Archive for August, 2009

Financials Only Bright Spot in August

Kurt Brouwer August 31st, 2009

Source: Bespoke Investment Group

Bespoke pointed out in the post accompanying the chart above that [emphasis added]:

The S&P 500 rose 3.36% in August, and interestingly, only two of ten sectors outperformed the index as a whole.  As shown below, Financials drove the entire market in August with a gain of 12.86%.  The Industrial sector was the only other one to outperform the S&P 500 with a gain of 4.14%…

Third Avenue’s New Bond Fund

Kurt Brouwer August 31st, 2009

The Third Avenue family of funds is well-known for its value-oriented approach to investing.  The group’s flagship fund, Third Avenue Value, has generally been a very solid equity fund, although it had an absolutely abysmal year in 2008.

Third Avenue has been investing in distressed debt for many years in its other mutual funds, but now it is opening a bond fund that can invest in a broad spectrum of debt instruments.  Unlike many bond funds, this will be a concentrated portfolio [emphasis added].

Third Avenue Fund Seeks Value in Debt (Wall Street Journal, August 31, 2020, Daisy Maxey)

…Third Avenue Focused Credit Fund, available to investors Monday, will invest in debt with any credit rating or without a credit rating, and may invest without limitation in distressed securities or other debt that is in default or the issuers of which are in bankruptcy. It may also hold significant positions in equity or other assets it receives as part of a reorganization process.

The fund will invest in below-investment-grade credits the manager believes to be undervalued, including junk bonds, bank loans and convertible bonds or preferred stock. It may also invest in debtor-in-possession financing.

…The new fund, the New York asset manager’s first in eight years, will be managed by Jeffrey Gary, who joined Third Avenue from BlackRock Financial in June. Mr. Gary had headed BlackRock Financial’s high-yield/distressed investment team, which managed about $17 billion, since 2003. Previously, he was a senior high-yield and distressed portfolio manger at AIG/American General and Koch Industries, and a distressed analyst at Cargill Financial before that.

…The fund’s ability to invest in all areas of the credit market gives it an advantage over many of its competitors, which are limited to a narrower range, Mr. Gary said. It will focus on investing in its “higher conviction” ideas, he said, limiting its investments to a concentrated portfolio of 50 to 60 companies. Third Avenue’s research on the top 25 high-yield funds shows that they hold 350 companies on average, he said.

…Famed value investor Martin Whitman, founder and co-chief investment officer of Third Avenue, is known for buying distressed companies for his Third Avenue Value Fund (TAVFX) and co-wrote the book “Distress Investing: Principles and Technique,” published in April…

Concentrated portfolios are an excellent way to outperform, but they also tend to be more volatile than more broadly-based portfolios.  This looks like an interesting fund.

Via: Abnormal Returns

Full Disclosure: Kurt Brouwer owns shares in Third Avenue Value (tavfx) and Third Avenue International (tavix) via a company profit sharing plan

Momentum Investing & Mutual Funds

Kurt Brouwer August 31st, 2009

We have not written much about momentum investing, which is in its simplest form trend following.  Take a given index such as the S&P 500 and track it over time.  When it begins moving up, buy in.  When it begins falling, sell.

George Soros and Reflexivity

Perhaps the most famous proponent of momentum investing or trend-following investing is George Soros.  In his book, The Alchemy of Finance (Wiley Investment Classics), Soros wrote that markets are inherently reflexive.

That is, buying begets more buying until a peak is reached and then selling begets more selling until a bottom is reached. A market that is hot (say oil in early 2008) will continue to attract buyers who act under the belief that it will keep going higher and higher. A market that is cold (say financial stocks in January and February 2009) will continue to freeze out even the most patient buyers because most investors think it may keep going down. Of course, neither belief is correct. No market (such as oil) grows to the sky, but no market (such as financial stocks) falls to zero either.  Beginning in March 2009, we saw the turnaround.  All the sellers of financials had sold and some buyers came in.  Over time, financials moved up, attracting more buyers and so on.

In other words, though we do not know how far stocks or commodities will fall, but eventually all the sellers will have sold and the bottom will have been reached.  Then, inevitably, the market will rally. Similarly, at some point, the price of a stock or a commodity will falter due to a combination of weakening demand and increasing supply. Again, we do not know how far up it will go before that point is reached, but reached it shall be…

Now, Barron’s reports on a bevy of momentum-oriented mutual funds issued by hedge fund investor AQR.

Source: Barron’s

Preaching the Gospel of Momentum (Barron’s, August 21, 2020, Andrew Bary)

QUANTITATIVE INVESTMENT STRATEGIES ARE SHROUDED in mystery. Most investors don’t even try to understand them, and many practitioners won’t discuss them, fearing that doing so could cost them their competitive edge.

One of the largest firms in the field is AQR Capital Management of Greenwich, Conn. Founded in 1998, it oversees more than $20 billion, primarily for institutional investors. AQR, which stands for Applied Quantitative Research, seeks to use some of best ideas of academic finance in the real world. It applies its proprietary models across a range of assets, including stocks, bonds and currencies.

Backed by a wealth of historical data, the firm believes in often-derided momentum investing, which favors buying stocks that have been doing well, relative to their peers or the overall market, and avoiding those with poor price momentum. AQR calls momentum investing an “undiscovered style” and a better complement to value investing than growth-oriented strategies. The firm seeks to overweight cheap securities that have strong momentum and underweight expensive ones that have weak momentum. Unlike most investment managers, AQR employs no fundamental analysts to cover companies. Instead, it seeks to hone its quantitative models and develop new ones.

The firm last month started three momentum-oriented equity mutual funds.

The first, AQR Momentum (ticker: AMOMX), which invests in the third of the 1,000 largest U.S. stocks with the best total return over the preceding 12 months. It will be rebalanced quarterly. The other two funds, AQR Small Cap Momentum (ASMOX) and AQR International Momentum (AIMOX), are similar. The funds are up since their inception but trail the overall market.

Cliff Asness, one of the company founders described AQR’s general approach to investing this way in the Barron’s interview:

We use the best of modern portfolio theory techniques, not necessarily quantitative models, to help serve clients. It started back in 1994 when I was at Goldman Sachs, and they asked me to form a quantitative-research group. Where our process might have consisted of a few measures of value and price momentum 15 years ago, it now generally consists of many factors from more subtle measures of value and momentum to signals obtainable from the actions of management, short-selling activity and inventory changes for commodities. Our models form a diversified systematic opinion on what we like and don’t like in all liquid assets…

The problem with quantitative investment stratagies is that they are difficult to describe with any accuracy.  And, they are not purely quantitative, that is computer or model driven.  The managers still have a lot of leeway in what signals they follow and how they weight them.

I’m not knocking the momentum-investment approach because it makes use of very basic human psychology — the herd instinct.  As such, it can be very useful.  It will be interesting to see how well these momentum investing funds work.

Hat tip to Tadas Viskanta (Abnormal Returns) for helping me clarify the meaning of the last quotation.

Healthcare: Underestimating the cost

Kurt Brouwer August 28th, 2009

Source: Senate Joint Economic Comm.

Government-run healthcare: What will it cost?

The ironic part about the current discussions of healthcare reform costs is that proponents of the plan initially said — and some are continuing to say — that healthcare reform would save money.  Unfortunately for them, the Congressional Budget Office (CBO) pointed out that the legislation before the House of Representatives (H.R. 3200) would actually add significantly to the deficit by as much as $1 trillion over the next 10 years.

That news caused many in Congress to gulp hard, yet the CBO estimate is almost certainly low if history is a guide.  I thought it would be useful to look at how far off previous estimates from Congress on Medicare costs have been  in the past.

When Medicare was passed, various future estimates of costs were made by Congress.  Those estimates were wildly off base, so much so that it is doubtful that Medicare would have passed, had there been an accurate cost estimate.  The chart above shows the estimate for the year 1990 of $12 billion versus actual spending of $110 billion.  The $12 bill estimate was adjusted for inflation.  So, the actual costs were nine times higher than estimated.

This report from the Senate’s Joint Economic Committee gives some historical detail for Medicare and other programs:

Are Health Care Reform Cost Estimates Reliable (Joint Economic Committee, July 31, 2020, Senator Sam Brownback (R-KS)

Since the end of World War II, major health care reform proposals have generally always cost more-sometimes significantly more-than the highest cost estimates published while the legislation was pending…

Medicare (entire program). In 1967, the House Ways and Means Committee predicted that the new Medicare program, launched the previous year, would cost about $12 billion in 1990. viii Actual Medicare spending in 1990 was $110 billion-off by nearly a factor of 10.ix

A certain level of error in cost projections is to be expected, especially regarding sectors as complicated as health care. But as Table 1 shows, the foregoing examples represent extreme under-estimates, with error ratios ranging from 1.2:1 to 17:1. What explains this phenomenon? For reasons that may never be entirely understood, health care appears to be an area with great room for overly optimistic assumptions regarding changes in the behavior of patients and providers, technological innovation, the practice of medicine, program take-up rates, future health cost inflation, and the likely success of proposed cost-control mechanisms.

…Whatever the causes, it seems there is a kind of Murphy’s Law of health care legislation: “If it can cost more than the highest available official estimate, it probably will.” The House and Senate are currently considering health care reform bills that would cost in the vicinity of $1 trillionxviii over the first 10 years and $2.4 trillionxix over the first 10 years of full implementation…

Here is the table referenced above:

Source: Senate Joint Economic Comm.

As you can see from the table, this is not just a problem for Medicare nor is it a problem limited to the U.S.  For a variety of reasons, estimating costs of government-run healthcare seems to be quite difficult.  So, I would not take current estimates as being cast in stone.  In fact, I would assume they are very low as Congressional estimates have been in the past.

California Borrows $1.5 Billion for IOUs

Kurt Brouwer August 27th, 2009

The State of California just cut a deal with J.P. Morgan Chase to borrow enough money to pay back the IOUs it distributed in lieu of cash earlier this summer.  This loan is a bridge loan to get the state through the cash crunch until it can sell revenue anticipation notes (RANs) next month.  Looks like  a good deal, albeit with some serious strings attached.  In return for granting the loan, J.P. Morgan Chase gets first crack at selling the RANs.

California, JP Morgan Chase close $1.5 bln loan (Reuters, August 27, 2020, Jim Christie)

California will pay no fees and 3.0 percent interest on a $1.5 billion loan from JP Morgan Chase & Co that will provide the state with money to pay its recently issued IOUs, State Treasurer Bill Lockyer said on Thursday. The loan also will help bolster the state government’s cash as it prepares for a multi-billion dollar sale of short-term debt next month to raise money for its cash-flow needs.

“It’s a wrap,” Lockyer told Reuters by telephone. “It allows us obviously to accelerate the repayment of the IOUs and to have some cash cushion.”

The government of the most populous U.S. state issued the IOUs, which carry a 3.75 percent interest rate, to conserve dwindling cash during its recent budget crisis.

California is scheduled to begin redeeming the IOUs, issued to taxpayers owed refunds and vendors, on Sept. 4.

The state through Tuesday had issued 414,000 of the IOUs, technically registered warrants promising payment, worth $2.26 billion, according to the state controller’s office.

California will repay the loan from JP Morgan Chase after its planned sale of revenue anticipation notes next month, Lockyer said.

Wait for it.  The clincher detail is coming:

Lockyer added that JP Morgan Chase will likely play a prominent role in the note sale.

“JP Morgan Chase should get credit for being consistently supportive of state needs,” he said. “I expect that JP Morgan Chase will have a lead role with others with that financing.”…

No doubt JP Morgan Chase will be in the catbird seat for future deals with the state.

For those who are keeping score at home.  The State of California ran out of money to pay obligations to vendors and taxpayers who were owed refunds.  So, it issued IOUs on which interest is due.  Now, it has taken down a loan to pay off the IOUs, which were essentially borrowed money.  Soon, the state will issue notes to pay off the loan.

So we have IOUs being paid off with a loan, which is being paid off with notes (borrowed money).  How much has this whole fiasco cost in terms of legal fees, interest, loan placement fees on this and future borrowings?

Don’t try this at home kids.

Via: Jack H. Scaff III

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