Financial Reference

While stock markets overall are reaching new highs, the past quarter has been eventful. The beginning of the end for the real estate bubble is leading to a general credit slowdown across all parts of the economy. While passive long-term investors can still sleep easy at night, the current environment is turning into a disaster for some well-paid finance geeks.

First, the mortgage debt used to finance the real estate bubble also financed many financial alchemists. The companies that originate mortgages aggregate a large number of mortgages together (or sell them to another company that aggregates them) and sells them into a company whose sole purpose is to hold the debt.

Once these mortgages are aggregated, the cash flows are very predictable, assuming there is no shock to the system. The problem right now is that there has been a couple shocks: a decline in the price of housing coupled with a huge rise in the use of exotic mortgages. The current crisis is having a huge effect on the mortgage issuers, aggregators, and trading desks, mostly effecting banks, investment banks, and hedge funds.

Second, the mortgage crises has led to a general credit/liquidity crisis. It is harder for less than ideal debtors to finance their companies. It’s not that creditors are now being stingy — it’s just that debtors were used to easy money. It’s similar to the problems in housing — companies were able to get financing, even when they couldn’t afford it.

Now that markets are returning to sanity, many of deals struck before the bubble burst are now being renegotiated or scuttled. The main effect of this will be to decrease the leverage used by private equity firms to take firms private, decreasing the potential returns and number of deals completed. This will be partially offset by an increase in strategic mergers — or companies buying rivals, suppliers, and users.

In the final tally, this quarter’s events were substantial for certain segments of the economy but could hardly be felt by a conservative investor with a conventional mortgage. While it remains to be seen how much the real estate and liquidity crises will reverberate throughout the economy, my own feeling is that the damage will be largely contained in select corners of the financial markets and, of course, to homeowners with exotic mortgages.

Despite the constant use of the word crisis the quarter, most long-term investors may not remember this quarter in a year.

I have historically used credit cards extensively to finance a portion of my stock portfolio. But now, credit card companies are making it harder to arbitrage.

In the past, I would receive cash advance offers for 0% financing for at least a year, with usually a $50-$100 transaction fee. It was easy money to take that money, invest in a money market or stocks and lock in some attractive returns.

Lately, however, the offers haven’t been as kind. I’m not sure if they caught on to my money making machine or if interest rate increases or credit defaults have made the companies reign in their offers.

In any event, I would like to roll over some cheap financing but am finding most of the offers lacking. At least I should have the cash to pay off any debt coming due. But I am going to miss the free lunch.

It’s so easy to figure out the cheapness of a stock. All you have to do calculate the P/E ratio by dividing the price of the stock by the earnings per share. Right? If only it was that easy…

Even though many well-regarded newspapers mainly limit themselves to the P/E ratio and the projected growth rate.

Many stories read like this, “HP trades at a forward P/E multiple in line with IBM and several points cheaper than Dell. This is a bargain of a growth technology company with the Price-Earnings-Growth ratio now under 1.”

In other words, all you have to do is compare P/E ratios — either current or forward (projected one year forward) — and you can figure out what is cheaper.

The problem with the raw P/E ratio is that it is overly simplistic. For example, the $14 billion in cash on Dell’s balance sheet is not accounted for in the ratio. If we account for the cash on the balance sheet, by taking out the interest income from income and the cash from the market cap, the adjusted P/E will show a much more accurate picture.

While this calculation is only the beginning of the analysis, it is an easy adjustment to make and can make a huge difference in the analysis.

(Disclosure: I own Dell but do not own any of the other securities mentioned)

Today, Hillary Clinton unveiled a universal health care plan. The first of many health care schemes that will come out of this election. While I support a reasonable solution to our serious health care problems, I am nervous that we will end up with another half-baked policy that will make our health care system worse off.

While it may seem hard to imagine that we could be worse off than we currently are: we have an increasingly large uninsured population, relying on expensive ER services for their primary care. Hospitals are increasingly at risk of going under because they have to provide services to those who can’t pay, while they are having their profitable services cherry-picked by specialty providers.

We have a government-funded services (Medicare and Medicaid) that already can’t be funded by the government. If we expand the government’s role, are they going to start accounting for these liabilities?

On the other hand, an increasing government role could improve some problems. Insurance and medical services are increasingly expensive. This is partially because people who pay their bills are subsidizing those who can’t or won’t. Making insurance mandatory should decrease the losses experienced by providers and drive down costs.

While I support decreasing the cost of health care by making insurance mandatory, I have some reservations about the politics of health care. My main reservation is how any program is going to get funded when the government can’t even fund it’s current medical obligations.

We have gone from the best of times to the worst of times — at least in terms of volatility. The market, at least in terms of the Dow Jones Industrial Average, has seen 200-300 drops become common. However, for most of us, this news should be on page 9 instead of the front page.

For most of us, the recent volatility is a non-event. The market is still solidly higher in the last six months. And therefore we should be better off than we were six months ago.

However, volatility does hurt some investors. The following is a list of some people who may have been hurt:

(1) Investors with a weak stomach. If you are likely to sell based on volatility, volatility does indeed hurt.

(2) Investors with too much leverage. Think hedge fund investors who are being forced to redeem their investments as their prime brokers became more risk averse and their positions move against them.

(3) Investors with a cash crunch. If you need to access your portfolio for living expenses, you may have been forced to cash out some positions at inopportune times.

(4) Investors with short term goals. Many people who invest other people’s money fit into this category. Short term goals come at the expense of long term results. The past few months, hedge funds have been seeing record redemptions.

In the long run, the volatility we have recently been experiencing is a non-event. While it can be emotionally painful to see the price of your portfolio change so drastically, the volatility should not effect the value of most of our portfolios.

Two months ago, I blogged about a company called Tubearoo, speculating that it may be bankrupt by early next year. (See the original blog.)

I complained that I could not short the stock, as it had no operations and debt coming due — not exactly a promising combination. The stock can not be shorted because it is traded over-the-counter.

When I wrote the article two months ago, the stock was trading at $2. Today, it sells for $0.50. I expect that this is only the beginning of the end for this stock. By next year, it will likely be worth even less.

Hedge funds offer a service. A most valuable service to be sure. Generally speaking, they offer the opportunity to profit in all types of markets. The idea is to profit, even when everyone else isn’t.

And it all worked…until, of course, it didn’t. Apparently, “all types of markets” doesn’t include the exact time a hedge is useful — when everyone else is hurting.

In fact, their excuse is that all of the other hedge funds are being forced to liquidate the same securities they hold in their portfolios. Their performance is not their fault — the problem is that everyone else has the same securities as them.

So what happens when they have good performance? Did they just front run other hedge funds?

In addition, if all of the funds hold the same securities, what are investors paying for? Is it really worth it to pay 2-and-20 for a common strategy?

“When you do not know a thing, to allow that you do not know it — this is knowledge” –Confucious

One of the biggest enemies investors face, is overconfidence. It doesn’t seem to matter whether the investor is professional or novice, one of the hardest things to admit is that you don’t know something.

Nearly all investors are confident in the direction of the economy, interest rates, stock markets, and even individual securities. Surprisingly, the returns of these overly confident investors often lag the comparable indexes.

So, what went wrong? After all, given their level of confidence, wouldn’t you expect them at least to earn a return equal to their benchmark?

The problem most investors face is not their knowledge or lack thereof, but their overconfidence. Investors that “know” exactly what is going to happen trade too much, trying to take advantage of their superior “knowledge.”

If investors would just admit to their lack of knowledge, they would be better off by sticking to their core competencies.

For example, my core competency is being able to perform a reasonable valuation of individual companies. I can not predict where the economy is heading, where the price of securities are going in the short term, where interest rates are heading, or what the next big thing is. So I don’t pretend to know what is happening in these domains.

As an investor, it helps to figure out what your core competency is and exploit that. Effort spent satisfying your ego by researching areas in which you don’t add value, is pointless. Knowing what you are able to do is something every investor should spend time figuring out.