Proposed securitization rules

I see that the administration has come to some roughly similar conclusions as me, in regards to reducing incentives to willy-nilly securitize crappy loans. Have they achieved the appropriate balance between efficiency of capital, and systemic risk reduction and system redundancy?

According to reports, the administration intends to reduce the vile habit of bankers throwing crappy loans through to unsuspecting investors (imagine, investors EXPECTING banks to have performed some sort of reasonable underwriting in the first place).

It appears that the administration intends to force the underwriting firm to hold at least 5% of the securitized loans through to completion, and further disallow firms to immediately book securitization profits. Instead, they would book the profits as the loans matured and would have that securitization income reduced if the loans performed badly due to weak underwriting standards.

While this is not quite as good as the 15-25% loan book hold-back I felt would be prudent, this is certainly a large step forward.

The 5% hold-back still amounts to 20 to 1 leverage in effect, atop the normal leverage that banks enjoy. Given banks particularly important place in our economy, I am not sure that is prudent enough.

While this is not quite as good as the minimum 15-25% hold-back, it is a large step forward from existing standards - yet I am still left wondering whether this is not a half measure.

I'm therefore hopeful that FASB rules will further help to dampen the capital leveraging effect through some proposed rules, yet to be issued.

Now, of course, reforming executive pay remains a important topic which needs serious attention in order to also reduce further systemic risk.

This is something I have written about previously, and that my internet "colleague", Rick Konrad, at Value Discipline, is writing about in greater detail.

I encourage you to visit his blog, read some of his posts (1, 2, 3) on the matter, and to add your voice by sending your elected official a quick email (find your congressperson here, find your senator here) encouraging such reform.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!


JW

The Confused Capitalist

Thinking ahead - planning your investment game

The last time I wrote, it seemed like the global economy generally, and the American economy in particular, was in for a serious bout of greacession.

However, the coordinated global attack on the economic slowdown and banking sector crisis appears to have had some effect with, most importantly of all, confidence being restored. That's not to say there won't be some washouts in the road ahead, but most commentators seem to agree that "The Great Depression, Redux" just won't happen at this time. Opinions on the severity and remaining length of the recession in front of us, and the inflation to follow (or not!) now seems to be the subject of debate, rather than the collapse of the economic system itself.

With all that in mind (or not) and remembering that the most important aspect of investment is the right temperament, here is an investment clock that can suggest various investment timing to be had in the cycle in front of us. Whereas it can often be quite difficult to tell exactly where in the cycle we are, at this time it is unusually clear, at least to the extent of knowing that we aren't in the boom phase, nor have we really reached recovery yet. We appear to be, undeniably, in the recession phase at this time.

Therefore, if you like sector rotation and feel you can use it to your advantage, then this Merrill Lynch clock should be very handy at this time.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!


JW

The Confused Capitalist

Officially, we are looking at GREACESSION

Well, it now seems clearer and clearer that this economic period going forward is going to be very tough sledding for some time.

It might be a year or two more, it might be four or even six.

What it isn't, it is becoming clearer and clearer, is a garden variety recession, which usually lasts two to six quarters of consecutive GDP decline.

Yet, to reasonable people, all signs and current actions do not point to a "Great" Depression. The hungry 30's were characterized by unemployment in the very high teens, possibly into the mid-20s, accompanied by significant deflation. And it lasted nearly ten years. Alternative "great" depressions in other eras have featured also high unemployment, and hyper-inflation. And they also lasted for a long period. Like what Zimbabwe has been suffering through since 2000.

No, what we appear to be in for here, is a "Great Recession", a "Greacession", if you will. A period of moderate GDP decline for several years, likely accompanied by moderate deflation. Unemployment will likely settle in the range of 10-14%, and stay there for several years.

Yes, the Confused Capitalist has officially recognized that the Greacession appears the most likely outcome of current circumstances.

"Greacession".

Remember, you heard it here first ... "Greacession"




JW

The Confused Capitalist

Long term value? Or frightened professionals?

I'm a fairly avid reader of various financial blogs and financial newspapers. Many of these blogs and the news reports relate to people who make their living in the stock market world.

I've noted a big theme among them - over the years, these professionals on the whole claim to be stock pickers who concentrate on "long-term value creation. Very few of them at or near the market highs said "Whoa, stock prices are pretty high - so I've got my fund positioned in 50% cash". There were a few notable exceptions of course, but mostly the long-term investment mantra remained chattered amongst the investment class professional masses.

Now that the market dropped, some of these same investment managers talk about "nibbling" on some "good" stocks, or "scaling" back into the market.

I'm confused! If the market was good enough for you when it was 60% higher than today, then doesn't your long-term value creation model hold intact? Or is that only palaver you dole out when the market is high, and you run scared just like the general public when the market is low?

Just asking.




JW

The Confused Capitalist

Obama's Approval Ratings Will Fall, unless ...

... unless he opens his presidency with (and continues) communicating directly with voters on the number and severity of problems facing the US. Too many people simply aren't aware of how serious the problems the US faces are, and their expectations will be (are?) far too high on what can be realistically achieved in a relatively short time frame.

As I consider it, there are many very serious issues that need attention over the next decade, and it's doubtful that even the most remarkable president would be able to fully turn "the good ship USA" around in that time on all of them. However, turning it does need, and if process can begin even on a handful of these items over two terms, then the future - which currently looks grim indeed will begin to brighten. By my count these items include:

1. Global climate change initiatives - only the most idiotic "flat-world" person would argue that this doesn't exist, or need serious attention to ensure simple survival;
2. National debt - now standing at around $80,000 per family and continuing to grow - this will continue to eat further and further into expenditures - a nasty "positive" feedback loop;
3. Repair of the seriously decaying national infrastructure (don't do more of the "same old, same old", but consider in conjunction with point #1 above, to ensure that the right kinds of infrastructure gets built - i.e. mass transit, bullet trains, implementation of geo-thermal as standard heating for national building codes, etc.)
4. Future style and cost of US intervensionism - perhaps using the military as a last resort is not that cost effective, and there are other ways to achieve the same goals, if a longer range view is taken (i.e. expect that policy decisions won't be immediately visible, but that total cost will be lower and long term results more satisfying);
5. Social security and medicare reform (reform both so they are based on proper actuarial accounting, so that future users of the service are paying the correct cost today) - the current "pay as you go" isn't sustainable into the future and burdens tomorrows young people with an effective "tax" from yesterday's workers;
6. Educational reform - approximately one-half of the nation’s entering postsecondary students do not meet placement standards and are not ready for college-level work and US students international performance is weak;
7. Current economic crisis;
8. Health care reform (any wealthy modern industrial country wherein 20% of its citizens lack medical coverage has to be viewed as a societal failure [please, think about the children before you add commentary about "choice"]);
9. Growing income inequality (a major prerequisite for a long-term stable society is some level of income equality).

The current addiction to short-term fixes won't help in this instance - rehab is needed to face these challenges square on. Whether the US, collectively, is ready to look in the mirror and face them, is yet to be seen.

Well, that's my litany - for a 30 minute video from Juan Enriquez detailing some of these problems, visit this link.

JW

The Confused Capitalist

Bigotry Alive Still

The tearful responses of many prominent black people after the election tells me that a great many of them have personally endured some amount of bigotry during their lifetimes. I suspect that had a women been elected president, the response would have been far more muted, as many of the most important gains made by women happened mostly decades ago.

Just as an Asian friend of mine was able to point out nuanced bigotry during a speech by a poorly chosen MC, acknowledging lifetime achievement by a great college teacher of mine, Dr. Fred Young, so too are many minorities sensitive (sensitive in the positive sense in that they are actually able to see something that exists) to bigotry.

I sincerely hope that racial reconciliation continues to occur and that people of all races, ages and faiths continue to open their hearts. May the promised land grow ever closer and closer.


JW

The Confused Capitalist

Two years out: Deflation or Inflation?

Everybody is talking about deflation these days as the flavour of the month. Commodities guru Jim Rogers makes the point that - virtually always - inflation follows monetary stimulus ... buy hard assets he recommends, to deal with the inflation which will inevitably follow the very significant stimulus being added world-wide to deal with the banking issues/financial crisis.

He says they are printing "gigantic" amounts of money, and "massive" ("terrible") inflation is coming, 6, 12, 24 months down the road, and the only way to get out of the way of this is to get out of paper assets.



Video Date: October 24 2008.

Further points he makes are that he expects agriculture also to continue to outperform given the very low stores of food globally. This is something to think about and study for your own portfolio.


JW

The Confused Capitalist

This blog endores Obama for President

Thankfully, this election has offered up one of the better pairs of candidates in some time. The debate, has mostly centred on issues; but still, we all could have done with a little less "Joe the Plumber" palaver, and a little more discussion of some of the very serious issues facing the US - perhaps the most serious litany of issues since the Great Depression and subsequent World War (or maybe more serious).

What is somewhat alarming is that neither candidate has had the fortitude to really begin to talk directly with voters about some of the seemingly unfavorable choices Americans must make in the next few years. All of them involve a move away from personal consumption and, in many cases, extravagance, to choices affecting affecting long-term future and prosperity. Never an easy talk at any time, but one that has to be started sometime - and sometime soon.

These choices involve beginning to slay the national debt time-bomb, the health-care crisis, the future style and cost of US interventionism, educational reform, climate change initiatives that must occur, and Social Security reform. Oh, and did I forget to mention managing the current economic crisis?

In short, there's no shortage of issues upon which the next president could prove himself to be one of the most remarkable presidents in the history of the union (or prove himself a poser at a critical time in history).

And while I have a soft spot for any tough-fighting (and effective) maverick like John McCain, I just can't get past his choice of Sarah Palin as running mate. In the end, her simple lack of knowledge about important worldly things - things a president has to have a handle on from Day One on the job - shows that this was more a choice designed to help McCain win, than thinking about what was best for the country. And now, more than ever maybe, we need a president who`s thinking about what`s best for the whole country.

On the other side of the presidential coin, we have Obama. He`s a man of obvious charm, but more importantly, intellect. That he`s been able to draw a wider and wider constellation of talented individuals towards him, like former Fed Chairman Paul Volker, and former Secretary of State Colin Powell, shows that they believe he`s got what it takes to do the job.

In my view, he`s been able to draw people together, rather than divide them, and this will be a much needed talent in the years to come.

Whether he does or will of course, depends upon many things, including getting elected.

Whether you agree with my choice or not, democracy, an exceptionally unusual privilege demands some hard choices on your part: participation.

Wikipedia: John McCain
Wikipedia: Barack Obama

Platform: John McCain
Platform: Barack Obama


Please feel free to add your comments - however, please keep it civil, and use your frontal lobes, rather than the lizard portion of your brains.

Investing Requires Flexibility to Take Advantage of Conditions

I wasn't sure whether to title this as "Investing requires flexibility", "Rush to liquidity won't necessarily improve investing results", or "US dollar strength won't last".

And that's because, currently, all three are tied together. Nearly every currency in the world has been pounded against the US dollar recently, as there's been a rush towards that currency. Now I can't say that I fully understand all of the reasons for that, but even currencies that should theoretically be strong have been caught in the backwash over the past few months. If you take a look at this currency chart, you can see that virtually every currency therein is down - and in many cases down very significantly - against the USD over the past three months.

So as bad as your short term investments might have done during this turmoil, if they were effectively denominated in other than USD, those ones probably did worse.

Furthermore, during this rush to liquidity (i.e. large cap US stocks, cash and equivalents) has left a lot of other quality investments (but which are less liquid) looking as roadside kill. However, for longer term investors who have too much of their portfolio dominated by USD products, this now presents some wonderful opportunities - perhaps opportunities you missed a couple of years ago.

For some, this might mean moving away from quality US stocks, to other developed country quality stocks. For others, this might mean finally buying the appropriate level of emerging economy stocks (or ETFs). Still others might use this opportunity to position themselves in quality small company stocks.

Whatever or however you decide to approach this opportunity, be aware of two factors: the pounded down overseas relative stock values won`t last - and neither will the current USD strength. Take this bear market opportunity to position your portfolio to look great five to ten years out. Be flexible.




JW

The Confused Capitalist

Wow - Value Village is here

Not too long ago, my daughter dragged me out with a friend of hers (me being the driver, of course) on an avant-garde shopping trip, which meant, that we had to troll all the cheapie thrift stores - Value Village, Sally-Ann, and so on.

Rather than sit in the car alone, I thought I'd take a look through the store while the two shopping mavens trolled the aisles, I was justly rewarded at the Sally-Ann when I found what appeared to be a brand-new pair of smooth leather Hush Puppies - normally a moderate to expensive shoe. They happened to fit me nicely too.

The price? $4.99. Checking the shoe on-line now at the Hush Puppy store, I think this is a $140 shoe. Brand new. Of course I bought them!

The stock market is like that now - given that I don't intend to draw down my stock account for at least 20 years, things look just great right now. I'm trying to get my hands on every stinking cent I can right now to push into the market.

Is everything rosy right now? No. Are we on the cusp of the Next Great Depression? I don't think that either. Given that, I think about my stock purchase of today - trying to look ten years out. And all I can think is BARGAIN, BARGAIN, BARGAIN

Don't think so? How about Chevron (CVX) at a 6.2 PE ratio and a 4.2% yield. How's that purchase going to look in ten years? How about Microsoft at 11.6 PE and 2.4% yield - wow, a meaningful yield from the most dominant software company in the world. Ten years out shouldn't this purchase look good too?

How about one of the drug makers - Glaxo Smith Kline (GSK), at a 12.5 PE and 6% yield? Is the pharmaceutical world falling apart? I don't think so, and that's why I own some.

How about Kinder Morgan Energy Partners (KM) - they supply oil and gas through their pipeline systems. Are people going to stop heating their houses? Yet it sports a 11.8P E and an 8.1% yield. How would that purchase look ten years out?

And how about some of the emerging market vehicles - I own one of the Wisdom Tree ETFs, the WisdomTree Emerging Markets SmallCap Dividend Fund (DGS). It sports a PE of just 5.8 on the index, and the fund itself traded yesterday at an 18% discount its NAV, meaning the effective PE is below 5. It also has a dividend yield of 8.6%, and the long term growth rate of the net income growth is estimated at 13% per annum. Let's see, an effective PE of under 5, and a growth rate of 13%?

BARGAIN, BARGAIN, BARGAIN!

Now where in the heck can I get my hands on more cash?

Disclosure: Long GSK, DGS.


JW

The immediate crisis is passing ... what the future must look like ...

Yes, the immediate crisis is now in the process of passing, with all the extraordinary measures taken to assure the financial system remains liquid. There will still be, perhaps, moments of further high-wire acts over the next 12-24 months, but these now appear less likely to take down the entire financial system, given the exceptional world-wide commitment to blitzkrieg measures as necessary.

I think that, given the unbelievable bungling by companies, CEOs , and boards in the banking and insurance sectors, a round of applause is due to central banks, and governments, world-wide in managing the crisis. This isn't the same as saying that they took measures to prevent the crisis from arising but, once it was upon us, took appropriate measures to make sure this didn't become "The Great Depression, II".

Given the enormous failure of systemic corporate foresight and governance on an individualized corporate basis, governments must now take steps to regulate systemic strength and redundancy into both the banking and insurance sectors. The government must also reform obscene and excessive-risk-encouraging executive pay schemes, since boards have clearly failed to perform their duties to protect shareholders in particular and, as a group, their actions have endangered society in particular.

Here's some quick thoughts on what some of this regulation can and should look like (by the way, corporate boards, take some notes in case this doesn't get legislated, as it's still solid corporate practice: good and prudent governance, if you will):

Banking:
Never again allow the total disconnect between the lender and borrower to occur, by mandating that any pools of capital moved "off balance sheet" (i.e. sold to hapless investors), have some significant portion retained by the originating institution. Whether that amount is 15%, 25% or 50% should be thought about carefully, with the two competing objectives of robustness of system, and efficiency of capital, duly and thoughtfully considered.

The FDIC and similar institutions need to consider "100 year events" in pricing their deposit insurance, as secular increases or declines playing out over a couple of decades can hide fundamental flaws in this type of insurance pricing (i.e. the current scenario). The pricing needs to properly reflect the risk of the loan book of a particular institution - in other words, those playing in areas of the pool with no lifeguard, need to have appropriately steep insurance costs to discourage the most egregious type of risk-taking - or alternatively, to protect the general public when the inevitable failures occur. More highly levered institutions also need to pay higher premiums.

Insurance/Banking:
Anything that looks or smells like some sort of insurance scheme is appropriately reserved. This means that pretty much anything that is insurance against some other event, and involves a trade (swap) of potential event happenings, or pricings etc. It doesn't take a financial genius to recognize that things that are "insurance" aren't always called "insurance". Here's some keywords for regulators, boards and investors to think as insurance: "hedge", "swap", "obligation" (in certain contexts), "derivatives", and so on. No longer should these be allowed to be unreserved. They are all some type of insurance, and need appropriate regulation and reserving to recognize those risks.

Pay schemes:
Federally regulated industries need to have banned, outright, stock option grants. Options encourage excessive risk taking, without the offsetting consideration to downside risk. A winner take all mentality, if you will. This must be discouraged, as it produces unacceptable systemic risk.

In fact, had boards collectively produced proper and appropriate compensation schemes, I argue that much of these systemic excesses may never have happened. For further thoughts on executive pay reform, go here. (In fact, I'd now go one step further and say that the CEO should have to own stock equivalent to at least two years base pay during his entire tenure + eighteen months, as CEO).



JW

The Confused Capitalist

Loss of capital

Here's something interesting that a lot of people don't often think about or realize ...

If the market drops a total of 50%, and you avoided the first 25% drop, and then invested, how much of your invested capital would you lose?

Answer in comments ...


JW

The Confused Capitalist

Pension Plan to Members: Stop Calling, yes, we are looking to BUY stocks.

The 30,000 members of the B.C. public service recently received an email from the government's pension manager: Stop calling us - your pension is safe!

Furthermore, they stated, we are looking to buy stocks in this environment, in order to "normalize" our equities exposure (currently at 62% of investments).

Canada's much larger pension plan, the CPP, won't have to begin any capital drawdowns until 2019. As they put it ...

"We can also invest a higher proportion of the fund in areas such as private equity and venture capital that typically require several years to generate returns. Also, substantial annual inflows allow us to make investments with new cash rather than having to sell existing investments to fund new opportunities."

So I think we can assume that, in this environment, they are probably stock buyers too.

I guess "someone" must be selling stocks to those with truly long-term outlooks.

The pension plans are buying - what does that tell you?


JW

The Confused Capitalist

Yes, it`s hard to buy when everyone else is selling: Did you think it would be different?

Random Roger did a posting last week about thinking contrarian, after large moves in the market. Obviously, perfect timing remains, as elusive as ever, yet the message is sound.

Although the world hasn't changed notably since August, the stock market acts like it has - witness the ginormous move of the S&P 500 today. In Canada, our major index dropped by 10% at one point.

Getting into the market, or rolling over double short ETFs at this point makes a lot more sense than buying more double-down exposure, as a rule of thumb. You need to think about that when idiots like Cramer are screaming to bail out of the market.



JW

The Confused Capitalist

Stock Market Investment Planning

The following provides links to the Market Tremors series, which is an examination of the factors you should consider when preparing a plan to invest in stocks.

It was written in September 2008, a period of extraordinary volatility, as the credit crisis unfolded as Congress considered whether to grant Treasury`s request for $700 Billion in authority to purchase distressed loans from the banking sector.

1. Background
2. Process
3. Rationale
4. Emotions
5. Holdings
6. Market Exposure

I will provide this as a permanent link on the right hand side of my blog, under the heading of `Learn-Useful Stuff`.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!

I hope you enjoyed the series and it proves useful in your investing.

JW

The Confused Capitalist

Market Tremors Series - Market Exposure

Market Exposure

This is the final installment, #6, in the Market Tremors series.

In prior postings, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance. That is primarily because the investor panics and begins chasing the wrong asset class, at the wrong time.

I suggest that all investors need to deal with these five questions, in order to have a good chance to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Market Exposure, through the lens of my own recent portfolio reconstitution. Here’s how I define Market Exposure:

Am I comfortable with the levels of equities I hold?

This is one of those questions that many investors spend a great deal of time on, as the market is cresting or crashing, with the idea of then repositioning the portfolio to better take advantage of whatever has already occured and is now in the rear view mirror.

There are basically only two types of investments: debt and equity. There are many sectors against which your debt or equity might be backstopped, but really, you only have two real underlying investment choices. It’s worthwhile thinking about that.

Equity is always the most volatile portion of any asset holding. As Warren Buffett once said “the company’s assets were questionable, but its liabilities were rock solid”.

So, with this in mind, you can be an owner, or a loaner.

Owners often borrow money, are subject to business and financial risk, strategy failure, management miscues, and so forth.

Loaners try to protect themselves against these risk factors by securing against assets valued at more than the debt. The price of debt (the interest rate, generally) is very clear. It’s relatively easy to make a decision on whether or not it appears attractive to you, relative to its risk profile.

Ownership, on the other hand, whether complete or partial (as in stock ownership) is more complicated. In addition to all those aforementioned factors, one has to judge whether the offering is at an attractive price. While there are lots of objective criteria upon which a purchase can be judged, the subjective portion is, and will always remain, large. Dr. W. Edwards Deming, the statistical expert who is perceived to be the father of the Japanese quality miracle, stated that “The most important things are unknown or unknowable” and “The most important things cannot be measured”– and he was talking to the insiders who could both measure and effect corporate change!

Given all these attributes that equities have, it’s not surprising that their pricing is volatile. During buoyant markets, the subjective portion will be perceived favourably, and priced accordingly. During bear markets, all those subjectives take on a negative hue, and are thus “properly” discounted off the price.

Its also worthwhile thinking about debt too – over the long term, it just barely matches inflation. If you are an extraordinarily strong saver, with a very low risk tolerance, then this might be a good match for you.

On the other hand, if that isn’t you, then you’ll likely want some equities exposure. However, you have to be mentally and emotionally prepared for market declines, and how much of your portfolio you will accept as being subject to those types of risk. For instance, as Barry Ritholtz has pointed out, the market had numerous large downward moves during the period between 1966 and 1982 – three times of around -25%, and twice between -36% and -45%. These types of moves are always possible in a weakened business and consumer environment.

While it’s always attractive to believe you can get rid of the downside risk, the reality is that you usually will miss having some real portfolio growth if you try to eliminate it all.

Where you stand on the amount of market exposure you are willing to accept depends upon many things: your risk tolerance in general, your emotional readiness to handle market and portfolio declines, the amount of time you can realistically be in the market (i.e. are you 25 or 75?) and your willingness to see your portfolio lag your friends during nice bull markets.

Nevertheless, its useful to model a couple of different equity exposures and think about how that might support your portfolio during bear markets, but possibly hold it back during bulls. There are no pat answers, and formulaic answers fail to account for investment strategies and investor differences. It is something you have to think about and model in your head at a minimum.

Finally, it’s unusually beneficial to think about these things well before the cresting of the bull market when greed is in full force, and before the nasty bear is clawing at your portfolio.

This concludes the Market Tremors series – I hope you enjoyed it, and I welcome any feedback you’d like to give.

Disclosure: Significantly invested, long, equities.


JW

The Confused Capitalist

Market Tremors Series - Holdings

Holdings

This is #5 in the Market Tremors series.

In prior postings, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance. That is primarily because the investor panics and begins chasing the wrong asset class, at the wrong time.

I suggest that all investors need to deal with these five questions, in order to have a good chance to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Holdings, through the lens of my own recent portfolio reconstitution. Here’s how I define Holdings:

What are my specific holdings – what is their orientation, what is their risk profile? How much am I counting on “the future” (potential growth of earnings etc.), rather than “the past” (historical earnings, etc.)?

This is one portion of these questions that many investors spend a great deal of time on, as the market is cresting or crashing, with the idea of then repositioning the portfolio. However, if you have properly considered these prior three questions, then the actual holdings become much simpler to select, and to hold onto during active market phases.

As I have mentioned, I have a concentrated portfolio, something I have always done, and feel comfortable with. In fact, just five stocks account for 50% of my equities. The other 50% of equities is held by five ETFs, with significant thematic overlap on two of those positions.

While just ten positions (5 stocks, 5 ETFs) sounds like relatively few, research has shown that diversification benefits begin dropping dramatically after just five holdings. That’s not to say that risk doesn’t continue to decline relative to market averages, just that the risk decline quickly tapers down.

According to Morningstar, three of my stock holdings have a wide moat, and two a narrow moat. Just 10% of Morningstar’s ranked stocks get “wide” moat status, and 45% get narrow moat (the remaining 45% have no moat). Moreover, these selections were recently selling at an average of just 69% of Morningstar’s Fair Value estimate. The average dividend yield is greater than 5%, and all of the stocks have had recent dividend growth. Additionally, all have had sufficiently long periods of decent or good earnings growth and good to very good returns on equity and capital. Furthermore, all except for one had a four or five star Morningstar ranking.

One note worth thinking about: several of my holdings were former “superstar” stocks or in superstar sectors – ones that never disappointed the markets, and became extremely pricey. In most cases, while the revenues and net income continued to grow at solid rates, it was at rates that the market eventually came to be disappointed with. As I write this, the market (S&P 500) has dropped by 19% against its high over the past five years, while three of my stocks declined between 40-70%, and one by 22% within that time period.

It’s worth considering in terms of your own holdings that I don’t believe for a minute they are attractive BECAUSE they’ve fallen (a trap many investors fall into), only that high PE ratios HAVE finally fallen back to earth. This has provided me attractive entry points relative to their existing earnings, dividends payments, and future potential. If you held one of these superstars through a decline, you must contextualize your thinking to see if it holds good value, AS OF TODAY. The fact you’ve suffered through the decline – too bad, so sad - but don’t bail now just because of that. It might just be your most attractive holding today. Really think about that.

As previously mentioned, my stocks were selected by screening for above average attributes (in fact, far above average) and generally in areas/sectors that are attractive for business on a long-term basis. Overall, I have achieved relative diversification here – none of the selections look like the others, as I have one industrial conglomerate, one bank (a UK bank), a teleco, a spirits (liquor) maker and distributor, as well as a hard asset owner/manager. There is very little or no thematic overlap.

In terms of the ETFs, I have oriented to growth possibilities. Here, my five ETF holdings consist of two emerging market selections (large/mid cap & a small cap; both with a dividend selection orientation), two alt/clean energy holdings (again, one that focuses mainly on large companies, while the other has a mid/small cap orientation), an agricultural ETF.

Each of these three ETF themes account for between 14% and 20% of my total portfolio. I’ve considered the relative valuation measures, and believe they are attractive for the emerging markets (PE ratios of below 11 in both of these ETFs). Furthermore, I have a stabilizing and relatively high dividend yield (5-7%) to go along with my two selections there. While many people would consider this a growth position, I also hold the opinion that it’s really a value position as well (although a volatile one currently).

The alt/clean energy ETF valuations, while not crazy, are definitely on what I consider to be the high side (PE ratios of 30 on average). Nevertheless, its worth considering that the ratio is elevated by the fact that some of the underlying companies aren’t yet profitable in this sector (making the “E” understated in “PE), something I expect will change as societal demand increases for this energy source.

Finally, agriculture is being affected by many of the trends that have previously affected oil prices: emerging economy changes (diet preferences in this instance), and a limited amount of the resource (arable land in this case). Add to this mix 70 million new babies every year and climate change, and it’s not difficult to think that this business sector will be larger ten years out as agriculture becomes more intensive.

In the case of all of these ETFs, I simply close my eyes and try and envision the future, ten years out. I simply cannot imagine that these market sectors are not much more significant than they exist today.

These emerging market economies will be much larger is a given I feel. I consider alt/clean energy to be a global imperative that is becoming more and more recognized. In terms of agriculture, there are numerous value drivers as mentioned.

So I believe am paying a reasonable price for most of these themes, although perhaps on the pricier side for the alt/clean energy. That is likely to be a more volatile holding than many of my other holdings.

In summary, in relation to my holdings, I personally feel more comfortable worrying about those ten holdings – which I think have above average characteristics – than I would be worrying about the whole market. Other investors – perhaps such as you - would of course having different comfort levels about this type and style of holdings.

Having said that, there’s also some tie in between emotions and holdings. It’s much easier to hold junk during market escalations, than during declines. For instance, during the NASDAQ go-go days, I personally owned a lot of junky stocks – no earnings, but lots of “prospects”. It ended up around the top (March 2000 or so) that I owned enough of this crap that I couldn’t sleep well at night. I eventually liquidated my holdings, which was luckily before the taking the 80% beating as the NASDAQ eventually tanked to. Still, the sting hurt, but it did teach me a valuable lesson about both quality, earnings, and value.

Finally, there’s one other thing to think about. As Geoff Gannon once wrote, there’s no reason that cheap stocks can’t get cheaper, and this could happen with each and every one of my picks or to the market in general.

As an example, South Korean stocks declined to a PE ratio of just two (as I recall reading it) following the 1998 Asian contagion. So the question to ask yourself is, “Would I be a buyer or seller at those prices?” and “How solid are my holdings, relative to market averages?”

While it’s seductive to think that you’d hang on to your positions in the face of such a deluge, obviously a great many investors weren’t or that pricing would never have arrived.

If you can come to terms with those questions in relation to being satisfied with your holdings over an entire market cycle, then you probably have a better than average chance at outperformance.

The final installment in this series will be “Market Exposure”, which will be published on Monday.



JW

The Confused Capitalist

Is Buffett's purchase into Goldmans really just insurance?

Much has been said and made about Warren Buffett's $5 Billion purchase into Goldman Sachs.

There's no doubt that Mr. Buffett is a very cagey investor, having waited until Goldman was (effectively) permitted to turn itself into a commercial bank. This lowered the risk of Goldman Sachs measurably, since they can now step up to the Fed and secure further funding, making the risk of failure fade considerably.

That he bought into an investment now that competitive forces have been considerably reduced should surprise no one, given Mr. Buffett's oft-stated opinion that he likes businesses with "pricing power". If a passel full of your competitors just bit the dust, or found themselves in the arms of a much more conservative commercial lending culture this, as an owner, can only have you rubbing your hands with pleasure.

Of course, you can't ignore the fact that he invested in what amounts to convertible preferreds (at WB's option effectively), happily collecting his 10% interest along the way. He's, as always, limiting his downside, while maximizing his upside.

But my final thought about this purchase is this: Mr. Buffett would happily see lower prices for some indeterminate period of time, but a financial melt-down wouldn't be in his interest, no matter how low the prices got.

Aside from his strong humanist streak (making him well aware of the human suffering that would cause), he's well aware of how long markets can potentially take to recover lost ground. In the case of the US and the Great Depression, the Dow Jones did not surpass the 1929 heights until 1954. Yes, 1954. One can only look at Japan today to see a similar market (if not Main Street) phenomenon in play.

So, I wonder whether, knowing that a more orderly decline of the stock market can play just as well - and probably better - into his hands, he stepped up with this purchase. A purchase, with his reputation, large enough to salve the panic-stricken, and yet with many of his classic down-side protection hallmarks. As a percentage of his total portfolio, and even of his cash holdings, $5 billion represents a small fraction of Berkshire's total assets.

I wonder if, in effect, Warren Buffett wrote a very large, very public, insurance policy against a disorderly market decline? An insurance policy that effectively rests upon his reputation, more than anything else?


JW

The Confused Capitalist

Market Tremors Series - Emotions

Emotions

This is #4 in the Market Tremors series.

Previously, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance.

I suggest that all investors need to ask and answer these five questions, in order to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Emotions, through the lens of my own recent portfolio reconstitution. Here’s how I define Emotions:

What is my emotional readiness to handle declines or lags in my portfolio, without changing strategies?

Of all the questions, this is the one that is most problematic for retail investors in particular, especially self-directed ones. That’s because there are so many sources for emotions to arise from, and everyone has a different risk tolerance and also because so few people work through questions like these. With rationale thought, chosen at a time of low stress, comes a better ability to handle the inevitable marketplace ups and downs.

Having said that, there are some sources of emotional distress that you can actively “turn off”. Firstly, we are bombarded today by news – including business news. The anchors and talking heads act as if its’ all meaningful to your portfolio.

Most of it isn’t. It’s mental plaque that’s tough to get rid of. Here are a few suggestions for doing so:

Unless you are actively seeking to reposition your portfolio, shut off or restrict your business news intake. You have to view it like an addition – one that’s likely harming your financial health. If you are repositioning your portfolio, fine, intake that news, collect information for awhile, then shut if off again, and STUDY and THINK about what this means.

As a corollary to that, you also need to stop checking your portfolio every day, or even every week. Generations ago, the saying was “A watched pot never boils” and this still speaks to the impatience of people, when their expectation of the speed of the anticipated change is unreasonable. Just like in the movie “Hitch”, your equities portfolio needs time to percolate.

“Hang on”, you say – “How will I know what’s going on with my stocks/portfolio?”

That’s the point – you won’t – AND you’ll stop thinking that each day or week is meaningful in the life cycle of a business or the stock market. It’s not.

If you’re worried you’ll miss some opportunities to buy, sell or reposition your portfolio, then do this instead: set up email “alerts” when your current or desired stock or ETF hits a certain price (buy or sell signals), and/or for earnings announcements. You really don’t need to be more in the loop than that.

If you don’t believe that, then think about this: with all the changes and gyrations in the Dow Jones Industrial Index in the past 50 years, an investor would have been better off to simply have held those stocks in the Dow of 50 years ago, including all spin-offs and buy-outs, than to have followed the Dow in its reconstituted form. And if that’s the case for a relatively slow changing index, then what do you think the odds are that you can outperform the market with all your shifty moves and break-dances?

In order to break the “watched pot” habit, buy yourself some sort of treat as a reward if you limit yourself to checking your portfolio and stocks just once a month, or better yet, just once a quarter. I can almost guarantee you that treat will easily pay for itself, and the addiction will have been broken!

One other antidote to emotions is to think about how much time you’ll be actively “in the market”. If you perceive that as less than ten years, it’s understandable you worry with every belch and burp of the market. Maybe you shouldn’t be in market at all. You need to consider this.

However, if your time frame is more reasonable, like 10 to 20 years, then print yourself up one of those long-term stock charts and eyeball it every time you’re tempted to trade because the markets’ aren’t moving your way.

The other thing you need to consider is the rationale and holdings within your portfolio; how those stylist leanings might affect your returns in a bear and bull market. For instance, if you invest exclusively in micro-cap stocks, and portfolio is down 45% when the market is “only” down 27% (and all your friends are complaining about that), how will you react? Can you really be at peace with this? Are you prepared to hold those positions (or similar) long enough to capture the returns available as an asset class over the business cycle? Or will you bail at the bottom?

Similarly, whenever the next bull starts, there’ll inevitably be one sector or stylist leaning that’ll crush returns in other asset styles. If you see yourself as a value investor, will you long to be part of that crowd, and inevitably give in, just as the sector is screaming towards its pinnacle? You really need to truly face your mental and emotional aptitude to handle a particular portfolio style. You must adapt that style if necessary to reflect something you can handle over an entire business and market cycle.

Finally, going through a process like this (all five steps), including providing a clear and cogent synopsis of your rationale and the key attributes of your holdings anywhere near your computer, should help stop you from trading indiscriminately. In other words, it will help you to control your emotions at tough times in the market – when the market is falling, or when your portfolio is lagging market averages.

The next installment in this series will be “Holdings”, which will be published on Thursday.


JW

The Confused Capitalist

Morgan Stanley and Goldman Sachs Saved

Breaking news: Morgan Stanley, Goldman Sachs, bailout.

Morgan Stanley (MS) and Goldman Sachs (GS) saved, read here.

Can you say "ka-ching" to the bailout price? ... just keeps rising.

Just like Morgan Stanley's and Goldman Sachs stocks will on Monday.

In more news involving prudent bankers, Wells Fargo (WFC) seeks small bolt-on acquisitions, story here.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!


JW

The Confused Capitalist