Financial Reference

I could have a blog just documenting the material errors I read in the financial press. My biggest victim would be “Money” Magazine. While they have many good articles that should help a lot of people manage their finances, they need to refresh their economics.

This month, they made a mistake any Econ 101 student could find. In an article entitled “Landlords in Waiting” (page 62 of the September edition for avid readers), they analyze involved in whether someone should rent or sell a house they own.

Depending on the assumptions used (i.e. the increase in value of the property and assumed net income per year), after two years the rental could be -$600 or $33,940. (Of course, these are only two outcomes, neither of which will occur, but the scenarios give you an idea of how important your assumptions are.)

The author claims that if you should rent if you think you are going to clear $33,940 but sell if you think you are going to lose.

The problem with this analysis is two-fold. First, the analysis doesn’t account for the paydown of principle on the mortgage. Second, and more importantly, there is no cost of capital for the equity portion of the investment.

People rarely forget about the explicit costs of the debt associated with an investment, but often forget about the cost of the equity. In fact, the article neglects to mention what the equity investment is.

Without this information, there is no way to know what the return on the investment or net present value of the investment actually is. The investment may be good or bad (which is found by comparing the expected return to the cost of capital), but we will never know.

Blackstone, a private equity firm that recently went public, has a huge tax problem. Currently, Blackstone pays taxes at a rate well below that of most U.S. Corporations. Congress may be about to change this.

As Congress debates whether to increase the taxes Blackstone and other (public) private equity firms pay, Blackstone is not standing still. Blackstone is trying to pressure Congress into letting them keep their sweetheart tax deal.

The firm argues that increasing taxes is counterproductive. One of the funniest arguments the firm has come up with is that increasing their taxes will reduce the value of their firm, thus reducing the capital gains taxes realized by their investors.

By that same logic, if taxes on every corporation were cut, the values of those firms would go up, increasing capital gains taxes. The argument is not unique to Blackstone and the private equity industry, in general.

The reason for not letting a company pay less than it’s share of taxes is obvious. A lower tax rate is a subsidy, artificially increasing the amount of capital into that particular industry. Do we really want to subsidize private equity? I can think of many other industries I would rather subsidize.

During times of market turbulence, it is tempting to seek safety and comfort. This is often done in one of two ways: (1) through selling risky assets for safer assets (think selling stocks for treasuries) and (2) through rebalancing.

Selling risky assets and purchasing safer assets after a market drop is never a good idea. It is either an emotional reaction or the result of a need for liquidity. In either case, the reaction is the result of a portfolio that was too risky to begin with.

The second reaction is often the correct one. By rebalancing, investors can allocate more capital to segments that have recently declined more. The idea rebalancing increases diversification and can increase returns. It can increase returns because segments that have recently declined are more likely to be undervalued.

In today’s market, financial advisors are recommending investors allocate more capital to real estate, cyclical firms, and international firms due to recent underperformance. However, the recent underperformance comes on the heels of many years of spectacular performance. The recent underperformers are still overvalued.

While I encourage people to re-balance their portfolio periodically, the current recommendations are misplaced due to the fact that many of the securities recommended are still grossly overvalued.

I have this vision for my bedroom - brown walls, white molding, hardwood floors, custom made curtains (made by myself), beautiful light fixture…

Of course, this is the product of watching too much HGTV, TLC, and the occassional decorating/house flipping show on Discover. It’s a problem. Every show has some gorgeous finished product that I would love to have in my own home. It wouldn’t really improve my life, but these show always lead you to believe that you’ll be calmer, more organized, a better hostess…

I painted by bedroom over the past couple of weeks and I’m in the midst of a quilt that will complete the bedding portion of the vision. However, all the other improvements would take large capital investments. I tend to be cheap (let’s say frugal) and Brian’s frugality makes me look like a spendthrift, which means that the larger projects won’t be happening any time soon… or ever.

Of course, I try to internally justify home improvement projects by thinking of increased value of our house. Surely putting hardwood floors in the bedrooms or tile floors in the bathrooms would improve the overall presentation our house would make when we sell it. But then there’s the question of when, if ever, we are going to sell our house. The home improvement shows would tell you that if you put in a $10,000 deck, you’ve increased the value of the property by $20,0000 - instant profit. Of course, some of the profit comes from doing the work yourself.

Then there’s the enjoyment that I would get from having a perfectly decorated bedroom. When I’m honest with myself, I think about the piles of clean and not so clean clothes that are always scattered all over the bedroom, the layer of dog hair that even a twice a week vacuuming regimen wouldn’t contain and toddler that tears through the room without regard for anything fragile (which is why there is nothing fragile in the room, or any other room in the house).

In theory I should stop watching these shows, but in the end, I’m sure I won’t. There’s nothing wrong with ideas. As long as the price tag stays reasonable.

As a value investor, I’m always looking for ways to exploit opportunities presented by other’s fear and greed.

Obviously, the major current fear concerns any company in the housing sector. In particular, mortgage companies are feeling the brunt of the pessimism.

I thought I found a good candidate in Thornburg Mortgage (Ticker: TMA), but before I could do the necessary research, the price of TMA recovered enough for me lose most of my interest.

Before I lost interest I found some juicy tidbits — more fun than any investment opportunity.

While most people thought they were buying a safe Real Estate Investment Trust (REIT) they were in fact purchasing something more like a hedge fund. Or, at least incurring the fees of a hedge fund.

Thornburg Mortgage is managed by a separate company. The management company has has a sweetheart contract. It boils down to a hedge fund management contract for managing a very leveraged mortgage REIT. The management fees are 1% of assets and 20% of profits (above LT treasuries +1%) — a hedge fund fee structure — plus expenses, plus long-term incentive compensation.

To say this is a sweetheart contract understates the contract. To increase fees, all they have to do is keep issuing shares — which they do on a quarterly basis, diluting current investors.

While the company still sells below book value, go into any investment with your eyes wide open. You would be paying hedge-fund fees, you should expect the same performance.

With all the volatility in the market, it’s good to remember the parable of Mr. Market. Created by the father of value investing, Benjamin Graham, Mr. Market is a reminder of how we should act in turbulent times.

As the story goes, Mr. Market is a very accommodating partner who, every day, shows up and offers a price at which he will purchase your interest in the partnership and sell you his interest in the partnership.

However, Mr. Market is a very emotional person who changes his appraisal of the company based on his mood. In a good mood, he will offer an extremely high price; in a bad mood, he will offer you his shares for a pittance.

How would you transact with Mr. Market? Would you sell to him when he offers too high a price and buy when he offers too low a price? Or would you, like so many market commentators, fall under his spell — letting your own emotions rise and fall with Mr. Market’s bipolar tendencies?

The easiest way to take advantage of Mr. Market is to figure out how much you think something is worth and compare it to Mr. Market’s price. If there is a large difference, buy or sell.

I know, who doesn’t want to read a blog called causation? It sounds like something your logic/statistics professor was talking about while you were nursing a hangover. But there are practical applications of the concept.

In the August issue of Money Magazine, they build some conclusions from a specious relationship. And even if you didn’t pay attention in class, thanks to fluffy magazines, you can get a refresher in logic every month.

Here is their blurb (Money, August p. 24):

Maybe Older Really is Wiser

More evidence that seasoned managers do it better: A recent Standard & Poor’s study found that while the average tenure of a domestic fund head was 5.5 years, those who led funds performing in the top half for the past five years had been with their firms 8.6 years.

If you think about this statistic for a second, it makes perfect sense. Are over- or under-performing managers likely to stay around longer?

The answer, of course, is obvious. Maybe, it’s not older managers that have higher returns, it could be that the managers with higher returns keep their jobs. Not exactly a huge logical leap in an environment that rewards short-term performance.

The next time a magazine quotes some data that shows a correlation (i.e. A and B are related), and assumes that A causes B, question their logic. It could be that A causes B, B could cause A, or something else (say, C) causes A and B.

In this case, it is obvious that returns (B) would be the major cause of tenure (A) rather than the other way around.

Private equity and hedge funds are making it really hard to love them. Most funds charge huge fees, both as a percent of assets and as a percent of returns, for managing client assets.

They argue that the fees are justified by the performance of their funds. For some of them, the fees may be justified, but for others they clearly are not. The problem is that it is nearly impossible to know whose fees are justified until it’s too late. Until the tide goes out, as it is currently with the subprime mortgage mess, there are very few ways to know who is naked.

Managers argue that incentive fees align their interests with the interests of investors. Presumably, without the huge performance bonuses, they would be satisfied with mediocre returns.

I have a better idea: managers should have their own capital in the funds. This will provide a similar incentive and cost investors nothing. I’m confused why investors should have to pay for the managers to take an interest in what they are doing. Especially when increasing returns should already line their pockets by (1) increasing the value of their own interest and (2) would help them attract more capital and therefore more fees.

On the one hand, managers argue that they need this performance-based system to encourage them to do a better job. On the other hand, they argue that it is not a performance-based bonus and should be taxed like capital gains. It’s hard to empathize with them when everyone else’s bonuses, from the relatively (relative to fund managers) lowly CEOs to mid-level managers, are taxed as income.

Their argument against treating their bonuses as income is that any increase in their taxes will be passed on to their investors, in particular pension funds. So, the argument goes, if you want to hurt the average American worker, increase our taxes.

Like I said, it’s hard to love them. They charge excessive fees because without them they wouldn’t try. They need the high fees to care. In addition, if you increase the taxes they pay, they will make the average American worker worse off. They are, in effect, holding the average American worker hostage to convince Congress to keep giving them preferential tax treatment.

My wife and I have been exploring the idea of one of us going part time. With our second kid on the way and my investment business growing, it seemed like a good time. That is, until we reviewed our budget.

I took great pride in having a good understanding of our finances. I thought I knew how much we were saving every monthand what our balance sheet should look like months from now.

So, it came as a big surprise to me a couple days ago when I realized my estimates were completely wrong.

We figured this out after we put our financial transactions into Quicken. It was hard to imagine we spent so much for our cars ($200/mo. for gas and oil changes), energy ($150/mo.), and “household” ($300/mo.).

The biggest surprise was household. I didn’t even realize it was a category — we spent WAY too much at Target, IKEA and Costco.

As skeptical as I was that Quicken would help us manage our finances, it seems to already be making us think more about where we can cut back and save more. Currently, including the repayment of principal, we save about a quarter of our pre-tax salary. But, after reviewing the summaries on Quicken we should be able to find more fat to cut in our budget so we can get to our goal sooner.

Even if you think you have a good handle on your finances, and even if — like us — you are saving a reasonable amount of your salary, it may still benefit you to look at purchasing Quicken, Money, or some other financial software to help locate areas you could improve your spending.