory
As I was thinking about the recent credit problems, I couldn't help but think there was a lesson to be learned for investing as a whole. Looking from today, we can say that some lending got completely out of hand. Since lending really is a form of investment, we can look at their rationale for making these loans to find the fault. Loan underwriting relaxed to a point where banks became less concerned with borrower's ability to pay, and instead focused on the asset price securing the loan. This can be seen in the rise in lending debt-income ratios, the percentage of income of the borrower going to pay off debts. Banks conventionally have a limit at 36%. Subprime lender Delta Financial, considered one of the better underwriters, went up to 55%; Other subprime lenders rarely disclosed their maximum limit. These lenders tried to make up for this by having lower Loan-to-Value ratios(LTV), which is the loan amount compared to the value of the house. This added more principal security.
The problem as I see it is one of financial misunderstanding. To me, an investment has an asset value and an asset cost. The asset value is simply the net present value of future cash flow, while the asset cost was what was paid to acquire the assets. So, a loan's "asset value" is really the discounted sum of the borrower's interest and principal payments, along with the cash-out value if or when the borower defaults. The asset cost though is simply the amount of money that was loaned. From this perspective, we can see that the problem was that lenders lost track of asset value when they became less concerned with the borrower's income and relied more on the underlying home price. If the homes could be sold for their full value this wouldn't be a problem, but there are very significant costs associated with foreclosures. So many mortgage companies made loans that were carried at face value when their real value was considerably less, given the likelihood of default.
Similarly, this same behavior can be seen during stock market bubbles. A stock is also worth the net present value of its future cashflow. This means the sum of the cash flow from the operating business as well as a final gain (or loss) if the company needs to be liquidated. In stock market bubbles, investors become less focused on the present value of the investments they purchase; instead, they are buying an asset at a certain cost and hoping it will appreciate when they sell it to someone else. The business' ability to justify the price through its cashflow becomes an afterthought. So for a long time, equity investments can be carried on the books at a price that is much higher than logic would justify.
Your goal in investing is to be buying when asset cost is significantly below asset value.
The beauty of Ben Graham's philosophy was its simplicity. His strategy was to invest in companies at two-thirds of their Net Current Asset Value (NCAV), or their current assets minus total liabilities. Current assets are expected to be converted into cash within 18 months, and they can usually be taken at near face value. Such an investment situation means that if the company stopped operations immediately, it would have enough cash to pay all of its obligations and then give what is left over to shareholder's for a decent return in a relatively short period of time- hence, you were buying a company for less than its NPV under a scenario where the fixed assets and the company were treated as worthless. So, there was a high level of cash security for this type of investment, yet the upside was also pretty limited. But Ben Graham knew that fixed asset values can be much different than their costs, and wanted to make a strategy that any Average Joe could use.
The days of finding pure NCAV ideas are getting slim these days as information has become much more available. Today, a investor must become much more accurate and comfortable in make income projections for a business. This means analyzing competitive advantages will play a much more important part in security analysis, and there will be the possibility for larger gains- and mistakes- for investors.
The problem as I see it is one of financial misunderstanding. To me, an investment has an asset value and an asset cost. The asset value is simply the net present value of future cash flow, while the asset cost was what was paid to acquire the assets. So, a loan's "asset value" is really the discounted sum of the borrower's interest and principal payments, along with the cash-out value if or when the borower defaults. The asset cost though is simply the amount of money that was loaned. From this perspective, we can see that the problem was that lenders lost track of asset value when they became less concerned with the borrower's income and relied more on the underlying home price. If the homes could be sold for their full value this wouldn't be a problem, but there are very significant costs associated with foreclosures. So many mortgage companies made loans that were carried at face value when their real value was considerably less, given the likelihood of default.
Similarly, this same behavior can be seen during stock market bubbles. A stock is also worth the net present value of its future cashflow. This means the sum of the cash flow from the operating business as well as a final gain (or loss) if the company needs to be liquidated. In stock market bubbles, investors become less focused on the present value of the investments they purchase; instead, they are buying an asset at a certain cost and hoping it will appreciate when they sell it to someone else. The business' ability to justify the price through its cashflow becomes an afterthought. So for a long time, equity investments can be carried on the books at a price that is much higher than logic would justify.
Your goal in investing is to be buying when asset cost is significantly below asset value.
The beauty of Ben Graham's philosophy was its simplicity. His strategy was to invest in companies at two-thirds of their Net Current Asset Value (NCAV), or their current assets minus total liabilities. Current assets are expected to be converted into cash within 18 months, and they can usually be taken at near face value. Such an investment situation means that if the company stopped operations immediately, it would have enough cash to pay all of its obligations and then give what is left over to shareholder's for a decent return in a relatively short period of time- hence, you were buying a company for less than its NPV under a scenario where the fixed assets and the company were treated as worthless. So, there was a high level of cash security for this type of investment, yet the upside was also pretty limited. But Ben Graham knew that fixed asset values can be much different than their costs, and wanted to make a strategy that any Average Joe could use.
The days of finding pure NCAV ideas are getting slim these days as information has become much more available. Today, a investor must become much more accurate and comfortable in make income projections for a business. This means analyzing competitive advantages will play a much more important part in security analysis, and there will be the possibility for larger gains- and mistakes- for investors.
Monday, August 20, 2007
Flight to Safety
Dazel from the Berkshire Hathaway Shareholders board pointed out something that hasn't recieved much press- the recent dramatic fall in treasury yields, especially short-term. See this link.
Meanwhile in the world of computer-model trading,
"Wednesday is the type of day people will remember in quant-land for a very long time," said Mr. Rothman, a University of Chicago Ph.D. who ran a quantitative fund before joining Lehman Brothers. "Events that models only predicted would happen once in 10,000 years happened every day for three days."
More "black swans"!
Meanwhile in the world of computer-model trading,
"Wednesday is the type of day people will remember in quant-land for a very long time," said Mr. Rothman, a University of Chicago Ph.D. who ran a quantitative fund before joining Lehman Brothers. "Events that models only predicted would happen once in 10,000 years happened every day for three days."
More "black swans"!
Friday, August 17, 2007
Pope and Talbot Announces Wood Pulp Increase
"Pope & Talbot, Inc. (NYSE:POP - News) today announces a $20 price increase to its customers in North American and a $30 price increase to its customers in Europe until further notice.
The new prices will be $850 in the North American market and $830 in Europe for its northern bleached softwood (NBSK) grades."
This is continued good news for SFK and the pulp industry. Meanwhile, I count three NBSK pulp producers still in troubled waters, which i define as negative EBITDA's and high leverage. These are Pope and Talbot(825,000 tonnes/year), Tembec(800,000 tonnes), and Catalyst Paper(525,000 tonnes).
Update: Also today, Catalyst announced the shutdown of 320,000 tonnes of yearly pulp production due to the B.C. union strike, which is causing a limitation of fiber in Western Canada.Thursday, August 16, 2007
Economic Recap
Back in March, I said the following:
"One can't underestimate the effects this could have. If many of these subprime loans prove unsustainable without the hope of refinancing, this could increase defaults, which could decrease home prices, which could spread the default risk up the credit quality ladder. Meanwhile, mortgage insurers will be affected, along with banks, which pretty much spreads out to everywhere. Consumer demand, which has been so reliant on asset monetization, can drop. That branches out to affect the whole economy."
Well, so far we are beginning to see the beginning of the effects on banks and mortgage insurers. (I should of included hedge funds). But it's important to remember that subprime is just one example of the overall credit bubble. If I had to make a case for overvaluation in the markets, I would focus on three things:
1. Historical P/E's
2. Historical Return on Equity
Average earnings for the the Dow Jones Industrial Average are 11% of the company's book value in any 20-year period between 1920 and 1986 (1920-39, 1921-40, 1922-41, etc.). "Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor." Warren Buffett said something similar, although I think he said 12%. Over the last decade, the DJIA Return on Equity has averaged 18%, with it currently running at 23%.
3. Leverage in the Economy
When things turn the other way, debt can get very messy. As the new Economist says, "because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information. ...Nobody knows how messy the inevitable bankruptcies will turn out to be. What markets need now is time to piece that information back together. Time before the next wave strikes." Similarly, many people have been claiming that high quality names have gone on sale during this recent market drop. I think it is way too early to tell.
"I place economy among the first and most important of republican virtues, and debt as the greatest of the dangers to be feared." -Thomas Jefferson, 1816
*Updated:
"One can't underestimate the effects this could have. If many of these subprime loans prove unsustainable without the hope of refinancing, this could increase defaults, which could decrease home prices, which could spread the default risk up the credit quality ladder. Meanwhile, mortgage insurers will be affected, along with banks, which pretty much spreads out to everywhere. Consumer demand, which has been so reliant on asset monetization, can drop. That branches out to affect the whole economy."
Well, so far we are beginning to see the beginning of the effects on banks and mortgage insurers. (I should of included hedge funds). But it's important to remember that subprime is just one example of the overall credit bubble. If I had to make a case for overvaluation in the markets, I would focus on three things:
1. Historical P/E's
2. Historical Return on Equity
Average earnings for the the Dow Jones Industrial Average are 11% of the company's book value in any 20-year period between 1920 and 1986 (1920-39, 1921-40, 1922-41, etc.). "Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor." Warren Buffett said something similar, although I think he said 12%. Over the last decade, the DJIA Return on Equity has averaged 18%, with it currently running at 23%.
3. Leverage in the Economy
When things turn the other way, debt can get very messy. As the new Economist says, "because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information. ...Nobody knows how messy the inevitable bankruptcies will turn out to be. What markets need now is time to piece that information back together. Time before the next wave strikes." Similarly, many people have been claiming that high quality names have gone on sale during this recent market drop. I think it is way too early to tell.
"I place economy among the first and most important of republican virtues, and debt as the greatest of the dangers to be feared." -Thomas Jefferson, 1816
*Updated:
Monday, August 13, 2007
ICICI Lombard
ICICI Lombard recently came out with its annual report for the 06-07 year. The numbers show a company that continues to be a great growth story- here are some of the numbers:
Fairfax currently has a 24% stake in the company and has it recorded on the balance sheet at a conservative valuation. I see the largest private insurer in a fast growing industry, and the chance to take a lot of business from inefficient government competition. This could be a much more significant part of Fairfax in the future.
| Financial Year | 2006-07 | 2005-06 |
Figures in nos. | ||
| No. of policies sold | 3,136,393 | 1,461,039 |
| No. of claims handled | 642,777 | 243,951 |
| No. of employees | 4,770 | 2,283 |
| No. of offices | 220 | 154 |
| Financial Year | 2004-05 | 2003-04 | 2002-03 | 2001-02 |
| Figures in nos. | ||||
| No. of policies sold | 607,926 | 249,531 | 98,293 | 9,148 |
| No. of claims handled | 84,970 | 23,487 | 8,022 | 420 |
| No. of employees | 1,249 | 561 | 284 | 116 |
| No. of offices | 96 | 63 | 35 | 11 |
Fairfax currently has a 24% stake in the company and has it recorded on the balance sheet at a conservative valuation. I see the largest private insurer in a fast growing industry, and the chance to take a lot of business from inefficient government competition. This could be a much more significant part of Fairfax in the future.
Saturday, August 11, 2007
The Brick 2nd Quarter Results
EBITDA down 3.5% for the quarter, up 1.8% YTD.
4.8% Same-store sales growth
Total sales up 7.3%
3 more franchises opened during the quarter, bringing the total to 29.
“With seasonally higher sales in the second half of the year and continued focus on cost management, we believe that we are very well positioned to drive increased profits for the Brick Group.”
Link4.8% Same-store sales growth
Total sales up 7.3%
3 more franchises opened during the quarter, bringing the total to 29.
“With seasonally higher sales in the second half of the year and continued focus on cost management, we believe that we are very well positioned to drive increased profits for the Brick Group.”
Thursday, August 09, 2007
A Closer Look at Exchange Bank
I wanted to show you what really caught my eye with Exchange Bank of Santa Rosa. And, I also wanted to practice using Excel. Below is the resulting chart I made:
Note first that some fields are obviously missing because I was unable to ge that data. Also, the Net loan losses for 2Q07 is an annualized number. Delinquent refers to 30+ days late loans, while non-performing is 90+ days late loans plus non accrual. Also note my excellent Excel skills. A few things stand out about these numbers.
One, their overall loan underwriting is superb. As a comparison, a look at Countrywide's servicing portfolio in the 2nd quarter showed 5.02% delinquencies, and 1.74% non-performing, and their portfolio is heavily adjustable. Second, they are also simultaneously very conservatively reserved. Most other banks I have looked up have a ratio of allowance to non-performing of 100 to 150 percent. Exchange Bank hasn't been under 300% for ages. (Countrywide is under 50%)
So despite my belief in a credit bubble, I am willing to invest in this bank because of their allowance cushion and their strict underwriting. This goes along with the other many qualitative aspects: Their number 1 county market share, low cost deposits, and a Return on Assets averaging 1.5% in an industry where 1% is considered good. (Countrywide is at 1.06%, and theyre also origination 460 billion in loans each year on only 14 billion in equity. I didn't intend to pick on Countrywide, but its just too easy. Fairfax does also own CDS's against their debt.) And to top it off, it is at 10x earnings. Now, due to the company's structure it can not get bought out, and there is a chance it might ride the financial momentum downward in price, but it would be an opportunity to add to a longer term holding.
Note first that some fields are obviously missing because I was unable to ge that data. Also, the Net loan losses for 2Q07 is an annualized number. Delinquent refers to 30+ days late loans, while non-performing is 90+ days late loans plus non accrual. Also note my excellent Excel skills. A few things stand out about these numbers.
One, their overall loan underwriting is superb. As a comparison, a look at Countrywide's servicing portfolio in the 2nd quarter showed 5.02% delinquencies, and 1.74% non-performing, and their portfolio is heavily adjustable. Second, they are also simultaneously very conservatively reserved. Most other banks I have looked up have a ratio of allowance to non-performing of 100 to 150 percent. Exchange Bank hasn't been under 300% for ages. (Countrywide is under 50%)
So despite my belief in a credit bubble, I am willing to invest in this bank because of their allowance cushion and their strict underwriting. This goes along with the other many qualitative aspects: Their number 1 county market share, low cost deposits, and a Return on Assets averaging 1.5% in an industry where 1% is considered good. (Countrywide is at 1.06%, and theyre also origination 460 billion in loans each year on only 14 billion in equity. I didn't intend to pick on Countrywide, but its just too easy. Fairfax does also own CDS's against their debt.) And to top it off, it is at 10x earnings. Now, due to the company's structure it can not get bought out, and there is a chance it might ride the financial momentum downward in price, but it would be an opportunity to add to a longer term holding.
Wednesday, August 08, 2007
SFK Pulp 2nd Quarter Conference Call and Recap
A lot of people are dissapointed with SFK's 2nd quarter report, so I thought I'd share my thoughts.
The two main things I think need to be addressed are the drop in sales volume, and the strengthening Canadian dollar and its effects.
Sales Volume
SFK's NBSK pulp sales volume was a very low 75,514 tonnes this quarter. In the conference call, the company addressed this due to a major customer cutting back purchases for the quarter. Someone on the call asked whether the drop was due to them being unable to shift the business fast enough, and management said it was partly that and partly a decision to wait until the customer came back, because the customer was close by and the transportation savings accrete to SFK. Regardless, I wouldn't be concerned because in the end pulp is still a commodity product, and one that is currently at low industrywide inventories. In the end, sales volume will be close to production, and in the call management said sales volume and inventories have already returned to normal. The NBSK Mill has a yearly production of 375,000 tonnes, so "normal" is about 93,750 tonnes per quarter. Note also that 2nd quarter and 4th quarter take maintenance downtime, so these quarters have lower production, offset by higher 1st and 3rd quarter production.
For those that want to know the effect, here's some basic math:
NBSK business cost of sales as total sales was 78.8% (47,628/ 60,414)
18,236 more tonnes x $800 CAN price per tonne = $14,589,000
21.2% x 14,589,000 = $3,093,000 extra free cashflow
Note also that this doesn't take into account the fact that labor and maintenance would not take additional expenses for the added sales volume, meaning our gross margin used is likely understating the extra free cash flow. But at the risk of becoming short-term Wall Street analyst-like, im going to not bother doing that calculation.
Strengthening of the Loony
This is where things that getting (more) complicated. The Canadian dollar strengthened from an average of .8535 to .9107 US/CAN. This has a few effects. First, since pulp prices are derived in US dollars, a stronger Canadian dollar means lower realized prices for SFK in its own currency, while its costs remain the same. But also, the company had an additional 3.8 million impairment of cash and accounts recievable that are denominated in U.S. dollars.
Also, and this seems to have been missed by many, is the effect of this on the RBK business. The RBK business is cost, revenues, and profit are all in US dollars, but since SFK reports in Canadian dollars, the income from this segment drops when the loony rises (in canadian dollar terms). But, to hedge this currency risk, SFK took the debt for this acquisition out in US dollars, so its debt obligations also fall as the Canadian dollar rises. However, due to accounting treatment, the company does not report this change on the income statement until the RBK business pays its first dividend to the parent company. So instead, SFK recorded a 5,451 million currency translation adjustment on its balance sheet to take into account the lower debt outstanding in Canadian dollar terms, but this never made it to the income statement (Unlike the 3.8 million impairment mentioned above)
Where Now?
The Canadian dollar has continued to increase since last quarter. Assuming the rate averages out to a new .95, we get the following "run rate" quarterly calculations:
1. Exchange rate at .95 US/CAN
2.$786 CAN NBSK revenue per tonne
2nd Quarter sales price was $800/tonne CAN. If you take into account an $18US rise in prices and the new exchange rate, the sales price for 3Q will be about $786.
3.$618 CAN NBSK cost per tonne
Cost of sales in 3Q is usually lower due to a lack of maintenance expense- it was $571 CAN 3Q06. But since this is run rate calculations, I will start from the 2006 cost of sales of $603 CAN. Costs are up 1.8% this year so far, but I added some leeway, giving a cost of sales of $618.
4. 93,750 tonnes sold per quarter
Again, due to the sales slowdown in 2Q, sales volume will likely be much higher than average next quarter, but since this is run rate im using the average number.
Run Rate
NBSK EBITDA 15,624,000
RBK EBITDA.. 3,500,000
SG&A Expense -1,350,000
Interest Expe. -4,000,000
Capital Expen. -4,000,000
Yields Free Cash Flow of $9,764,000. For those that were concerned, yes this run rate would mean a distribution cut seems likely. Oh, and also, the stronger Canadian dollar would also reduce debt obligation by 4,850,000 in the 3rd quarter, meaning when that currency adjustment is realized, that will be upward of 10 million now on the income statement, though that should also be ignored as far as income goes.
Those are the numbers. Now here's why I'm holding, and you can choose to agree or disagree from here. The company is still cheap, at about 10x cashflow under current conditions. But on a broader worldwide scale, the Eastern Canadian production is ripe for change. Canadian pulp does not need to be automatically considered at a disadvantage to worldwide production. Labor makes up a small percentage of costs, and in fact operational costs at most eastern Canadian mills are actually lower than other places due to very low energy cost. The main burden is fiber. Fiber makes up about $300 of the cost per tonne of pulp in Eastern Canada, about $125 in Western Canada, and significantly lower in Latin America. Canadian fiber doesnt need to be so expensive- rather, it is a problem of too much fiber demand in one region, escalating prices. The industry figures are below:
49 million tonnes worldwide hardwood pulp demand per year
11 million tonnes of pulp(all grades) production in Canada
12 million tonnes of pulp production in Europe including Nordic countries and Russia
9 million tonnes of pulp production in South America
13 million tonnes worldwide NBSK pulp demand per year
7 million tonnes NBSK pulp production in Canada
NBSK pulp is a particular grade that requires stronger fibers found in only some places (mostly, Canada). NBSK also accounts for 28.8% of pulp demand. As a grade, it will likely survive, and give Canadian producers a competitive advantage. But on a broader scale, the fiber disadvantage of Eastern Canada is taking its toll, and this is the first place that excess capacity is coming off. Looking at it today, both Tembec and Pope and Talbot seem discounted already for bankruptcy in the markets. Tembec has 825,000 NBSK production, 1,035,000 hardwood production; Pope & Talbot has 820,000 NBSK production. Also, the merger of Abitibi and Bowater combine two powerhouses in Eastern Canada, possibly spurring much needed rationalization. As a very low cost producer, obviously any fall in fiber prices will greatly benefit SFK. This may sound like wishful thinking to some, and you are slightly right- more research is needed to make a compelling case one way or the next, and hopefully a few calls can help answer some of my new questions. Yet, this year western Canadian fiber is up 57%, compared to only 3% in eastern Canada. A cheap valuation with a possible catalyst, good management, and secured by higher replacement value keeps me invested and feeling relatively safe.
The two main things I think need to be addressed are the drop in sales volume, and the strengthening Canadian dollar and its effects.
Sales Volume
SFK's NBSK pulp sales volume was a very low 75,514 tonnes this quarter. In the conference call, the company addressed this due to a major customer cutting back purchases for the quarter. Someone on the call asked whether the drop was due to them being unable to shift the business fast enough, and management said it was partly that and partly a decision to wait until the customer came back, because the customer was close by and the transportation savings accrete to SFK. Regardless, I wouldn't be concerned because in the end pulp is still a commodity product, and one that is currently at low industrywide inventories. In the end, sales volume will be close to production, and in the call management said sales volume and inventories have already returned to normal. The NBSK Mill has a yearly production of 375,000 tonnes, so "normal" is about 93,750 tonnes per quarter. Note also that 2nd quarter and 4th quarter take maintenance downtime, so these quarters have lower production, offset by higher 1st and 3rd quarter production.
For those that want to know the effect, here's some basic math:
NBSK business cost of sales as total sales was 78.8% (47,628/ 60,414)
18,236 more tonnes x $800 CAN price per tonne = $14,589,000
21.2% x 14,589,000 = $3,093,000 extra free cashflow
Note also that this doesn't take into account the fact that labor and maintenance would not take additional expenses for the added sales volume, meaning our gross margin used is likely understating the extra free cash flow. But at the risk of becoming short-term Wall Street analyst-like, im going to not bother doing that calculation.
Strengthening of the Loony
This is where things that getting (more) complicated. The Canadian dollar strengthened from an average of .8535 to .9107 US/CAN. This has a few effects. First, since pulp prices are derived in US dollars, a stronger Canadian dollar means lower realized prices for SFK in its own currency, while its costs remain the same. But also, the company had an additional 3.8 million impairment of cash and accounts recievable that are denominated in U.S. dollars.
Also, and this seems to have been missed by many, is the effect of this on the RBK business. The RBK business is cost, revenues, and profit are all in US dollars, but since SFK reports in Canadian dollars, the income from this segment drops when the loony rises (in canadian dollar terms). But, to hedge this currency risk, SFK took the debt for this acquisition out in US dollars, so its debt obligations also fall as the Canadian dollar rises. However, due to accounting treatment, the company does not report this change on the income statement until the RBK business pays its first dividend to the parent company. So instead, SFK recorded a 5,451 million currency translation adjustment on its balance sheet to take into account the lower debt outstanding in Canadian dollar terms, but this never made it to the income statement (Unlike the 3.8 million impairment mentioned above)
Where Now?
The Canadian dollar has continued to increase since last quarter. Assuming the rate averages out to a new .95, we get the following "run rate" quarterly calculations:
1. Exchange rate at .95 US/CAN
2.$786 CAN NBSK revenue per tonne
2nd Quarter sales price was $800/tonne CAN. If you take into account an $18US rise in prices and the new exchange rate, the sales price for 3Q will be about $786.
3.$618 CAN NBSK cost per tonne
Cost of sales in 3Q is usually lower due to a lack of maintenance expense- it was $571 CAN 3Q06. But since this is run rate calculations, I will start from the 2006 cost of sales of $603 CAN. Costs are up 1.8% this year so far, but I added some leeway, giving a cost of sales of $618.
4. 93,750 tonnes sold per quarter
Again, due to the sales slowdown in 2Q, sales volume will likely be much higher than average next quarter, but since this is run rate im using the average number.
Run Rate
NBSK EBITDA 15,624,000
RBK EBITDA.. 3,500,000
SG&A Expense -1,350,000
Interest Expe. -4,000,000
Capital Expen. -4,000,000
Yields Free Cash Flow of $9,764,000. For those that were concerned, yes this run rate would mean a distribution cut seems likely. Oh, and also, the stronger Canadian dollar would also reduce debt obligation by 4,850,000 in the 3rd quarter, meaning when that currency adjustment is realized, that will be upward of 10 million now on the income statement, though that should also be ignored as far as income goes.
Those are the numbers. Now here's why I'm holding, and you can choose to agree or disagree from here. The company is still cheap, at about 10x cashflow under current conditions. But on a broader worldwide scale, the Eastern Canadian production is ripe for change. Canadian pulp does not need to be automatically considered at a disadvantage to worldwide production. Labor makes up a small percentage of costs, and in fact operational costs at most eastern Canadian mills are actually lower than other places due to very low energy cost. The main burden is fiber. Fiber makes up about $300 of the cost per tonne of pulp in Eastern Canada, about $125 in Western Canada, and significantly lower in Latin America. Canadian fiber doesnt need to be so expensive- rather, it is a problem of too much fiber demand in one region, escalating prices. The industry figures are below:
49 million tonnes worldwide hardwood pulp demand per year
11 million tonnes of pulp(all grades) production in Canada
12 million tonnes of pulp production in Europe including Nordic countries and Russia
9 million tonnes of pulp production in South America
13 million tonnes worldwide NBSK pulp demand per year
7 million tonnes NBSK pulp production in Canada
NBSK pulp is a particular grade that requires stronger fibers found in only some places (mostly, Canada). NBSK also accounts for 28.8% of pulp demand. As a grade, it will likely survive, and give Canadian producers a competitive advantage. But on a broader scale, the fiber disadvantage of Eastern Canada is taking its toll, and this is the first place that excess capacity is coming off. Looking at it today, both Tembec and Pope and Talbot seem discounted already for bankruptcy in the markets. Tembec has 825,000 NBSK production, 1,035,000 hardwood production; Pope & Talbot has 820,000 NBSK production. Also, the merger of Abitibi and Bowater combine two powerhouses in Eastern Canada, possibly spurring much needed rationalization. As a very low cost producer, obviously any fall in fiber prices will greatly benefit SFK. This may sound like wishful thinking to some, and you are slightly right- more research is needed to make a compelling case one way or the next, and hopefully a few calls can help answer some of my new questions. Yet, this year western Canadian fiber is up 57%, compared to only 3% in eastern Canada. A cheap valuation with a possible catalyst, good management, and secured by higher replacement value keeps me invested and feeling relatively safe.
Tuesday, August 07, 2007
Monday, August 06, 2007
A Peak Inside Fairfax's CDS Portfolio
Given the enormous volatility going on in Fairfax's CDS portfolio, I thought i might try to shed some light on the matter. Below are some of the major holdings for a subsidiary, Odyssey Re America, at end of December 2006. Prem has stated that some of these are looking for capital appreciation, while others are to hedge their reinsurance recoverables and business. The ones in bold are the ones I assume were for investment rather than hedging purposes.
Company / notional amount in millions
Ace Holdings - 110
Allianz France - 130
Societe Generale- 175
Aegon - 105
Swiss Re- 75
Ambac - 110
AIG (?) - 330
Countrywide- 130
Freddie Mac- 235
Hanover - 155
JP Morgan - 75
MBIA - 65
MGIC - 205
PMI Group - 230
Radian - 260
Washington Mutual - 210
XL Capital - 200
Most of the counterparties for these deals are Citibank, Duetsche Bank, and Barclays. I'm particularly glad to see Countrywide, MGIC, PMI, and Radian among the bigger holdings on that list, especially since I'm not too optimistic on their futures and because their debt protection costs have been soaring the past few days. I'll be watching these names closely for updates.
Company / notional amount in millions
Ace Holdings - 110
Allianz France - 130
Societe Generale- 175
Aegon - 105
Swiss Re- 75
Ambac - 110
AIG (?) - 330
Countrywide- 130
Freddie Mac- 235
Hanover - 155
JP Morgan - 75
MBIA - 65
MGIC - 205
PMI Group - 230
Radian - 260
Washington Mutual - 210
XL Capital - 200
Most of the counterparties for these deals are Citibank, Duetsche Bank, and Barclays. I'm particularly glad to see Countrywide, MGIC, PMI, and Radian among the bigger holdings on that list, especially since I'm not too optimistic on their futures and because their debt protection costs have been soaring the past few days. I'll be watching these names closely for updates.
Sunday, August 05, 2007
2nd Quarter Earnings Update
Earnings season has come and mostly gone for the companies in my portfolio. Here's a brief overview.
The Bad
Bancinsurance
The company reported 1 million in net earnings, or $.20 diluted EPS.
Shareholder's equity increased to 37.41 million, or $7.406 per share.
The big negative for this quarter was the .5 million increase in reserves for the discontinued bond program, as well as the addition of this statement:
"Highlands has provided claim information to the Company with respect to alleged losses during 2001 and 2002 for bail bonds issued in the State of New Jersey and for federal immigration bonds. Highlands has indicated in filings that it has additional exposure for bail bonds issued in states other than New Jersey. Highlands has not provided sufficient information for the Company to quantify certain of these additional losses or allocate such losses among the 2001 and 2002 years in which the Company participated and the 2000 year in which the Company did not participate. As of June 30, 2007, the Company is reserving to its best estimate of future Highlands losses based on the most recent loss information received from Highlands with respect to immigration bonds and New Jersey bail bonds only."
Also, commission expense continues to go up as business shifts to other products.
The one positive is that the company started providing more information about their premiums, including how much is ceded to the reinsurance companies. For the six months ended june 30, written premiums ceded were 14.29 million, compared to 4.16 million last year.
SFK Pulp Fund
SFK earned distributable cash of only 7.6 million for the quarter, although several factors were affecting the figure.
On the NBSK side- besides it being a maintenance shutdown quarter, the company also lost some business from some customers and was unable to replace it in time. Sales volume in the quarter was only 75,514 tonnes, while production per quarter for the mill averages approximately 93,000. Since NBSK pulp is a commodity product currently at record low inventory levels (24 days according to Canfor), I am not worried about the quarterly drop in volume.
The other main factor was the continued strengthening of the Canadian dollar. Quarter over Quarter prices actually fell from $821 CAN to $800CAN, even though prices have been rising in US terms. Also, the company took an additional 3.8 million charge from writing down U.S. accounts recievables.
The main thesis behind SFK still remains intact. Although the Canadian dollar has continued to increase since the 2nd quarter, this affects all other Canadian pulp mill operators equally, and Econ 101 tells us producers will continue to curtail production. (The most recent announcement being from Pope and Talbot for 68,000 tonnes NBSK pulp) Also, we are seeing the fiber price imbalance between Western and Eastern Canada also starting to reverse, which will put additional upward pressure on pulp prices. There will be a profitable spot for a low cost producer like SFK in such an environment when all is said and done.
The Good
Fairfax Financial
FFH has come along way and things are really starting to shine.
Underwriting income for the quarter increased to 87.2 million, net earnings per share of $8.92.
Book value increased to $165.50 per share, debt continues to be paid off or extended.
I've long stated my agreement with Prem's prediction of a one in fifty year event coming along in the markets. The positioning of his portfolio looks brilliant right now.
-Majority in cash and long term US government bonds, and no exposure to mortgage securities.
-Equity portfolio is 80% hedged with shorts against the market or specific stocks.
-a large CDS portfolio against financial services companies. At the end of the quarter this had a market value of 198 million. By the end of July, given recent market events, the market value of this has increased to 537 million, and so far since August the move has been significant as well.
Also, so far the hurricane season has been benign, and if things continue this way we can look for a positive reserve adjustment by year end.
Exchange Bank of Santa Rosa
YTD net income of $6.59 per share, Book value of $78.16 per share.
Continued excellent loan performance and conservative accounting:
-Nonperforming loans as % of total loans at .41%
-Total Delinquent loans as % of total loans at .66%
-Allowance for loan losses of 1.81%
As I am writing this, I'm realizing that I have never done a complete and thorough write-up on Exchange Bank. Many of you are probably wondering why I would invest in a bank given my negative thoughts on the financial industry, so look forward for some clarification soon.
The Bad
Bancinsurance
The company reported 1 million in net earnings, or $.20 diluted EPS.
Shareholder's equity increased to 37.41 million, or $7.406 per share.
The big negative for this quarter was the .5 million increase in reserves for the discontinued bond program, as well as the addition of this statement:
"Highlands has provided claim information to the Company with respect to alleged losses during 2001 and 2002 for bail bonds issued in the State of New Jersey and for federal immigration bonds. Highlands has indicated in filings that it has additional exposure for bail bonds issued in states other than New Jersey. Highlands has not provided sufficient information for the Company to quantify certain of these additional losses or allocate such losses among the 2001 and 2002 years in which the Company participated and the 2000 year in which the Company did not participate. As of June 30, 2007, the Company is reserving to its best estimate of future Highlands losses based on the most recent loss information received from Highlands with respect to immigration bonds and New Jersey bail bonds only."
Also, commission expense continues to go up as business shifts to other products.
The one positive is that the company started providing more information about their premiums, including how much is ceded to the reinsurance companies. For the six months ended june 30, written premiums ceded were 14.29 million, compared to 4.16 million last year.
SFK Pulp Fund
SFK earned distributable cash of only 7.6 million for the quarter, although several factors were affecting the figure.
On the NBSK side- besides it being a maintenance shutdown quarter, the company also lost some business from some customers and was unable to replace it in time. Sales volume in the quarter was only 75,514 tonnes, while production per quarter for the mill averages approximately 93,000. Since NBSK pulp is a commodity product currently at record low inventory levels (24 days according to Canfor), I am not worried about the quarterly drop in volume.
The other main factor was the continued strengthening of the Canadian dollar. Quarter over Quarter prices actually fell from $821 CAN to $800CAN, even though prices have been rising in US terms. Also, the company took an additional 3.8 million charge from writing down U.S. accounts recievables.
The main thesis behind SFK still remains intact. Although the Canadian dollar has continued to increase since the 2nd quarter, this affects all other Canadian pulp mill operators equally, and Econ 101 tells us producers will continue to curtail production. (The most recent announcement being from Pope and Talbot for 68,000 tonnes NBSK pulp) Also, we are seeing the fiber price imbalance between Western and Eastern Canada also starting to reverse, which will put additional upward pressure on pulp prices. There will be a profitable spot for a low cost producer like SFK in such an environment when all is said and done.
The Good
Fairfax Financial
FFH has come along way and things are really starting to shine.
Underwriting income for the quarter increased to 87.2 million, net earnings per share of $8.92.
Book value increased to $165.50 per share, debt continues to be paid off or extended.
I've long stated my agreement with Prem's prediction of a one in fifty year event coming along in the markets. The positioning of his portfolio looks brilliant right now.
-Majority in cash and long term US government bonds, and no exposure to mortgage securities.
-Equity portfolio is 80% hedged with shorts against the market or specific stocks.
-a large CDS portfolio against financial services companies. At the end of the quarter this had a market value of 198 million. By the end of July, given recent market events, the market value of this has increased to 537 million, and so far since August the move has been significant as well.
Also, so far the hurricane season has been benign, and if things continue this way we can look for a positive reserve adjustment by year end.
Exchange Bank of Santa Rosa
YTD net income of $6.59 per share, Book value of $78.16 per share.
Continued excellent loan performance and conservative accounting:
-Nonperforming loans as % of total loans at .41%
-Total Delinquent loans as % of total loans at .66%
-Allowance for loan losses of 1.81%
As I am writing this, I'm realizing that I have never done a complete and thorough write-up on Exchange Bank. Many of you are probably wondering why I would invest in a bank given my negative thoughts on the financial industry, so look forward for some clarification soon.
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.
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):
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.
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.
Moat
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.
Risks
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.
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.
Moat
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.
Risks
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."
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.
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.
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