February 2008
February 24, 2008 03:00 p.m. A Digest of Analyses and Forecasts
This past week I was treated to a range of presentations by a number of top investment professionals. You haven’t heard of many of them, but they are well regarded and worth listening to. I attended a seminar in Stamford, Connecticut and also heard presentations before my pension fund board. Here are some highlights worth considering:
- In many credit investments the market is pricing in a default rate at twice the current rate. Either investors are over-reacting or the economy will get worse.
- We are in a “liquidity event.” This can happen to any liquid asset other than the safest assets (treasury bonds). Investors decide they do not want to own any risky assets, and the market stops to function. Information and fundamentals do not factor into the price; only emotion and risk avoidance matter.
- Today’s liquidity event appears to be unprecedented. It was not caused by an infrastructure problem in the markets or doubts about financial reports. It also has been unusually long when compared to other events, such as that in 1998.
- Liquidity events are nonpredictable and nonquantifiable. Resorting to historic data or analysis will not help understand the event or its scope. A suggestion is for every portfolio to hold an asset or position that does well in liquidity events. These will have negative returns during other periods but preserve some capital during liquidity events.
- There is real value in most assets affected by the liquidity event, even those for which there currently is no market. Investors need to wait out the period of nonliquidity.
- Andrew Lo, a prominent academic and practitioner, believes the market declines in late 2007 and Jan. 2008 were due to unwinding of investments in one or more hedge funds that had to sell investments to meet redemptions. After the unwinding, the markets settled down. Lo expects such events to occur most of 2008 and perhaps longer.
- Investors and the markets are more short-term oriented because of the growth in hedge funds and their compensation based on one-year returns. Longer-term investors such as sovereign wealth funds might ultimately do better than hedge funds because they will buy valuable assets and hold them for the long term.
- Private equity investing is over-rated as a means of diversifying a portfolio or increasing returns. Only the top private equity funds produce meaningful long-term returns, and not all those funds are able to repeat. Costs are much too high for the returns produced, and most investors don’t know how to accurately measure the returns.
- Emerging markets will have a rough patch for the next six to 12 months. Longer term, however, the nature of these markets has changed and they should be a part of a long-term portfolio. These markets now have real growth based on internal consumer spending and are less dependent on the developed countries.
- Investors should not try to imitate the portfolios of the Yale University or Harvard University endowments. Those will change. Instead, they need a process that allows them to get into new opportunities early.
- Real estate investment trusts have had their worst bear market in some time. While there is little sign of softening in fundamentals of REITs, their prices softened considerably. There should be softer fundamentals in coming months. The degree of softening in fundamentals will depend on the severity of the recession or downturn. It is hard to tell what properties are worth now, because so few transactions are taking place. Credit is tighter and has higher standards. Cohen & Steers believes that we should be near the end of the bear market. REIT stocks will rise before fundamentals do, just as prices softened before fundamentals. The price recovery probably will be in the shape of a “v” rather than a gradual rise.
We will incorporate these and other insights in our portfolios in coming months.
February 19, 2008 09:00 a.m. The Law of Secondary Effects
Last week’s news showed how a financial crisis has secondary effects that sometimes are rather sweeping. It also shows why a crisis in the finance industry can be more wide-reaching than one in another industry, such as autos or steel.
Blackstone, the investment and private equity firm, made a lot of news in February 2007 by purchasing the assets of Equity Office Properties, the nation’s largest owner of commercial properties. Blackstone paid a high price for the properties but almost guaranteed itself a profit by actually selling some of the properties before completing its deal with EOP. One of the sales was of a set of building in New York City to real estate entrepreneur Harry Macklowe.
Now, Macklowe is in a lot of trouble. He used short-term financing and personal guarantees to purchase the properties. He believed that he would be able to refinance or resell the properties within a year. Unfortunately, the market, especially the financing market, for commercial properties changed rapidly. Macklowe is unable to refinance the debt, and payment is due. He might have to relinquish the properties and other assets. Fortune has a good article on the situation on its web site at:
Trouble also reared its head in the auction preferred stock market. This is a market for long-term preferred stock but for which the dividend rate is re-set at short-term intervals. Last week the market all but disappeared; there were no bids for the preferred that were bidding for re-sets. As a result, some New York exempt issues had to begin paying about 20% on issues that were yielding 3% to 4%.
This problem affects some closed-end funds. They leverage their portfolios by issuing auction rate preferred. Fortunately, the market over-reacted to the problem, because special provisions in the preferred issued by most closed-end funds provides that if there is no bid the yield is set by a formula which puts the rate today at between 4% and 5%, comparable with what the funds were paying anyway. Investors did not fully realize the rules and sold off closed-end funds last week thinking the closed-ends would be crippled and would have to cut their yields.
These are just a couple of examples of how the changes in the credit markets over the last year are affecting people and businesses that have nothing to do with residential housing and subprime loans. A number of financial assets are becoming attractively priced for longer-term holding. The problem is we don’t know how many of these unknown effects of the crises will continue to crop up. New problems and effects are likely to keep appearing until sometime after home prices stop declining.
February 15, 2008 09:00 a.m. Bad News Tumbles Out
Investors keep thinking the markets have hit bottom and that the financial crises are behind us, and then more bad news surfaces. A simple review of this past week’s headlines in The Wall Street Journal shows that we don’t know all the effects of the mortgage and credit crises.
“AIG Is Forced To Write Down Mortgage Links”
“Is AIG On Slippery Slope”
Major insurance company AIG was told by its auditors to write down the value of financial instruments tied to mortgages. The auditors said there were material weaknesses in AIG’s accounting. AIG previously said its maximum losses would be $1 billion. The accountants forced it to write down $4.88 billion.
- “Student Loan Issues Under Stress”
“Credit Woes Hit Funding For Student Loans”The credit crisis is reaching securities tied to student loans. Investors don’t want to buy those securities now. A consequence is that interest rates on the securities are rising and some colleges say they have to curtail student loans, because they cannot bundle and sell the loans as in the past.
- “After Losses, Auditors Take A Hard Line”
This is a followup to the AIG story, arguing that we can expect more large companies to announce write downs as their auditors get involved. So far, the announced write downs have been voluntary by management. The accountants might be tougher. More write downs would increase the effects of the credit crunch. - “Delphi’s bankruptcy Exit Hits a Snag”
The auto parts supplier cannot exit bankruptcy protection on schedule, because its banks say they cannot syndicate the necessary loans to other lenders. The article says the credit markets for these types of loans “remain virtually shut.”<
- “How Fed Rates Cuts Are Helping to Fuel a Hong Kong Boom”
Already inflated real estate prices in Hong Kong are being propelled higher. Hong Kong ties its dollar to the U.S. dollar. When the Fed lowers rates, rates are reduced in Hong Kong. That makes homes more affordable in Hong Kong, pushing prices higher, and perhaps creating a bubble. - “Commercial Building Boom Peters Out”
Commercial construction and sales had remained strong, despite the residential housing problems. But higher interest rates, tighter lending standards, and a slowing economy are reducing the loans available, increasing their cost, and reducing commercial activity. That is why real estate investment trusts have been in a bear market.
That is a lot for the markets to absorb in one week. The only good news was slightly higher than expected retail sales. But closer analysis of the sales revealed the number was not a sign that consumers were returning to stores and restaurants. One can argue that such a load of bad news in one week is a sign that the worst is upon us and we are at or nearing a bottom. That is an aggressive, speculative position. It is just as likely that there will be more weeks like this one. The only real good news in the week was that stocks did not drop precipitously. That could mean that the bad news that is likely to come already is priced into the markets. We will be examining that issue closely in the coming weeks. Markets tend to bottom before the economy and surge while the economy still is declining.
February 4, 2008 09:00 a.m. A Turn in the Markets?
The markets hit a bottom on January 23. The major indexes climbed about 5% for one week and put together a nice strong of daily gains totaling about a 10% return since the bottom for some indexes. The picture, however, can be misleading if an investor looks at only the point gains. The markets have been highly volatile. While the recent trend has been for higher prices, the ride has not been smooth. Also, many stocks that led the rally through mid-2007 are not looking attractive. They no longer are market leaders, and there are no stocks that have established leadership in the short rally. Despite the sharp rally, the major indexes ended January down around 5% or more.
Another point worth remembering is that the nine highest-returning days in U.S. stock history occurred in the 2000-2002 bear market. While the recent rally could indicate the beginning of a new bull market, it also could be a bear market rally in a more extended downturn.
Some good news is that there is buying interest from Warren Buffett, Wilbur Ross, sovereign wealth funds, and some big companies. Investors should keep in mind, however, that these investors are not market timers and are not buying broadly. They are making specific investments for strategic long-term reasons and believe the prices of the stock they are buying are good bargains. They also are prepared to see the prices decline after their purchases.
We still face declining consumer confidence, slow retail sales, rising commodity prices, and a soft labor market. All are indications that consumer spending might not be at a bottom and investors should be cautious.
February 4, 2008 09:05 a.m. Bottom Fishing Tips from an Expert
A great deal can be learned about investing by reading the quarterly shareholder letters of the better mutual fund managers. Take a look at the Oct. 31, 2007 missive from Martin Whitman of the Third Avenue funds.
Recently Whitman’s Third Avenue Value fund began “investing heavily in the common stocks of companies suffering through the current housing crisis.” Whitman makes clear that he is not picking a bottom in housing and financial services companies and is not able to. He is not even arguing that the stocks are near a bottom. He also says that he “has no good idea of how deep the crisis will become, or how long it will last.” He is guessing that the crisis will last two to four years.
Whitman is buying the stocks now because they are selling at meaningful discounts from the net asset values determined by Third Avenue. He also believes that each of the companies the fund acquired is in a strong financial position. That means that fund believes each of the companies will remain solvent without requiring major access to the capital markets or other cash infusions.
Third Avenue is not market timing. It has invested in trouble companies and industries many times in the past. The fund buys the companies when it believes they are selling cheaply. It is not unusual for the stocks to continue to decline in value after the fund purchases them. The fund is patient, and as long as it is satisfied with the underling strength of a company it will hold the stock until the price turns around. This could take years, and the fund is patient with its investments.
I frequently hear from investors who want to know if I think the market problems are at a bottom. Like Whitman, I don’t know, but I do believe opportunities are being created.
There are two ways investors can approach this problem. One is Whitman’s way. If you think we are somewhere near a bottom, can sustain further price declines, and can wait a few years for an investment to pay off, begin selectively purchasing beaten down investments now. The alternative is to wait until a bottom clearly is reached. You will miss the initial returns off the bottom, but you will avoid paper losses or having to wait patiently for the investments to turn around.
