December 29, 2008

Debt with Equities Like Returns

Debt seems to be a theme for me over this year. most of my purchases were in debt related instruments. I have invested in Commercial real estate debt, bank loans and the quasi debt preferred shares.

1. Purchase of bank loan Close-end-fund PHD at $6.75:

The Credit markets recovered over the few weeks particularly in the non government debt. Some of the funds that I was analyzing for investment in bank loans have moved up, some by 30%. The spread on bank loans have come down significantly from few days ago as displayed
in the chart.

There are a lot of improving signs in the credit environment:
  • LIBOR is came down and it should provide significant debt service relief
  • Mortgages are down to historic rates
  • Corporate yields are down indicating trust in corporate paper or at least some money is moving into that market.
  • even high yield rates have gone down.
  • all this is accomplished with treasuries at historic lows still, i.e. the spreads are still the same but yields have came down because people are buying and capital is flowing into the credit market rather than treasuries.

2. Commercial Real Estate Debt:
I have bought NorthStar Realty (NRF), maybe prematurely in hindsight but I still like it, to capitalize on the cheapness of commercial real estate debt.

From Bloomberg:
Top-rated commercial-mortgage bonds, which returned 32 percentage points less than Treasuries in October and November, have offered a record 12 percentage points more than government notes through Dec. 24, Barclays Capital index data show.

Debt markets are improving amid hopes that prices fell enough to account for potential defaults and as the U.S. government continues efforts to thaw credit and curb a yearlong recession. One of the AAA classes of a $7.6 billion 2007 Goldman Sachs Group Inc. commercial-mortgage-bond deal, considered a market benchmark, has jumped 24 percent, according to Ken Hackel, head of fixed-income strategy at RBS Greenwich Capital Markets.
I am considering to double down in the new year on the name; I am waiting for the possible dividend cut first. NRF will make it through this crises and will have high odds of making high returns:
  • The company has $326 million in cash while its market cap is about $250 million.
  • Its portfolio of loans are predominately prior to the 2005-2007 glut of weak underwriting and loose credit standards.
  • It has underwritten all of its loans so it has first hand knowledge of its economics.
  • Management owns 11% of the company so its interest is aligned with shareholders.
  • It has a large portfolio of health related commercial real estate which is doing strongly and values are going up.

3. Preferred Shares
I have accumulated preferred shares in Bombardier and Brookfield Asset Management to take advantage of price volatility versus the credit worthiness and strength of their balance sheets. I will add to both of these positions in the future.

I think debt have sold off more than equities and was offering equities like return with much better security in the event of default. Investors have raced to buy Treasuries for no return and it will not be long that they will seek better yields in the credit markets.

I have an equity purchase that I will make in the new year and I anticipate to be a big chunk of my portfolio. I have been studying the company for over six months and I have gotten a very comfortable feel of its competitive advantage and prospect.

Hope you have a happy new years!

December 20, 2008

Distress Investing

Please consider reading Third Avenue Funds shareholders letter about investing in the distressed assets and investing in this new era.

He details a case for investing in debt instruments of the financially distressed companies. Distressed investing is highly rewarding but you have to consider its fit for your own competence and abilities. Distress investing needs sophistication and expertise in areas of law, accounting and negotiation, or access to talented resources that can provide you with the help needed. Investors need to understand their abilities before buying these issues. In my opinion distressed security investing is best left for those who specialize in it. In such markets where information is scarce, those who are informed will take advantage of those who are not.

Please consider chapter 12 of Seth Klarman's Margin of Safety for a premier on the subject. You can read the whole book as it is a good summary of how an investing process should run.

December 14, 2008

Senior loans: how to invest?

LCDX Graph
I have posted about senior bank loans as an attractive area in the debt market right now. The tenant of the thesis is as follows:
  • defaults will increase beyond 10% however recoveries on first lien and senior loans will be better than junk and could come at 50-60% below the 75% historical average
  • at 70 cents on the dollar the IRR will around 22%
  • the principal is almost covered by the recovery of the defaulted issues while you can enjoy a wide spread yield over treasuries.

However what I struggled with is how to invest in this idea. Individual loans are about inaccessible to retail investors and you need a large number of issue to diversify. Open ended funds can struggle with redemption forcing them to sell at inopportune time. On the other hand closed-end-funds (CEF) do not have that issue; shareholders can sell on the open market. I have narrowed the the alternatives to the following CEFs:

Yield %Premium/ Discount to NAV%
As of Dec 11,2008

I have considered the following questions is my selection:

  1. What sectors make up the majority of the funds assets?
  2. What type of bank loans: senior vs second lien?
  3. What is the percentage of leverage employed? Is it debt vs preferred leverage?
  4. What is the discount to NAV? Is it bigger that historical averages?
  5. What is the manager quality: tenure, rating and his/ her commentary and communication to unit holders.

My preference is to buy PHD as a vehicle to invest in this theme, here is why:
  1. 18% of assets are in health care loans, which a bit safer and should outperform.
  2. The majority of their loans are senior; senior loans make up 88% of the funds assets. There are some second lien loans but does not make up a significant percentage of the fund.
  3. The fund trades at 22% discount to NAV compared to 11% historical average. The large discount is a result of the recent suspension of dividends due to preach of preferred shares covenants. However the dividends have been resumed.
  4. Its leverage is in the form of preferred shares which can not force the fund to
    liquidate like loans. The fund already started to pay it down. Preferred leverage is 38% of total assets and the fund began to redeem
    some of this leverage earlier this month. Total preferred outstanding is $234m and the fund redeemed $10m worth of these securities.

Off course there are many other funds that I reviewed but I did not like for a reason or another. Here are some of my notes and thought on those funds:
Why I excluded it
  • high degree of leverage employed by the fund. It had 57% leverage as of October 2008. However most of their leverage is in the form of preferred shares.
  • between corp bands and senior loan the fund has a big exposure to financial services: 10%
  • 73% bank loans that include subordinate loans the fund does not have to
    hold senior loans. there is a fair amount of second lien loans in their
  • The fund is conservatively leveraged at 26% but the leverage comes in the form of loans and notes payable very different than preferreds. Debt can be called forcing the fund to liquidate at a loss, while preferred shares, depending on the indenture, usually, redeemed at the fund option.
  • the fund is trading at its average historical discount of 10% to NAV.
  • The fund is leveraged by preferred shares and notes payable. The combined leverage is 45% of assets.
  • The fund trades at a premium to NAV. The fund also newer so it might explain why it is trading ant a premium. the leverage deployed maybe lower than other funds but it is not that low. It may have to do with fund manager buying shares in the fund.
  • insiders are buying; they bough $474,000 during the last year
    in the fund. Actually, insiders hold close to .5% of the fund outstanding units.
  • the fund total leverage is 40% of total assets. leverage
    in this fund comes in two types: loans and preferreds. I am worried about the loans
    part. The fund is substituting preferred financing with notes payable.
    probably to satisfy Citi as it needs its money back from the frozen ARS.
    The form of leverage is going from OK to worse.
  • Citi group owns 21% o the preferreds and an entity like CIti can push the fund into decision that are not in the best interest of unit holders. I am speculating that the move to issue the notes payable to redeem the preferreds was as a result of Citi's demand.
What do readers think? I have some discussion with some readers interested in the theme and I value their input.

December 12, 2008 JPM Buying CLOs Worldwide

- JPMorgan Chase & Co., the largest U.S. bank, is seeking to buy as much as $780 million of AAA rated portions of collateralized loan obligations, according to a list of securities the company circulated to traders and investors.

The bank is asking for offers tomorrow from holders of the debt backed by high-yield, high-risk corporate loans, said five traders who declined to be identified because the request isn’t public.

I have talked about how the market for bank loans is an opportunity right now. Buying these a portfolio of these loans and holding them to maturity or default is almost a no brainer investment.

JPM and others are beginning to raise demand for these loans. However other than buying CLOs, the retail investor is limited to closed-end-funds, which have their own associated risk, in the form of leverage, to capitalize on the idea. In addition, CLOs have over funding provision that can enhance security for the most senior tranches.

December 7, 2008

Value Idea: Bombardier Preferred

I have bought another preferred issue. The issue is BBD.PR.D trading on the TSX. It pays $1.31 or 13% yield. The issue pays fixed dividend until August 2012 then it exchanged for a floater paying dividends equal to the prime rate. I have managed to buy a small position on Friday@ $10.26 on the TSX, waiting to add more.

Business Overview
The company manufactures jets and train systems; its revenues almost split evenly between the two divisions.

The majority of its sales comes from Europe, while sales in Emerging markets are growing at a healthy clip. BBD has been announcing major contract wins over the last 6 months. The company will be further aided by the rapid decline in the Canadian dollar as it will lower the cost of BBD's goods to foreigners. The Canadian dollar is expected to remain subdued if a weak recovery and the pressure on commodities that would likely accompany it follows the global economic slowdown. After all, the loonie is 96% correlated to commodities, according to UBS. The company has a huge backlog of orders and potential for margin improvements; its backlog of $52 Billion.

Credit Assessment
The debt has been reduced by strong cash flow from operations. BBD's total debt in 2005 was $5.7 billion in the latest quarter it was $3.8. The company financial position continues to improve and coverage and leverage ratios are improving. In addition, the improving business fundamentals and growing revenues will allow for more improvements.

BBD's cash flow are strong and improving:
  • The company has cash position of $3.3 US. almost equal to its long term debt.
  • Free Cash flow to total debt have risen from 17% in 2005 to 42%.
  • Cash From Operation (CFO) has grown from $768 million in 2005 to $2 Billion in 2008.
While its Balance Sheet continues to de-leverage:

  • From table above liquidation value of assets is almost twice of BBD's total borrowings.
  • If I apply the same calculation from table above to historical figures we can good improvement. The liquidation value has undergone a drastic improvement in the quality of the collateral that secures BBD's debt and preferreds over time. (see chart)
  • Coverage ratios are also been improving

The BBD.PR.D issue price action does not make any sense over the last few months. The preferred should have some downside protection compared to the common. The preferreds with better security and dividends have mirrored the price performance of the common. The preferred is down 35% just the same as the common over the last 12 months.

Moreover the preferred dividend yield of 13% is higher than the common expected earning yields of 8.6% (P/E inverted).

What can go wrong?
  • BBD out of business: In this event I think there are good odds that the liquidation value of its assets can cover liabilities and unfunded pension benefits and spill over to common equity.
  • interest rates: higher rates in the future can decrease the preferred value, but it will be a floater in 2012 offsetting such risk. In the meantime I enjoy fixed rate.
  • liquidity of the issue: The issue has low volume so entering and exiting has to be done slowly. I still have not accumulated my full position but I am waiting opportunistically for good entry prices like the one I got today.
  • Sales backlog can be delayed by customers. However the train division will keep churning revenue and grow at high rates as government around the world spend on infrastructure to stimulate their economies; the company will be a beneficiary.
  • Pension plan unfunded liabilities. The company has a relatively large unfunded pension liabilities.
Given these risks, I think at this price and coverage ratios detailed above I have enough margin of safety not to risk any permanent loss of capital.

Over the past few posts I have been saying that fixed income is a huge opportunity these days. I can invest and compound my money at 12-18% in issues with better security than common stock. Some of these issues have a margin of safety that ensures there is no permanent loss of capital. I expect to make more investment like these. And to those who invest in treasuries earning less than 2% because it is risk-free, guess again!

December 5, 2008

Value Idea: Senior Debt

“There are no bad bonds, only bad prices,” the saying goes. And at these yields fixed income is a better opportunity than equities.

Although I was on the right track in my previous two posts, see here and here, about debt being a good opportunity, junk bond is not the right class at this time. I need better margin of safety either in promised yield or better recovery rate, which I can achieve by buying more senior debt in the capital structure. This can be accomplished by investing in senior bank loans.

Senior bank loans are
...close relative of its better known cousin - the high yield bond market. Both are bi-products of the busy private equity calendar of recent years. There are several types of loans in the market today. In the following I will focus on only the highest quality loans - the so-called senior secured loans (also known as first lien loans) which are essentially fully collateralized bank loans provided to companies which have restructured their balance sheets - often in connection with a leveraged buyout. The loans run for 4-5 years, sometimes longer, and are usually priced to yield Libor + 50-300 bps. They are issued at par, they mature at par (barring a default situation), and the typical loan-to-value is less than 50%, so the loans are usually very well protected. In a default situation, equity, high yield bonds, mezzanine debt and second lien debt all stand in front of senior secured loans when the creditors knock on the door.
What is your credit risk with these loans? The bank debt is, by and large, "senior," in the sense that in a crisis it would be paid off before junk bonds from the same issuer. Unlike junk Bonds they have better collateral and recovery rate making my thesis for investing in high yield debt a better one. Unlike junk, which can see recovery rate of 40%, senior loans historically achieved 74% recovery rate (Source: Credit Suisse). The seniority of the bank debt makes up for some of the weakness in the borrowers' balance sheets. The long-term default rate on these loans is in the 2.5% range but was higher during the dark days, not so dark compared to today, of 2001 and 2002 (Source: Eaton Vance, asset management firm Annual report). However we are coming out of a credit bubble and historical average will be blown out of the water.

At the beginning of the month, senior secured loans traded around 80 cents to the dollar. Four weeks later the average price had dropped to 50-60 cents to the dollar.

The worst default rate for senior secured loans on record is 8% and the average historical recovery rate in bankruptcy situations is 74%. If you assume a 35% annual default rate and a 50% recovery rate, at current prices, the IRR to maturity is 22%.

How to invest in these Loans?
Loan participation closed end funds (like EVF or BHL and many others) -- which buy bank loans to the companies, as opposed to bonds issued by them -- are less risky than high-yield bond
funds in two key respects: seniority, as explained above and loans have floating rates. When interest rates rise, bonds lose value because their fixed interest rates become below-market. But loans hold their value because their interest rates follow the market higher, allowing loan participation funds to raise their dividends. Of course, when interest rates are declining, the interest rates on the loans go down, leading loan participation funds to cut their dividends.

There are risks inherit in owning the funds that own these loans. The same aspect of making these loans attractive, high recoveries in the event of default, typically is not being taken advantage by fund managers. I think most funds would sell tanking loans rather than ride them through a likely default/lengthy bankruptcy process.

Another issue is the leverage employed by these funds. Typically Closed end funds issue leverage from 25% to 50% of assets under management to juice returns. If assets value fall below 200% coverage, then dividends and distribution will be halted until asset coverage is restored.

So selection of which fund to invest in is paramount. Actually you can argue that to take advantage of this opportunity closed end funds is not the proper tool. I would consider it if I was given a good discount to NAV as a margin of safety.

I have the following issues to choose from: PHD, BHL, EVF. I have presented the case for this investment, the only question now is how to monetize this idea, which will a topic for another post.

December 3, 2008

Value Idea: Junk Bonds- Again

I want to discuss the Junk Bond idea again, as I am trying hard to kill this investment idea. I will start first with some commentary by Bill Miller from his recent communication with his investors regarding credit spreads:
One of the most important bullish signs has been little remarked upon. The monetary base, which consists of cash in circulation or in banks, had been decelerating during the entire [crises] time the Fed had supposedly been injecting liquidity into the system since last August. Thus, the amount of what economist Milton Friedman called high-powered money to stimulate the economy was decelerating, and so was the economy as the crisis continued. Now, though, the base is exploding as the Fed has finally turned up the liquidity pump. Since just after the GSE [Fannie Mae and Freddie Mac] seizure, the Fed began expanding the monetary base, so far by over $300 billion, an unprecedented increase. It takes a while for all that liquidity to find its way into the system, but find it, it should, and the transmission mechanism is typically through capital markets first. As it does so, the odds are very good credit spreads will begin to decline sharply and equity prices rise.
Right or wrong in his view, I always view macro economic forecasting as a roll of dice at best. I try hard to never merit any investment idea based on economic forecasts; the idea has to stand on its own merit. But I though it was a good mention.

Unlike equities, fixed income investing holds finite number of risks. These risks predominately are:
  • Liquidity Risk (ability to find bids on your bonds): If I hold individual names this would be a big one.
  • Interest Rate Risk: With fixed income, higher rates usually kills returns for bonds. However, junk bonds typically behave like stocks coming out of recessions.
  • Refinancing Risk: Ability for businesses to refinance their borrowings. This one will be acute since there is almost no credit circulating for good companies let alone junk status ones. And in an era of vanishing leverage junk companies will get no financing to roll their debt so defaults will be higher than previous crises.
  • Credit Risk: Generally this is a big one. And it is more paramount in this period than historically. We are coming out one of the largest credit bubbles in history, so undoubtedly writing standards for junk bonds in recent years have deteriorated from past years. That means that any historical averages for default and recovery rates will be almost irrelevant. Historical recovery rates averaged around 40%, I think that rate should not be remotely expected in this crises. Furthermore, the highest default rates on record were 15% recorded during the great depression era. Another point to consider is that the default rate is a blended rate across all issues from BBB rated to CCC and non rated issues. So with Junk bonds you have to assume higher rates. I will assume it will be 17.5-20%. The most recent years high default rates were recorded in 1990-91 as they topped the 10.14% and 10.27% respectively.

However the Case for Junk Bonds is as follows:
History tells us that U.S. Treasury securities generally outperformed spread sectors when financial markets were descending into crisis and investors were seeking a flight to safety. But history also tells us that these periods of out-performance were generally short-lived and difficult to time. And as markets emerge from these periods, and valuations begin to normalize, the yield differential of spread product over U.S. Treasuries could offer compelling value.

A look at the graph, (Source), we can see a clear relationship between Junk-Treasury spread and future incremental returns over treasuries. In all years where spread moved over the average spread of junk-treasuries, investors were rewarded with higher returns in junk compared to treasuries. For example, when the spread reached 10.5% in 1990, the forward year junk return was 26% over treasuries.

As the crisis atmosphere recedes and the economy improves, logic says that it will happen sooner or later, default risks are likely to recede. In this environment, spreads tend to normalize, which can lead to better relative performance from high yield bonds.

The question is, are the wide spreads pricing enough compensation in the form of higher yields to assume this risk of high defaults and low recoveries?

Breakeven Yield Analysis
I use simple breakeven analysis, demonstrated by Altman and J. Bencivenga (1995), to show the breakeven yield (BEY) that must be promised in order to compensate for expected default rates and recovery rates.
The end result is a comparison between actual yields at a point in time and the breakeven yield. This shows the yield premium (if any), at any point in time (i.e., the amount to compensate investors for risks, other than expected default risk, involved, e.g., liquidity, unexpected losses, flights to quality, etc).

The results are as follows:

Recovery rates
Default 20.00% 30.00% 40.00%
10.00% 12.42% 11.31% 10.20%
15.00% 18.11% 16.35% 14.58%
17.50% 21.22% 19.10% 16.97%
20.00% 24.52% 22.02% 19.52%

If we assume Armageddon with default rates of 17.5% and 20% recovery rates, I need to be promised a yield to maturity of 21% to breakeven with treasuries. Current yields to maturity of Junk bonds (JNK) is 21%, which is the breakeven point for my base case scenario. Anything better, junk bonds will deliver handsomely, and if these assumptions are too optimistic then it is not worthwhile investment. It seems that the promised yield for junk is at the edge, leaving no margin of safety for errors in my assumption and calculations.

IRR Cash Flow Analysis
The problem with BEY analysis is that it does not take account for holding periods and cash flows. So I will conduct an IRR cash flow analysis, it is the same that I made in my earlier post. Again the assumption, and they are unrealistically pessimistic:
  1. 5 year holding period
  2. 17% default rate throughout the holding period of 5 years, never will happen. You might get two years of high defaults.
  3. 20% recovery rate throughout the holding period.
  4. I assume I am buying Junk at 60 cents to the dollar.
  5. Average coupon rate of either JNK or HYG is 8.7%
  6. defaulted bonds are assumed non workable and will be removed from books, another unrealistic scenario, some of the defaulted bonds will be put to special service firms that will rework payments.
The results are as follows (all figures are with $1):
Year: 1 2 3 4 5
Par value $ 1.00 $ 0.83 $ 0.69 $ 0.57 $ 0.47
Coupon pmts $ 0.07 $ 0.06 $ 0.05 $ 0.04 $ 0.03
Defaults $ 0.17 $ 0.14 $ 0.12 $ 0.10 $ 0.08
Recovery $ 0.03 $ 0.03 $ 0.02 $ 0.02 $ 0.02
Net cash Flow $ 0.11 $ 0.09 $ 0.07 $ 0.06 $ 0.52 (return of principal:$.47)

My IRR is 9.57%, that return can be achieved by investing in more secured debt instruments.

I have backed away from my earlier conclusion in my previous post and I am less enthusiastic about junk bonds. The investment appeal rests with the assumption of defaults and recoveries. If you think that defaults and recoveries are going to be better than priced by the market then you have a good investment. If not then High Yield debt is appropriately priced by the market.

My problem with the junk bonds is that I am not getting a bargain. There is no margin of safety for potential errors in my analysis. To do this deal I need better promised yield from junk or better debt seniority, which will entail better recoveries and margin of safety.

December 2, 2008

Pimco Will Postpone Some Dividends -

Pimco Will Postpone Some Dividends -

Several closed end funds have suspended distribution to shareholders. The operational risks from closed end funds have surfaced due to the severe decline in assets and credit crises. I have noted to this when I have talked about investing high yield closed end funds. The problem is

... closed-end funds must maintain asset coverage of at least 200% with respect to senior securities, such as auction-rate preferred securities. That means for each $1 of preferred stock issued, a fund must have at least $2 in assets. A fund is prohibited from declaring or paying a dividend that would put it below the 200% asset-coverage ratio.

As a result of the market's declines, the Pimco funds' asset-coverage ratios have fallen below the required 200% level, the firm said.

However, most of these dividends are postponed and will resume once asset prices correct.

November 30, 2008

Value Idea: Junk Bonds

There is more deep value in debt instruments than equities. Debt at these yields will give you more than adequate returns with a good margin of safety than equities. In the pecking order of bankruptcies, corporate bonds, even high yield, come
before the equity holders. Some consider equities to be the butt of the investing world, as they rank at the bottom of every body else.

In this post I want to focus on Junk or high yield bonds, a more politically correct term after the Drexel fiasco in the 1980s.

Junk bond values reached a historic peak (measured by the narrowness of the spread between junk yields and Treasury bond yields) in June 2007, when they bottomed out at 268 basis points over Treasuries. In the past six months, spreads have doubled, to 1800 basis points. The default rate for high-yield bonds has also been at historical lows of 3%. Currently Junk bonds sell for 60 cents to the dollar.

However, as the economy settling in to what seems a deep and long rescission defaults will spike and could reach up to 17%. At current levels, the market is pricing in a rise in defaults from
3.4% now to 15%-20% as the economy and corporate profits continue to slacken with no end in sight. The record default rate was 15.4% way back in 1933, again during the -- you guessed it -- Great Depression.

To give you an idea of the scale, the default rate in 1933 was 15.4%; in the early 1990s recession, it reached 12%. These are still far in the distance. Over the year to the end of October, only 2.9% of American junk bonds had defaulted, according to Standard & Poor’s (S&P). It expects the rate will rise to 7.6% by September 2009 (or 9.6% if the economy tumbles).

The case for High Yield:
  • Junk yields are high enough that even if defaults hit Depression-era levels, the bonds should beat Treasuries over the coming years.
  • Inter bank lending rates have moved lower so did mortgage rates. You can argue that these are prelude to reduced lending rate for corporate borrowing. If so then you will see meaningful recovery in prices.
  • The market is pricing an unprecedented default rate of 20%; it may be right. But if it's too pessimistic, the long-term payoff in junk bond mutual funds could be tremendous at these prices and yields.
  • As corporations delver and rebuild balance sheets,the best use of corporate cash now may be to buy back bonds at discounts, effectively discharging debt for pennies on the dollar.
  • Recovery rate: When talking about default rates, one has to mention recovery rates. The standard assumption, historical average, is that the recovery rate will be 40%.
The Case against High Yield Bonds:
  • The deleveraging in debt is occurring at an unprecedented level so when the market prices unprecedented 20% default rate, that may be warranted.
  • Can debt maturity be refinanced? With governments also likely to tap the debt markets heavily, investors may be worried about the prospect of their portfolios being weighed
    down by fixed-income assets.
  • Higher rates lead companies to cut back on borrowing. A drop in borrowing typically means less corporate spending and sales growth, another reason why companies won't earn as much money and stock prices will stay low and the credit metrics of borrowers will deteriorate further.
  • In the past decade hedge fund supplied the high yield market now hedge funds are being squeezed by redemption so who will supply companies with cash in exchange for yield.
  • We are in a negative reinforcing cycle that will take some time to be broken. High borrowing cost will prevent companies from rolling their maturing debt forcing more defaults, as more debt defaults junk bond yields will go higher preventing companies from borrowings and defaulting on maturing debt, and so on. Until borrowing costs come down to levels that will make economic sense to businesses, default will move higher and junk bonds will decline in value.
  • The higher the default rates the lower recoveries will be so the standard 40% recover may not be realized. A recovery rate closer to 25% or lower may be more like it. Case in point in 2002 when defaults reached 13% recovery rates turned to be well below the average, actually it was 25%.
  • Default rates can shoot beyond the trough of the business cycle.
In order to make the case for or against high yield bonds, I am going to do a simple stress test. I have the following assumptions:
  • The average high yield bond trading about 61 cents to the dollar,
  • 15% default rate (Please note that default rates will never jump to 15% from its level of 4%. A more realistic scenario for default rates is to ramp up to the 15% mark and that could take a year or more, but for simplicity, I will assume they will jump immediately to the 15%)
  • 40% recovery rate from defaulted bonds.
  • 5 year investment horizon
Given these parameters you will achieve 14% Internal Rate of Return (IRR). That's pretty good. even if we assume a more of dramatic default rates of 20% and recovery rate of 40% then the IRR would drop to 11.5%. Actually if we perform various scenarios of default and recovery rates we come with the following IRR outcomes:

Default %
Recovery rate%


Those returns are enabled by the low price you pay for high yield bonds. Just remember that the price you pay is the major determining factor of expected returns.

Investment Strategy:
A possible strategy here is to be long junk bonds and short equities. If the argument against holding junk bonds is financial armageddon (default rates will be higher than is priced in), then a strategy of going long junk bonds and at the same time, shorting equities should be a profitable one. In the worst case scenario where equities bounce (nothing is wrong with the economy), you
are protected by a rally in junk bonds as well as spreads come in. But should the economy implode, your short will do well and at least you get your recovery rate in junk bonds. If nothing happens, you get you close to 15% plus while waiting for either scenario.

I do not short so if I am going to execute this strategy I will buy a put on an equity index and go long junk bonds.

You can buy individual issues like GM, ford or utilities like TXU or you can buy ETFs like HYG or JNK. There are many closed end funds that hold High yields bonds that are trading at steep discount to their NAV so you can get more margin of safety by buying them.

Personally I prefer to buy the ishares high yield ETF (HYG). I will avoid leverage with closed funds and I will be more diversified than owning one or two issues of bonds. Moreover, HYG's holdings are invested in issues in the health care and electricity sectors, non economic sensitive sectors; those two sectors represent just under 25%.

The pricing of high yield bonds offer tremendous value with small probability of permanent loss of capital. For investors to lose on investment in HYG, for example, the economy has to implode at unprecedented rate, beyond great depression levels.

November 29, 2008

Value Idea: BAM Preferred Shares

I have detailed my case for the Bookfiled Asset Management (BAM) preferred here. I will elaborate on some additional points on its investment merit.

I have picked issue, which has the following characteristics:

  • Floating rate issue, i.e., dividends change depending on the Canadian prime rate.
  • The issue is redeemable at BAM option at $25 per share, i.e., the issue has face value of $25.
  • Dividends are cumulative, i.e, if the BAM decides to skip a dividend payment then dividends would still owed to the investor.
BAM's preferreds offer me an excellent opportunity to earn great return that I could not simply pass up. I have bought BAM.PR.B at $7.9 per share to earn a dividend yield of 10.5% annually. There is room of capital appreciation as well. The face value of these preferreds are $25 per share; they are trading at almost 70% discount to where it was trading just a year ago. I do not think this price will be the absolute bottom but in the long run the odds are in my favour to earn
satisfactory returns.

Brookfield Asset Management (BAM) has four operating categories from which it generates cash flows:

  • Property: those are unique properties in supply constrained markets, mostly downtown properties in major urban centres, mostly through its ownership of Brookfield Properties (50%), another holding of mine, although it operates some properties on its own as well.
  • Power generation properties in demand stable markets like North east and west cost.
  • Infrastructure assets like transmission lines and timber fields.
  • Asset management for institutional entities. BAM uses these funds and co-invest with its clients in the above three categories. moreover it does manage security instruments as well.
BAM have great management talent, which its philosophy is to buy unique valuable assets at a fair price rather than average asset at a discounted price. See this presentation by their CEO to appreciate the value philosophy of this management team. Moreover, BAM has been creating value to its shareholders by spinning unique assets, like Brookfield Properties and Brookfield Infrastructure.

This is a bet not only on the assets earning power but on management to deliver value. I think betting on management was underrated in the investment discipline, where asset value and earning power was the focus.

Additional points of consideration:

  • Interest rate risk: these are floaters and their dividends payment correlate to prime interest rates, so the risk of more interest rate cuts will lower its payout. Retail investors mostly hold preferreds and their actions are mainly driven by fear, so these shares trade violently each day and sometimes their trading does not make much sense. At current prices investors are pricing them as if interest rates will never rise again. I betting that interest rates in few years will rise and will rise rapidly, in such case these preferreds will gain. However if they do not I am earning more than satisfactory returns.
  • You could buy fixed rate preferreds and you will do well but I would like to reduce interest rate risk from this issue and floaters are great way to do it.
  • Cash flow levels are solid: Currently BAM have about $3 billion of core liquidity and generate about $2 billion of cash annually. Moreover, FFO per share for the third quarter was US58¢, up from US51¢ in same quarter of the previous year. Excluding net gains and unpredictable items, BAM’s adjusted FFO available for common stockholders at US50¢ per share, up from US45¢ a year earlier. Adjusted FFO is funds from operations after the payment of all interest and expenses. It is not quite the equivalent of free cash flow, but a good indicator that BAM is a good generator of cash. BAM’s cash flows remain solid, while it’s financial position is strong an it is cash rich at a time when others face forced liquidations and cash is king.
  • BAM has maintained acceptable balance sheet ratios with just under 30% debt-to-total capital (book value) and cash flow-to-debt of 0.33. BAM’s coverage ratios also remained strong in 2007, with interest coverage on a remitted basis of 5.3 times and fixed charge coverage of 3.9 times.
  • Debt level: BAM Investment-grade financing strategy is to hold fixed rate, diversified and long-dated maturities. The strategy matches their assets and reduces any risk of funding miss match that could lead to asset fire sale or forced liquidation. Moreover significant chunk of BAM's debt is non recourse. This deb is associated with mortgages on their commercial properties. Why is this important? because no single property can take down the company if it ran into trouble.
  • In the event of balck swan bankruptcy, my capital hold a good probability to be protected. If we assume a 75% liquidation value of BAM long term assets there will be just enough funds to cover preferred holder and wipe out common equity holders. Off course preferred shares rank higher than common equity and should see full recovery of their book value; book value of all outstanding preferred is $870 million. And because we are buying those issues at deep discount we have almost 45% margin of safety.
BV As of Q3 2008
Recovery values
Liquid assets- values will hold
Long term tangible assets
Less all liabilities
Surplus available for preferreds and common equity

I am not only like their preferreds but I like their business model and management. I am looking at their common valuation to determine if an investment in their common equity is warranted.

November 26, 2008 / Columnists / Martin Wolf - Why fairly valued stock markets are an opportunity / Columnists / Martin Wolf - Why fairly valued stock markets are an opportunity:

Great article about the valuation of today's market. I have been using the modified PE described in the article as my guide in valuing the market and as the article details the valuation of this market has not been seen in a long time.

Since the end of last month, I have been buying more of the market indices, like Emerging Markets index (EEM) and Russell 2000 (IWM). I have also bought Brookfield Asset Management (BAM) preferred shares, which I made the case for here.

There are great bargains especially in fixed income markets. I can say that in the fixed income universe you can find compelling risk/ reward propositions than in the equity markets, the BAM preferreds are such an example. I will have a future post talking about these opportunities.

November 16, 2008

BofA out Amex in

I am rolling my capital allocated to Bank of America into American Express (AXP).

I have been mulling getting out of BofA position for awhile. The buyout of Merill Lynch have changed my outlook on the bank. Mainly due to the integration risk and the diverse cultures of investment banking and retail. This merger would have been difficult to complete in normal circumstances but with the stress of bad economy and credit crises this could be impossible to pull off.

Also the financial landscape has changed a lot since my investment in BofA. BofA, as I reasoned when I made my investment, held a competitive advantage over its peers by being the largest retail bank with coast to coats network of branches, which ensured that it held a relative competitive advantage in its economies of scale to its peers. Now with the rapid continuing consolidation in banks, that is no longer the case. Other banks like JP Morgan and Wells Fargo achieved that position by buying Wachovia and Washington Mutual. So that relative competitive advantage disappeared, which can lead to margin compression over the long term.

Buffet also sold out of BofA so I get my confirmation to my thought process.

I am not saying BofA will perform badly, but there are more risks associated with the business. BofA management is still good and have a lot of experience with merger integration and the opportunistic acquisitions they made in the last 6 months can secure their position in the global banking industry. However the return is more speculative than say with AXP or JPM.

My cost basis for BofA is $42 per share I sold it at $18 for a loss of 57%. That hurts. But I will not dwell on it, as I need to find the best risk/reward proposition for my capital and at the moment BofA does not fit that bill. American Express, on the other hand, will offer me a better return, I think, once market settle down. I bought AXP at $20 per share.

AXP has several competitive advantages that makes it a unique investment.

  • brand: BusinessWeek ranks it 15th out of 100 most valuable global brands.
  • network that akin to toll bridge earning fees on transactions from retailers and interest and fees from users
  • retailers have limited bargaining power in this industry. Credit card networks can increase fees with little of resistance from retailers.
  • what will be good for BofA will be good for AXP, while the opposite is not true. BofA will have specific risks associated in its operations that can overwhelm its earnings.
  • Buffet ownership gives a backstop for any permanent loss of capital in AXP, while with BofA government involvement present a risk for permanent loss of capital, think of AIG.
  • With the sale of BofA i generate some tax loss amounts that will be used to offset some of my earlier capital gains in the year, something I think I will not discuss for awhile.

Here is a good case for AXP as undervalued investment by Vitaliy N. Katsenelson.

I think by redeploying capital from BofA into AXP I will be better served. I will sell my investments when I believe that I could redeploy the capital in investments that offer more attractive risk-reward profile. I will always be willing to sell an existing holding at a profit or a loss, if I can find a better use for the funds.

November 7, 2008

NorthStar business model re-evaluation

Any lending operation currently are re-evaluating their going concern and the future of their business model. Any financing operation without a stable deposit base is at risk and have a bleak future. That's why the investment bank have disappeared from wall Street. But this change will affect many other operations depending on leverage,like leasing companies, mezzanie funds, commercial real estate reits..etc. One of my holdings NorthStar realty is one of those affected as it is a commercial financing company.

The entire sector of REITs specializing in financing commercial-property transactions are facing headwinds. Companies like NRF, Gramercy, CBRE Realty Finance Inc. and Arbor Realty Trust Inc., have seen their access to capital severely reduced by the credit crunch. They are also suffering from a dearth of property transactions and rising defaults.

The business model of traditional commercial-mortgage REITs -- which act like leveraged bond funds, making money only if the yields on their investments exceed the cost of their borrowings -- has been rendered obsolete by the credit crisis. Early this year, Gramercy bought a REIT that owns real estate to help diversify its business.

from the Wall Street Journal:

The reason: These companies have depended heavily on the ability to sell securities stuffed with the loans they originated, called collateralized debt obligations, or CDOs, in order to lock in financing for a longer period of time to match their mortgage portfolios with long-term maturities.

Today, with the CDO market all but shuttered, there is a lack of long-term debt financing that they can rely on to fund the acquisitions of assets.

"While I expect further loan impairments, the real focus will be on liquidity and any potential violation of their credit facility and bond covenants,"
NorthStar already has diversified away from the mortgage reit model into operating commercial real estate business before the credit crises. NRF has diversified into Net-lease operations through two joint ventures, Wakefield Capital, LLC, owning medical facilities and another venture, LandCap partners, with Goldman Sachs to buy distressed land rom home builders.

They have just reported their earnings and I have to say the report looked really good. Here are some highlights:
  • continue to buy back their own CDOs at 50% discount; mark-to-market works on both sides of the balance sheet.
  • The have no non performing loans (NPL).
  • Book value increased to $15 per share from $12 in Q2 2008
  • Management owns better than 10% of the company
    and is managing for the long term.
  • very good liquidity and cash position.
  • reaffirmed their dividends.
Despite an excellent report this quarter, management did indicate some
potential problems:
  • There are very uncertain loans on their watch list which very easily can become NPL; of especial significance is the WaMu tenant lease which brings over $5 million in revenue per year. JPM after taking over WaMu from the FDC has 90 days from acquisition to decide what to do with the leases.
  • NRF is accumulating cash and not doing much loan origination, which will impact future earning
  • also management said their earnings will be less if LIBOR continues to decrease which is what they expect, again hindering their net income and dividend.
I think at this point I will keep my investment in this business as the fundamentals and the reasoning that I bought NRF are still valid. NRF has a favorable chances of surviving this episode of the crises and emerging as a commercial real estate company. Yes the price have dropped significantly, and chances are it may drop further, from my cost basis but I think I will hold this one.

November 4, 2008

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test -

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test -

A great article about AIG reckless underwriting of credit default swaps. The article is a great illustration on the difference between risk and volatility. I have argued this difference in several posts and I still believe that a lot of investors, even professional, as illustrated by this article, confuse risk and volatility.

Several take away from the AIG case:

  1. Models do not articulate risk, they articulate volatility.
  2. Common sense and conservative policies go along way in protecting capital.
  3. Historical data should not be relied on for investment decisions entirely; it can always be manipulated to show whatever case you want them to show.
  4. Good and conservative management matter much more than assets and technology.

Value idea: Preferred Shares

The dislocation in the market has presented several opportunities not only in equities but more so in debt instruments. Here is one example the preferred shares of Brookfield Asset Management (BAM).

Brookfield Asset Management Inc. (Brookfield) is a global asset management company. The Company operate and manage assets in property, renewable power, infrastructure, specialty investment funds, and fixed income and real estate securities. The subsidiaries of the Company are Brookfield Homes Corporation, Brookfield Properties Corporation, BPO Properties Limited, Multiplex, Brookfield Power Inc., Great Lakes Hydro Income Fund, Brascan Brasil, S.A., Brascan Residential Properties, S.A. and Brookfield Investments Corporation.

Upside potential of the shares:
  • The preferreds trade at Junk level valuation. Pref issues M and N trade on a perpetual basis at 11-12% discount rate. However, BAM is an investment grade rated firm; its rating was recently affirmed by DBRS.
  • The preferred shares have a current yield of 9% for the two issues, at that yield you can double your money in about 10 years.
  • Strong management team that have strong acquisition and valuation discipline
  • Long term quality assets in place from power, infrastructure and property.

Downside risk for the preferred in particular:

  • Interest rate risk: typically preferred shares go up when interest rates go down. This relationship have been broken lately due to negative sentiment and investors liquidating out of fear. The relationship will return to normal levels in due time. However the prospect of central banks raising rates in hurry after the credit crises subsides can hurt the preferred.
  • Liquidity risk that can lead to withholding dividend payments.
  • Leverage risk / adequate debt service provisions.
  • Redemption risk as the company can redeem the issues at its option however the risk comes with a nice upside as it will be redeemed at par.
  • Conversion risk to common by the company. Here the company can convert the issues to common but with a premium to the trading price of the common shares.
  • Black swan: any event leading to company bankruptcy: book value of the company is $3.2 Billion ( total assets less intangibles less liabilities). If we assume a bankruptcy recovery rate between 55%-65%, reasonable rate as based junk bond historical recovery rates, we can see up to $2.5 billion to recover for equity and preferred shares. Off course preferred shares rank higher than common equity and should see full recovery of their book value; book value of all outstanding preferred is $870 million. And because we are buying those issues at deep discount we have almost 45% margin of safety.

Which issue to choose?
It depends on several things. you premium on liquidity as many issues have limited liquidity than others. Some issues have floating rate dividends while other have fixed rates. This requires more research on your part.

I am going to zero on issues B, M and N for selection.

November 2, 2008

Expert prediction: flipping a coin is better

Let me begin this post by two endearing quotes about economists:

An economist is expert who will know tomorrow why the things he predicted yesterday didn't happen today
Lawrence J. Peter

Economics is an extremely useful form of employment for economists
John Kenneth Galbraith

Media has reported on economists and investors who called the crises and profited from it. Some of those people are John Paulson the famed hedge fund manager who made multi billion dollar in 2007 betting against sub prime. Another is Prof. Roubini who "predicted" the crises and continue to give sound bites to the media.

I always enjoy reading about the newly minted expert of a crises or an episode of the economy. Before Paulson and Roubini there was Abby Joseph Cohen, the famed Goldman Sachs strategist, who called the S&P during its bull run in the 1990s and was hailed by media as the market genius. Internet companies had their prophets as well. There are a host of so called "experts" who came and gone. Those experts rode their once in a life time call on economic or market matters but disappeared into the sunset when they tried to do it again. I reckon that Roubini and Paulsn will face the same fate.

Lets look at these experts in another light. If there are 20,000 experts, why does only one guy have this figured out? What is special about them?

Walk into some big arena filled with 20,000 people each standing and holding a quarter. Ask them to flip it one time: heads you remain standing, tails you sit down. Repeat the trial 14 times among the people who remain standing only. A normal distribution of outcomes would say after fourteen trials you would reasonably expect one person to be standing up, actually 1.22 to be exact. Ladies and gentlemen, I give you Professor Nouriel Roubini, Andrew Lahde Capital, who saw his accomplishment for what it is and called it quits, andPaulson.

My point of the post is economists and the "expert" of the day had his/her lucky call, odds are stacked against his next call to be right. Do not chase expert and their performance as predictions are always harder when it is about the future!

November 1, 2008

Acman's value idea:Target Spin-off

One of Target (TGT) largest shareholders, Ackman, the hedge fund manager of Pershing Capital, have proposed a transaction to unlock value in TGT. You can view his presentation here. I have to say that I always enjoy Ackman's work; it is always detailed and a learning experience.

I have to say that the transaction does not make much sense to me. It is a lot of financial engineering that, most likely, will not create any value to shareholders.

The core of the transaction is to spin-off of the land that TGT's stores are build on, TGT keeps owning the buildings, into a REIT that will charge TGT rent and perform building maintenance and development of new stores. The REIT pays dividends to shareholder and because it is a REIT it does not pay any taxes. According to Ackman TGT will be $70 after the transaction and $83 in a year, somehow. What the transaction boils down to is : tax. That is it. The new structure eliminate some taxes, actually, redistribute it to you , the shareholder.

My problem with this is creating value by tax redistribution only is tax policies are outside management control. Tax policies can change therefore relying on a tax policy to create value can disappear very quickly. Management can create better sustainable value by using some of the levers it can actually control: revenue, expenses and cost of capital. The transaction is a lot of ado about nothing in my opinion.

A company value is the perpetual discounted present value of its free cash flow. Then, there are two way to create value for shareholders.
  1. increase free cash flows, and that can come from two things:
    1. increase revenues
    2. increase operational efficiencies or decrease operating expenses and capex.
  2. decrease the discount rate or the cost of capital, a company can accomplish this by:
    1. decreasing borrowing costs,
    2. optimize the company's capital structure.
None of Ackman financial wizardry do any of the above. TGT is an excellent retailer with good management but I do not think the transaction adds much to the pie.

October 29, 2008

Economic Scene - Are Stocks the Bargain You Think? -

Economic Scene - Are Stocks the Bargain You Think? -

NY Times take similar theme as my post last week. It is a good read.

The point of my post and the NY times article that the markets is always about valuation and nothing else. Economics and the credit crises future impact matter less than you think. If you buy at an attractive enough valuation you will be rewarded.

US dollar: Why is it going up

There could be a case to be made for higher inflation and a weak US dollar. The trade deficit and the enormous debt on the balance sheet of the US will lead to higher inflation and lower value of US financial assets. So the US dollar SHOULD slide, but markets have a mind of their own. This is more of a long term outlook once the economy has some legs under it.

What is obvious right now is the economy continues to slow and credit creation continues to contract, it's going to be very hard to get sustained inflation. I think prices are going to respond to the slower global economy. If that's true, then demand for commodities, demand for everything, goes down and some inflation subsides, as inflation is a lagging indicator and credit is a leading indicator. There's not a lot of credit being issued these days.

As for the US dollar, it generally appreciate when the global economy is slowing and in the time of financial uncertainty investor typically flock to US treasuries which means dollar appreciation. Moreover, leading central banks will pursue aggressive rate cuts, which only the US Fed was doing lately, to stimulate their economies. Lower rates abroad are positive for the US dollar.

You can certainly see this in the surge of the dollar lately. The dollar index surged 18% to 92 this month. For the week on the downside, the Brazilian real declined 9.8%, the Australian dollar 6.9%, the Norwegian krone 6.2%, the Swedish krona 6.1%, the Euro 5.7%, the Danish Krone 5.7%, the South Korean won 5.6%, the South African rand 4.8%, the Canadian dollar 4.5%, the Mexican peso 4.3%, and the British pound 3.9%. Examining this week's rout in some of the "emerging" currencies, the Iceland krona declined 16.3%, the Romanian leu 10.6%, the Hungarian forint 8.2%, the Czech koruna 7.3%, the Polish zloty 6.9%, the Turkish lira 6.3%, the South Korean won 5.6%, and the Chilean peso 5.4%.

The dollar have no legs to stand on; there is no fundamental reason for it to be higher. So I would not alter any investment strategy based on the recent trend. Some began to sell multinational corporation as they will hurt by higher US dollar. The rationale goes as those tail winds that elevated their earnings in the past will become head winds depressing their earnings.
The US election will not alter a weak dollar as both candidates are powerless to do anything about the deficit and government spending.

In my investment selection I will take advantage of this and pick those multinational, energy and metals as they will provide the greatest appreciation once the eventual decline in the dollar resumes.

October 18, 2008

Is the market under valued? yes but....

It is time to value this market and look at real adjusted Price/ Earnings ratio (PE). As discussed before I use this ratio to determine if the market is fairly value or not. The ratio adjusts for inflation by calculating real earnings and real prices by adjusting them to the CPI index, as published by the government. The ratio also adjusts for economic cycles by averaging the last 10 years of earnings. This way it adjusts for abnormal economic activities, whether it is a peak or trough. Whenever I refer to PE ratio in this post, I reference the real-adjusted PE ratio.

There are good news and bad news. The good news is the market is trading under its long term PE average. The bad news is markets always have to overshoot the average on the downside. Look at chart attached.

The long term adjusted PE ratio is 17 and we are trading at an adjusted PE of 15. Real earnings have grown by 15% from the burst of the tech bubble in April 2001, while real prices have declined by 42% in the same period. Also real dividends have increased by 47% over the same period. Off course the market was over valued at that point with an adjusted PE ratio of 34x and as a result the PE ratio have contracted by 56%.

The decline in equity prices have made valuation look attractive. The contraction in prices and PE ratios have outpaced the real increase in earning and dividends. This makes the market attractive for meaningful equity investment.

However, there were no significant bull market in history that began with a double digit adjusted PE ratio. The bull market of 1880s, 1920s, 1950s and 1980-1990s all have started with an adjusted PE in single digits. The bull market of the 1920s started with PE ratio of 5x and ended at 35. The bull market of the 1980-1990s began its run with an adjusted PE ratio of 8.7x and ended with a staggering ratio of 45x.

So until we get to an adjusted PE ratio of under 10x do not buy all at once. Pace your purchases. And because I do not want to time the market I will buy some at the present, which I did by taking advantage of these prices, and allocate funds for later time if markets decline further. At this pace of decline we will get there very quickly.

Economic headlines are always bad and factor in worst case scenarios entering a recession. There is nothing new in this recession that will make it any different from the others. It may be longer but there is no question that businesses will adjust and grow their earnings. As a result investors who buy at attractive valuation will make good returns in the long run.

October 5, 2008

Value Idea: Emerging Markets- Part 2

Previous corrections have seen emerging markets lag behind developed markets by 50 per cent or more, so far it has only down by 30%. So there may be a further decline for EM index. As I argued in my earlier post this represent opportunity. But Emerging economies are not created equally: different countries pose significant inflation and credit risk. Some have trade deficits that weight heavily on their currencies and economies. Moreover, as an asset class there are several risks associated with such an investment. Lets look at the major risks:

Credit risk and downgrade

Emerging market credit conditions have peaked after five years of improving fundamentals, and a "pronounced downside" is becoming apparent to some of those economies, Standard & Poor's
said in a recent report.They argue that credit has more downside risk and very limited upside as developing economies slow and enter a rescission.

The ratings agency warned that less benign credit conditions in industrialized nations have clouded prospects for the growth of world trade, with a negative impact for emerging markets. Although the credit crises is a developed economy problem but the prospect of spillage to EM economies is a real risk from the following mechanisms:
• Counterparties. There is a direct impact through counterparty channels. The list of financial institutions liable to be affected includes all but the most isolated and remote financial service
institutions of the world.

• Risk perception. The second channel is indirect, through risk perception. The problem is that many global relationships evolve day-by-day, resulting in significant uncertainty about the way risk spreads in the global economy.

• Cost of capital. The price of risk rises substantially. This affects all asset classes that are categorized as high risk.

Out of 43 emerging market central governments rated by S&P, 33 have stable outlooks, eight have negative outlooks and only two --Poland and Slovak Republic-- have positive ones.

Countries with negative outlooks are the Dominican Republic, El Salvador, Hungary, Kazakhstan, Pakistan, Serbia, Sri Lanka and Vietnam. In the last six months, S&P upgraded six emerging market sovereign credits, most of them in the Western hemisphere -- Brazil, Peru, Trinidad and Tobago and Uruguay. During the same period, four emerging market sovereign credits were downgraded -- Pakistan, Ukraine, Georgia and Argentina -- the highest percentage of downgrades since 2003.
Here are some country thoughts on the credit risk of specific countries:
While the usual weak spots of emerging markets (eg, Thailand, The Philippines, South Africa, Argentina, Hungary) could suffer substantially in the wake of what is essentially a mature economy financial crisis, those with more robust structures — although with chequered pasts — may also be tested (eg, Turkey, Indonesia, Mexico).

At the same time, the successful new global powers are either still not strong enough (China, the Gulf states), still too isolated (India, Brazil), or happen to be in the midst of ongoing turmoil
(Russia), such that no significant global impetus can be expected to come from their direction.

Capitol outflows from EM

Capital flows to emerging economies could drop to around $550 billion in 2009 from an estimated $730 billion this year, sapping a major source of growth in countries such as Brazil and China, as per estimates: source Financial Times.

Most of the capital that flows into emerging economies has been in the form of loans, not portfolio investments, which only make up 8 percent of the total. Loans from banks and other institutions altogether make up 57 percent of total net private sector flows, while foreign direct investment accounts for 35 percent.

Moreover, in 1997-98, more debt was sovereign. Now, much of it is corporate, taken out by Indian, Chinese and other emerging-market companies. That implies a global credit tightening could have as big an impact on emerging markets as slowing import demand in the rich world.

This means the shockwaves from Wall Street's implosion over the last few weeks that have accelerated a process of risk reduction and froze money markets will likely have a direct impact on emerging market capital inflows. This will almost certainly hurt growth in emerging economies, one of the main drivers of global growth over the last year. This could slow growth in global gross domestic product below 3 percent -- a level the International Monetary Fund considers a recession.

How to invest:

I prefer ETFs to invest in this asset class; this way I avoid analysing individual companies and diversify company specific risk by holding index.


MSCI Emerging Market Index (EEM) is an obvious one and easy to gain exposure to this assets class. I hold this one and I will continue to buy it as my equity exposure to EM. Most equities in this ETF are Brazilian and Chinese, making up to 30% of the fund. Those are very favorable countries with strong growth prospects going forward.

Specific Country ETF. You can hold individual country ETFs, however you need to do your homework on which counties have solid fundamentals. If you are going to go this route look for countries with large exports relative to their imports. These counties will see their currencies appreciate against the dollar. In this category I prefer to look at: China, Brazil, Korea and most Asian countries excluding Japan. I would avoid Turkey, south Africa and most Latin countries due to weak fiscal policies and large national debt.

EM Debt
To get exposure to EM debt is a tougher task. As a lot of the products out there are hedged and own mostly US dollar denominated debt. This obviously negate part of the reason to invest in EM, to hedge against the dollar depreciation. Local bond investments in Brazil, Mexico, and Poland remain attractive given relatively high nominal and real interest rates. I still did not find a product that would satisfy my criteria in this category, so I would rather accumulate EEM at this time than invest in suboptimal asset.

September 30, 2008

US Banking like Canadian Banking Now

The past few weeks, make that days, have changed the face of US banking. Banks are now concentrated in 3 powerful entities: Citi, Bank of America and JP Morgan. The three biggest banks in the country are now bigger than ever, with a combined 31% of all U.S. deposits. Bank of America leads the pack with 10.99% of all U.S. deposits. J.P. Morgan trails only slightly at 10.51%. And Citigroup ranks as the only one of the big three below the 10% cap, with 9.8% of all U.S. deposits.

Now talk about too big to fail. Those banks will never be allowed to fail and they can take all the risk they want. But expect tighter regulation by the government to make them even quasi government entities.

Welcome to the Canadian banking model, where few banks monopolize the industry. Canadian have always called for deregulation to open up banking for outside competition but the government relented. The results higher fees, lousy customer service and high lending rates.

So to my friends in the US get ready for a lousy banking model.

September 27, 2008

Value Idea: Emerging Markets

I was working on this post all of last week but Barron's today has published a similar idea you can find it here: "Emerging Markets are cheap and they're the future". It is nice to get a verification of the idea.

Emerging markets (EM) equities and debt look very appealing, debt in particular. Emerging markets index has declined more than 33% this year, while EM debt spread have soared to 300 basis points over treasuries, its spread was 170 BPS in 2007.

Investors over the past few months have scaled down their holdings in emerging market equities and debt considerably. Capital flight from these markets was due to the credit issues faced by the developed world. Investors feared that credit issues will spread eventually to the Emerging Markets. EM funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the previous five years (source: Financial times, Economist).

I think the changed perception of EM risk is an opportunity. I see that a good risk/ reward proposition is in EM, debt in particular. Although perception of risk has changed, the fundamentals do not support the increased risk due to the following:

  1. future growth is much more solid in emerging markets with less structural issues and headwinds to limit its progress.
  2. emerging markets currencies will appreciate against the potential collapse in US currency due to current and trade accounts deficits.
  3. Developed economies are facing recession and credit risks while EM are facing one headwind in global recession. EM hold surplus foreign reserves as a result their credit situation is
    much better than the US and Europe. Its ability to fulfill its debt
    obligation is not impaired

For sure emerging markets will slow down as a result of the rescission in the US; there is no decoupling ever and I am not arguing this. But the upward growth trend is not broken by the current credit crises.

First, Emerging markets economies are growing 4 times as fast as developed nation economies according to IMF. They no longer depend on foreigner to make capital investment; now they are capable of doing that on their own to spur growth.

Second, Emerging markets do not produce only cheap goods, but they have produced multinational companies that compete on the same level with developing nations companies. These companies will expand into developing economies to add markets and spurring growth. This will translate into higher job creation at home and higher wages.

Third, by the numbers emerging markets account for 80% world's population and 50% of GDP growth but only 8% of stock markets capitalization. The imbalance have to be corrected by owning more of the world's assets and occupying more in market capitalization.

Fourth, EM are cash rich and own a large portion in basic resources. As a group, they are in far better shape than ever before.
Many are commodity exporters and many commodities are at record highs.
Recently, crude oil is around $100 a barrel while
other commodities prices have also been increasing, although they came off their recent highs lately. Moreover, over the
past five years, many emerging market governments have taken steps to
insulate themselves from the effects of a global financial crisis.

EM governments are cash rich with reserves at record level. They are sitting at 75% of global cash reserves. Those reserves will support their currencies against the euro and dollar. Although currency appreciation is not the outcome those couturiers want to happen, there is no escaping it. The US dollar faces lots of head winds: ballooning trade deficits and ever increasing debt load. Treasury and the fed are continuing to pump dollars in the system debasing its value; it is astonishing that the dollar has not fell off cliff thus far.

This brings me to what will Sovereign Wealth Funds (SWFs) and cash rich countries do with this capital. The recent credit issues of US have given SWFs and cash rich countries pause and hesitance to invest in the US. These parties want to diversify away from the US to reduce their exposure. EM assets allows them to do just that, particularly EM debt.

My strategy is to be a buyer of EM debt and patient accumulator of equity, as it is highly correlated with global equity markets. I do not know when markets will recover therefore EM equities may languish a bit so I will cost average over the next little while. This strategy will provide me with the following:
  1. income as EM debt spread is high for no fundamental reason
  2. hedge against US dollar decline
  3. appreciation once investors come back to the market
  4. improve my asset allocation by increasing debt portion in my portfolio.

Now, emerging markets are trading once more at a significant discount. There
are some good reasons for this. The turmoil in states bordering Russia
suggests a rise in political risk. For example, stocks in the Ukraine
doubled in barely 18 months, but since January they have halved.

A lot of emerging markets are in the low double digit PE. Falling to single digit PE would provide very attractive entry point.The chart to the left displays that EM equities on PE basis are trading at a discount of 50% to the S&P, while debt has a spread of more than 300 basis points to treasuries. (Charts courtesy of Financial Times)

Next post I will discuss the risk associated with investing in EM also what type of instruments to use to monetize the idea.

September 21, 2008

Universal Banks | Is there a future? | The Economist

Is there a future for investment banking? | Is there a future? | The Economist:

Further commentary about the merit of supermarket banks, the one BofA trying to create with the purchase of Merrill Lynch.

"...... universal banks appear to offer clear advantages to both shareholders and regulators. Yet some of those advantages are illusory. For regulators, larger, diversified institutions may be more stable than investment banks but they pose an even greater systemic risk. “The universal bank is the regulatory equivalent of the super-senior mortgage-backed bond,” says one analyst. “The risks may look lower but they do not go away.” And deposit funding is cheaper than wholesale funding in part because those deposits are insured. Measures to protect customers may end up allowing banks to take on risks that endanger customers.

For shareholders, too, the universal bank may offer false comfort. A model that looks appealing in part because assets are not valued at market prices ought to ring alarm bells. Sprawling conglomerates are just as hard to manage as turbo-charged investment banks. And shareholders at UBS and Citi will derive little comfort from the notion that the model has been proven because their institutions are still standing. If the independent investment banks survive, they will clearly need to change. But they are not the only ones."

September 19, 2008

Update to my Portfolio

It was a very interesting week. I have made few buys and some sells, here are the highlights:

What I bought on Wednesday during the market decline:
  • I added more of Brookfield Properties (BPO) at $17.50. I think BPO has unique assets in high barriers to entry markets. I ignored the noise of higher vacancy rates due to the turmoil on the financial markets and expected layoffs from banks. The company has good management and I think buying it at this time for the long term is worth of the risks.
  • I added to the FirstService position. FirstService is commercial real estate service company that is trading now at less than the valuation one division of their holdings, which is residential property management. The company is mistook as a brokerage business and it is being punished because commercial real estate transaction are almost vanished. Sure its brokerage business will suffer but the residential business is solid. The company is being opportunistic and buying other businesses at the moment to position its business for the rebound. Its management is good and they are aligned with shareholders as they have an economic interest of about 25% of the company.
  • I have added to Haliburton option position. I am under water on the position but I think HAL has room to run here and very attractive on a valuation basis.
What I sold in today's rally
  • I sold US Bank corp into today's rally. I bought USB at $30 few months ago and it reached my valuation target I sold at $38, a return of 26% plus dividends received through the holding period. USB is very fine bank it avoided all the nonsense that is plaguing most banks today. It actually closed at 52 week high today. I think the bank is very solid with good management and focused on its core business with no ambition for empire building. But I got to get out right now on valuation basis.
  • I sold United Rentals @ $17.45. I have lost on this position as I bought it at $21. I have entered into this trade to take advantage of a tender offer the company initiated but it did not work as I intended.
  • Sold small position from my fixed income as yields have came down significantly during the panic. Prices of government bonds have went through the roof lately I am selling into that panic.
I still have a lot of cash I need to deploy but I am not in hurry. I have my shopping list and I will wait for attractive valuation, as I think we will visit some of the lows we have witnessed in the past.

Bank of America & Merrill: Brilliant or Dissaster in the making

As you may have heard BofA is buying Mother Merrill. What to think of this move?

Well, I am not enthusiastic. In the best of times large acquisitions like this have high probability of failure so I am not quite sure what is the situation in a troubled time like this. However this is far better than buying Lehman I must say.

I bought the shares of BofA because it is a retail bank with no exposure to investment banking, not a big one anyways. Now BofA is building an empire to reach all corners of US finance. I do not like the business of empire building. Just look at Citi business model of being a banking supermarket. It did not work. It was too difficult to manage and hid risks away from management.

BofA management are good and they have solid experience in integrating acquisitions. But this is an investment bank where its true assets and core competencies lie in its people and the relationship they build with clients. It is very different than a retail bank, which is about processes and customer service.Investment banking encourages the superstar while retail emphasize the system. It is a big culture clash.

I am mulling my position in BofA as I am not sure I can track it or follow it now due to the added complexity. I have not decided to sell yet, so I will keep running scenarios to the merit of the business.

Below is a good article about the marriage between BofA and Merrill that differ from all the typical media stance cheering the deal and celebrating Ken Lewis acumen of deal making.

The big question: In agreeing to buy Merrill Lynch, is Bank of America saddling itself with an unmanageable pile of toxic assets? While the potential long-term benefits for both firms are compelling, the short-term risks of doing such an enormous deal in the middle of a financial panic could end up being too much for BofA to handle.

If there were no credit crisis, the deal would appear to be a steal. For a mere $40 billion or so — the deal value has declined, along with BofA’s stock, from the initial $50 billion — BofA will be able to combine its giant retail-banking network with Merrill’s extensive network of personal financial experts. The cross-selling opportunities and the expected $7 billion in annual cost savings virtually pay for the deal.

Nevertheless, the price that BofA paid and the savings it promises to reap could take a back seat to its ability to support Merrill’s assets on its balance sheet.

BofA cannot use its large depository capital base to back up much of Merrill’s riskier assets, so it needs to be stocked and ready with cash. If BofA does not have the required amounts of capital to absorb these assets, some of which are particularly radioactive, it could find itself in the same boat as its broker-dealer rivals, begging for cash at a time when the world’s wallets are closed.

To complicate things, BofA is still in the process of absorbing the troubled mortgage lender Countrywide Financial, which it bought earlier this year. That deal will force it to put $172 billion worth of risky mortgage assets on its books. Countrywide is still hemorrhaging money and more write-downs are expected. About 35 percent of Countrywide’s subprime mortgages are said to be in default, and it could get worse.

Merrill Lynch still has $5.6 billion in subprime assets on its books, according to analysts at Oppenheimer & Company. That would combine with Bank of America’s $5.2 billion for a total of $11.5 billion in sludge. That is more subprime exposure than UBS, Morgan Stanley, Goldman Sachs and Wachovia — combined.

BofA says that the combination of Merrill and Countrywide’s assets on its balance sheet is expected to bring its Tier 1 capital ratio — a key measure of financial strength — down to about 7.4 percent. That would be the lowest of all the major financial institutions and not too far from the 6 percent mandatory level required by the government.

It could be worse: David Trone, an analyst Fox-Pitt Kelton, says he believes that BofA may have been using marks that overvalue some of its assets. He estimates that BofA’s Tier 1 capital ratio, after the acquisition, would be more like 6.65 percent if Merrill’s portfolio is marked to current market prices.

That would leave a thin margin for error, and there could be a rough road ahead.

Bank of America has billions in personal loans, credit card debt and car loans outstanding. If the economy continues to head south, more people will start defaulting on their commitments. That would burn through BofA’s loan-loss provisions and eat away at its profits. The result could be a tumbling stock price, which might require BofA to raise capital to fill the gap in its common equity. BofA could raise capital by cutting its dividend, but that would cause its stock to fall as well and send a negative signal to the market.

While other banks are deleveraging and selling their troubled assets, BofA is going the opposite direction and taking on more. If the credit crunch ends today, BofA could cross the finish line and make out like a bandit. But if it continues or gets worse, the nation’s largest bank could regret its impulsive wedding.