Sunday, August 31, 2008

The Weird Answer to Excess Liquidity

The loose lending standards and the low rates of the past few years are collectively known as "excess liquidity". In traditional central bank fashion, this is to be generally avoided since the tail end of a long period of this brings nasty consequences.

The severity of these consequences is partially dependent upon the length of time the excess liquidity was available, plus the corresponding reaction of both the central banks, commercial banks, investors and the public reaction itself as the liquidity is drained off.

In the 1970s, the drain of excess liquidity meant markedly higher lending rates, as inflation began to soar in response to the excess liquidity. Lending rates, in most industialized countries, continued to rise, until inflation was defeated in one last hurrah, as the earliest part of the 1980s dawned. A decade long battle that ultimately required lending rates in the 15-20% range to defeat.

Now, it appears, the answer to excess liquidity is this: raise rates to something beginning to resemble normal long-term banking averages - and watch the banking system begin to wobble, wobble, wobble. When the time is ripe (or some critics argue, over-ripe), introduce the forebearer of excess liquidity (low central bank rates) to deal with the number of weakened banks. This will allow some of the (less) reckless banks to repair their balance sheets, the strong to get stronger (and thus buy out some weak competitors) and for, more generally, faith to be restored in the system.

So the answer to the 2000s excess liquidity situation is - more liquidity.

Weird, right?
Further explanation, here.

Friday, August 29, 2008

Housing Market to Contine Its Wobble

Having been around the real estate industry in one capacity or another for nearly 30 years, reading just one story like this wherein Barclay's Capital estimates that over $300 Billion of US option ARM (adjustable rate mortgages) mortgages are still due to re-set, makes me aware that the housing market won't be out of its slump any time soon.

The "homeowner" (air quotes as they have no equity) will finally realize they can't afford a payment due to re-set typically 60-80% higher than currently. This will drive an unbelievable volume of homes onto the market.

Given the majority of these option ARMs don't re-set until 2010-2011, don't count on this housing market slump subsiding anytime soon.

Every housing rally for the next few years will inevitably prove to be a suckers rally, as more houses continue to pour onto the market under foreclosure - as the most financially desperate find the American Dream has collapsed on them.

I'll make one more wild-ass prediction - the housing market losses to date (around 18% nationally) will be roughly matched by a further loss of between 12% to 20% more. The roller-coaster hasn't reached the bottom yet folks - hang on - it'll likely take at least another 18 months before calls of "this is the market bottom" are likely to be close to being true.

Greenspan's legacy continues to be written.


The Confused Capitalist

Friday, August 15, 2008

Monoline vehicle insurer profits to turn up

I expect that monoline auto insurers profits will turn up over the next year or two, as two significant factors in accidents come into play:
  1. The amount of driving done - the media is reporting that as gasoline prices have risen, the American consumer is driving less than last year - about 5% less.

  2. Various anecdotal reports are that drivers becoming aware that speed is a factor in gas mileage and are slowing down.

These two factors together may well provide for a significant drop to the bottom line over the year or two, as accidents fall due to less driving, and driving at lower speeds.

It may further very well be that as all staples and non-discretionary inflationary costs hit home more, your typical "drinking driver" won't be able to afford to drink as often, thereby dramatically lowering accident rates for those insurers specializing in the high-risk driver category.

Something to consider if you invest in insurance companies.


The Confused Capitalist

Wednesday, August 13, 2008

Bank Writedowns - Who has the money?

A recent posting over The Big Picture talked about the global bank writedowns being, to date, in excess of $500 Billion, and either half-way ($1 Trillion) or just one-quarter ($2 Trillion) finished.

My question to all you readers is simple: since the writedowns represent real dollars that have left the bank balance sheets and ended up elsewhere, where do you think most of it went?

  • Effectively free or reduced rent by unqualified home buyers?
  • Consumer goods purchases?
  • Home flippers with excessive profits?
  • Realtors (too many sales)?
  • Home builders?
  • Other?

What do you say?


The Confused Capitalist

Executive Pay: Confusing "Doing Great" with a "Rising Tide"

Image: Not great surfer still managing to "ride the tide".

That executive pay, particularly for the top 5-10 corporate jobs in most large companies, needs reform, is no secret to any informed shareholder in a public company, especially with the recent implosions in the financial sector. With stock compensation schemes that can balloon the leaders pay in excess of $10, $50 and $100 million annually, without materially benefiting the corporation over the long haul, things have gotten totally out of control.

Executives should be well-paid, but in keeping with the idea that they are "employees" of the shareholders rather than corporate owners (what a quaint notion!). Further, their management expertise and acumen should be valued in comparison to a competitive peer group, rather than the stock market in general (stock options). What must happen is for compensation schemes to measure a competitive group of managers, rather than thinking they are great because the tide in that particular sector is rising.

In other words, former Home Depot CEO Bob Nardelli (quarter-billion dollar Bob) shouldn't be compensated for Alan Greenspan's decision to inflate housing prices, and all the subsequent housing market activity that renovation and home-building retailers benefited from. His contribution to Home Depot's fortunes should be measured and paid against a competitive market sub-set (like home building/renovation retailers & home-building companies, for instance). Shareholders should pay a great manager very well for doing great against his/her competitors, rather than rewarding (penalizing) for the rising (falling) tide of the sector they operate in.

With this idea in mind, here's my top 10 list for executive pay reform structure:

  1. Stock options are completely and forever ceased to be granted, and instead low-interest loans are offered to the executive team to BUY stock in the company;

  2. Corporate boards become far more activist in protecting shareholders from egregious pay structures based on results that are later re-stated, by dispensing employment contracts that call for the return of incentive pay based on erroneous original measurements;

  3. Measuring and paying for (incentive pay) performance against a proper set of five to ten market competitors - in the Olympics, the swimmers aren't measured against the rowers, and this needs to stop in the economic marketplace;

  4. Measurement should include benchmarks like: changes in return on invested capital (ROIC) compared to the competitor subset;

  5. Inventory turns, compared to the competitor subset;

  6. Debt ratios, again compared to the subset;

  7. Changes in market share against the subset;

  8. Changes in profit and free cashflow (or profit/cashflow ratios) against the subset;

  9. Changes on all of the above, 2 and 5 years after the executive has left their position, so that the "long-tail" of their decisions, for good or ill, are properly rewarded or penalized;

  10. A "hold-back" on a certain percentage of all of the above incentive pay, so that the Board doesn't have to go "cap in hand", begging the CEO for a return of some improperly rewarded gains.

Reforms like this would provide the proper and necessary alignment of shareholder's interests, with management's desire to achieve maximum pay - all the while, keeping both the risk and reward of any potential action clearly in mind.

Executive pay reform: an idea whose time must come.


The Confused Capitalist

Tuesday, August 12, 2008

Value Investors - The Pendulum will swing back in favour

A recent blog posting over at Morningstar sniped at Professor Jeremy Seigel of Wisdom Tree, indicating that his firm's stock selection methodology and retention of assets depended on his call that a market bottom had been hit.

The post compared the performance of several Wisdom Tree ETFs to various total market benchmarks, showing relative YTD performance is lagging for Wisdom Tree dividend selection process. While true, it ignores the beating that all value benchmarks have taken since the credit crisis began in the summer of 2007.

As most value investors know, they aren't going to beat the benchmark every year - but it's going to happen often enough to outpace "growth" funds by about 2% annually over the long haul.

What's been unusual about this bear market is that it's the so-called value stocks leading the slump, whereas value stocks almost always outperform in weak markets.

Obviously, in this case, that's because the fact is that so many stocks that are usually labelled as value stocks, due to either low PE ratios, or relatively high dividend yields, have found themselves trashed and tarnished by the credit problems. That's because financial firms (whether retail or investment banks, stockbrokers and insurers), which usually have relatively low PE ratios and relatively high dividend yields - putting them squarely in the value camp - have been the epicenter of the credit and economic problems. Wisdom Tree's dividend selection process obviously weights orients a portfolio towards a value selection.

Comparing other value ETFs against growth ETFs show that this phenomenon isn't restricted to Wisdom Tree selections.

For instance, since just before the credit crisis began (I am using June 1 2007 as the date), the Barclays iShares products tracking growth or value indices show the following divergences:

- For international stocks, the MSCI EAFE (Europe, Australia, Far East)iShares index-tracking products shows that the growth product (EFG) has lost -13.2% of its value, compared to much larger -25.3% loss for the value product (EFV). In that context, Wisdom Tree's International Dividend Top 100 EFT (DOO) loss of -16.6% is pretty good.

- For large cap domestic stocks, the iShares growth product (IVW) has lost just -9.0%, while the value product (IVE) has lost -20.8% of it's value. Again, in that context, the Wisdom Tree Large Cap Domestic ETF (DLN) loss of -19.8% is understandable.

- Finally, for domestic small cap, the iShares growth product (IWO) lost 6.5%, while the value ETF (IWN) lost -17.2%. Here, the Wisdom Tree loss is larger at -23.2%.

Given that growth rarely outperforms value for any stretch of time, I believe that the relative outperformance of value must be just around the corner.

In summary, I'd suggest to all value investors in general, and Wisdom Tree ETF holders in particular, to hang on. Retail investors are notorious for dumping underperforming funds, not long before the corner is turned. Don't be one of those fools.


The Confused Capitalist

    Sunday, August 10, 2008

    Still beating the S&P 500 with a simple portfolio

    Back in early 2006, The Confused Capitalist suggested a low maintenance model portfolio that I felt would outperform the S&P500 over the next five years or so. The portfolio was based on certain themes, some of which are ones which have generally proven to outperform over longer periods of time, such as buying value positions and small companies.

    Additionally, I felt that commodities and emerging markets would continue to benefit from the world situation, and that the US dollar would continue to be under pressure - thereby adding to investments denominated in something other than US$. I suggested positions in a total of six ETFs, at values of 7.5% to 25% of the portfolio, with most around the 20% range.

    When we reviewed this portfolio on June 17 2007, we found it had outpaced SPY by 5.4% over the 14 months since inception. It's now been 14 months or so since that review, and the market has changed notably over that time frame; let's check in with our model portfolio to see how it has performed.

    Since then, SPY has dropped by 15.5% and is now priced at $129.37. Let's see how our own simple ETF-based portfolio, which looks like this, performed:
    • 20% weighting to a broad-based international ETF - EFV - $78.92 - ishares product tracks the MSCI EAFE Value Index, which tracks European, Australian, and Far Eastern markets. This ETF closed at $58.96 on Friday August 8, 2008, for a 25.3% loss.

    • 18.6% weighting to small company - IWN - $85.11- ishares product tracks the Russell 2000 Value Index (US small cap). This ETF closed at $68.84 on August 8 2008, for a 19.1% loss.

    • 25.7% weighting to emerging markets - EEM - $44.14 (adjusted for a 3 for 1 split) - a broadly-based (for emerging markets) ishares product tracks the MSCI Emerging Markets Index. This ETF closed at $41.16 on August 8 2008, for a 6.7% loss.

    • 19.4% weighting to the value portion of the S&P 500 - IVE - $83.78 - an ishares product tracking the value portion of the S&P500. This ETF closed at $65.90 on August 8 2008, for a 21.3% loss.

    • Commodity-oriented countries: The Canadian ETF (EWC; 7.6% weighting) - $30.58- and a Brazilian ETF (EWZ; 9.1% weighting) - $62.66. The EWC closed at $29.35, for a 4.0% loss, and EWZ closed at $74.61, for a 19.1% gain.
    Overall, this portfolio lost 13.1% of its value compared to our last review in June 2007.

    Last year, both this portfolio and the SPY were up, although this portfolio beat the SPY by 5.4%.

    So this year, both SPY and this portfolio are down, although this portfolio did beat the SPY by 2.4% which is still pretty significant outperformance.

    The relative gains and losses on the portfolio aren't sufficient enough to warrant a re-balancing yet, so here are the relative portfolio balances going forward:

    • EFV -19.5%
    • IWN - 18.5%
    • EEM - 26.0%
    • IVE - 19.1%
    • EWC - 7.8%
    • EWZ - 9.1%


    The Confused Capitalist

    Wednesday, August 06, 2008

    Three Excellent Emerging Market ETF's

    The other day, I posted about two popular emerging market ETF (EEM, VWO) choices. While you aren't likely to go too wrong adding one of these two major ETFs to your portfolio, I believe you can do better.

    The three choices I examine here are all fundamental analysis ETFs, rather than based on old-fashioned market weighted capitalization like the prior two choices. What this means is the underlying stock choices are chosen on a rules-based entry system rather than how fat (or skinny) the valuations have gotten. I have written about fundamental analysis systems before, including here and here.

    Wisdom Tree has used a dividend-rating system to select stocks most likely to outperform. This is based on back-testing that has shown that, firstly, dividend-paying stocks outperform their non-paying brethren, and secondly, that higher yields more often than not indicate relative undervaluation. Finally, Wisdom Tree's research shows that a basket of these stocks also have lower volatility than a comparable market-cap index.

    The FTSE RAFI indexes, used in many Claymore and PowerShares products, uses four factors to weight stocks. These factors aren't related to the markets enthusiasm (or lack thereof) for the company itself, and extensive back-testing has shown these type of indexes outperform old-fashioned market cap indexes, such as the S&P 500, MSCI EAFE, and Dow Jones Industrial Averages. The factors are dividends, cash-flow, book value and sales.

    The three choices we are looking at are Wisdom Tree and PowerShares products. They are the PowerShares FTSE RAFI Emerging Markets ETF (PXH), the WisdomTree Emerging Markets High-Yielding Equity ETF (DEM), and the WisdomTree Emerging Markets Small Cap Dividend ETF (DGS).

    Let's take a look under the hood of these choices. Firstly, cost and turnover. On cost, none of them has a significant cost advantage, with DEM and DGS are 0.63%, and PXH at 0.85%. Turnover in PXH is 8% annually, with DEM at a remarkable 3% annual turnover. DGS does not have a reported turnover, but given that this is a small cap ETF, you can expect it to be relatively high, certainly higher than any of the choices I've discussed to date.

    Let's look at the average company size and some of the top sectors in each product. In terms of average company size, these are all distinctly different products. DGS defines 92% of their portfolio as small cap, with the remainder as mid-cap. DEM is relatively agnostic for cap size, with 39% defined as large cap, 41% as mid-cap and 20% small cap. PXH, on the other hand, is primarily a large cap ETF, with 88% so defined, plus another 8% as mid-cap and a smattering of small cap.

    In terms of the top four sectors, finance holds first or second place in all of them, and ranges from 26% in DEM to 19% in both DGS and PXH. Energy achieves one of the top four spots only in PXH, and there it holds first place with 26%. Information Technology holds down fourth spot in all the portfolios and range from 10-16%. Materials, at 14% is unique to DEM, while telecomm at 15% is unique to PXH. DGS has consumer discretionary in top spot at 19% (a unique top four holding) and industrials in third spot at 17% - again a unique top four holding.

    Stock concentration is quite different among the three choices, with DGS holding around 400 stocks, and with the top four stocks holding 4.3% of the total portfolio value, and the top 20 companies accounting for 16% of the portfolio.

    DEM holds around 300 stocks, with the top four stocks comprising 11% of the portfolio value, and the top 20, some 38%.

    PXH is heavily concentrated by comparison to all of the choices reviewed so far: it holds around 160 stocks, the top four stocks account for a heavy 26% of the portfolio value while the top 20 stocks hold 60% of portfolio value. Essentially, this portfolio lives and dies with the top 20-30 stock choices.

    Let's turn to country selection. In the Wisdom Tree ETFs, the top two countries represented in these ETF's are the same, with Taiwan holding top spot in both between 26-29%, and South Africa coming second at 11-15%. Brazil, Turkey, Malaysia, and Thailand fill out third and fourth spots at between 8-9% with the Asian choices in the DGS ETF.

    The PXH ETF has China in top spot with 19%, South Korea with 18%, Brazil with 15% and Taiwan with 14%.

    Finally, we turn to relative value measures of the portfolio. Dividends, as can be expected, rate high in the Wisdom Tree products, with recently reported yields of 7.92% (DEM) and 6.17% (DGS). The yield is not reported for PXH, but I'd say a reasonable guess, given portfolio size, and that consideration is given to firm size including dividends, would be in the 3-4% range.

    PE ratios are attractive across the board, with DGS unexpectedly at the low of 9.3, DEM at 9.8 and PXH at 10.2. The price-to-book ratio varies from DGS, again at the low of 1.1, to 1.9 for DEM, and PXH at 2.7. Finally, the price-to-sales ratio is given only for DGS and DEM, at 0.71 and 1.21 respectively, which are both attractive, particularly the DGS.

    Finally, let's look at the performance of these products year-to-date (note: DGS and PXH are less than one year old, hence the YTD comparison), compared to the iShares MSCI product EEM.

    (Click to expand in size)

    While PXH looks alot like EEM on the above chart, I believe that this is coincidental to some extent and the differences in the products will reveal themselves over time.

    Looking at the products, DEM certainly appears to have low volatility, making it an easy choice for investors who prefer low volatility. Furthermore, the process for inclusion into the ETF also makes significant outperformance a reasonable possibility going forward.

    DGS has relatively low volatility given its small cap orientation. I think of it as having just large cap volatility, but with the promise of small cap returns and a better selection process.

    PXH is the large-cap ETF of the three. Offsetting to this usually comforting factor are the rather large bets on a relatively few number of firms, something you have to be comfortable with in order to be comfortable holding this ETF. On the other hand, the selection process is likely the most robust over the long haul for outperformance.

    I lean slightly more toward the dividend approach in this instance, rather than other relative valuation measures, since other measures are more likely to be manipulated by accounting shenanigans, or simply poor disclosure practices. As the saying goes, "Dividends don't lie" ... and "Dividend investors sleep better". So for my money, I prefer the two Wisdom Tree products in this instance, although I have enormous belief that the PowerShares product will also prove itself over time.

    In conclusion, I don't think the relatively low expense ratio of VWO is superior to the relatively low portfolio valuations offered by these three products and the superior selection process they employ, compared to both EEM and VWO. I believe the returns on all three of these products will outpace EEM and VWO over time.

    Disclosure: Long positions in DEM, DGS.


    The Confused Capitalist

    Sunday, August 03, 2008

    Emerging Markets Choices

    Recently, some members of the investment business have suggested that emerging markets offer unusually good value.

    This, of course, offers me the opportunity to once again explore one of my favorite topics.

    According to one recent article, despite the growth of emerging markets to currently represent 13% of the world stock market capitalization, British investors have only 1.6% of assets in those markets. Presumably, American and Canadian investors are in the same boat.

    This is all the more alarming given that these markets are widely forecast to achieve 50% of the world economy in 20-30 years time. That means that most investors aren't playing the largest visible theme of our times.

    Given the growth in ETF's and mutual funds catering to this segment, there's no excuse for most stock investors with a 10-15 time horizon not to be in this market. This is a growth component that simply must not be ignored.

    Having said that, I'd like to take a look at two of the most popular emerging market ETF market-capitalization choices, plus three ETF choices from purveyors who use a rules-based fundamental analysis to choose an emerging market basket.

    The first two are choices from Barclay's iShares (EEM) and Vanguard (VWO). They are based on selecting on tracking broad-based market-capitalization based indexes. Market capitalization indexes (such as the S&P 500, MSCI EAFE, etc.) select the largest companies by market capitalization for inclusion into the index.

    Critics argue that these type of indexes over represent over-valued companies, and under represent undervalued companies, and investors therefore leave some potential alpha on the table, while attracting unwanted volatility. On the other hand, supporters of these indexes argue that, despite these flaws, owning such an index proxy is still a reasonable way to participate in most of the stock markets gains, in a tax and cost efficient manner.

    Let's take a look under the hood of both of these choices.

    Firstly, cost and turnover. On cost, Vanguard (VWO) has it's legendary cost structure sliced to the bone, with just a 0.25% cost, while the Barclay's product (EEM) has a 0.74% cost. A 0.49% point advantage isn't to be sniffed at, but it't not the only item of consideration. Turnover for VWO is 9% annually, the second highest rate amongst the five products we'll look at. The iShares EEM has a turnover of just 5% annually. In a non tax-deferred account, these two cost and turnover factors are offsetting, with no clear winner. In a tax deferred account, the VWO is the better choice, if these were the only two factors under consideration.

    Let's look at the average company size and some of the top sectors in each product. and company size. country choices. In terms of average company size, both are similar with Morningstar defining between 77-80% of the companies held therein as large or giant, and between 18-22% as mid-size. That means either fund has virtually no exposure to small cap stocks, and both can be thought of as large cap ETF's.

    In terms of the top four sector allocations, both have financial firms (banks etc.) at between 18-22% of the fund, energy at between 16-20%, and materials between 18-21%. The only difference is for the fourth choice, which for iShares EEM is information technology at 14%, while for Vanguard VWO it is telecommunications at 12%.

    In terms of individual stock concentration, the top four choices of EEM comprise some 16.2% of the portfolio value, while for VWO it is 12.2%. The top 20 choices comprise some 40% of the value of EEM, while for VWO it is 27%. EEM holds about 350 securities in total, while it's nearly 900 for VWO.

    On these three later factors of market size, sector choice and stock concentration, there isn't that much to choose between these. So let's turn to country selection.

    In both ETFs, the top four countries represented in these ETF's are pretty similar, with Brazil in first place representing 16-18%, and either China or South Korea in second or third place between 11-13%. The difference is in fourth place, where Russia represent 11% of EEM, while fourth is held by Taiwan in VWO, again with 11%. Overall, once again, very little to choose from between the two.

    Finally, we turn to relative value measures of the portfolio. However, I have to complain about "the people's choice", Vanguard, long a champion of the individual investor. Their disclosure of valuation of the portfolio, in a word, sucks! The only valuation measure they offer is price-to-book (PB) ratio, wherein all of the other choices we'll look at provide at least the price-earnings (PE) ratio and the dividend yield of the portfolio, with some others also providing the price-to-sales (PS) ratio.

    Having said that, the PB ratio of VWO is 2.8, compared to 3.7 for EEM. Morningstar calculates the dividend yield at 2.22% for VWO and 2.70% for EEM. Combining these two measures of relative valuation, suggest these portfolios offer relatively similar attractiveness from a valuation standpoint.

    Yahoo calculates the PE of EEM at 11.9 (versus iShares own calculation at 18.0), and VWO at 13.0. Given the differences in PE calculations I've seen between Yahoo and ETF providers themselves, I don't think the Yahoo calculations are particularly reliable. On the other hand, Morningstar calculates the cash-flow ratio of both portfolios to be between 8.5 (EEM) to 8.9 (VWO). Therefore, there's little to choose from here, except to say that both portfolios appear relatively expensive, given the valuation characteristics of the three other product choices that I'll cover in a future posting later this week.

    And, although no one looks at historical charts - given that we're all aware that past performance is no guarantee of future performance, let's see how the two products have performed against each other and the S&P 500 ETF (SPY) over the past year.

    Given the similarity between the products, I'd say it's hard to pick a clear winner. Perhaps if Vanguard would get into the modern era, and provide its investors better information, as well as it's outstanding cost structure, it would be easier to make a choice between these two.

    Later this week, I'll look at three fundamental analysis ETF choices.

    Disclosure: No positions held.


    The Confused Capitalist