Financial Reference

Given a choice, investing in a non-financial company that uses little debt is much better than investing in one that uses debt extensively. But it’s hard to create a simple rule for the amount of debt a company should use.

In Brandes’ book, “Value Investing Today” he uses a general rule of not investing if the level of debt is greater than 100% of tangible equity. Like any other rule with regard to the correct level of debt, this rule is a huge oversimplification.

First, financial companies use a tremendous amount of debt in their operations and should be evaluated against a much different target. The industry in which the company operates matters a great deal when evaluating the debt level of a company.

Second, tangible equity is an accounting idea only. It does not reflect the actual value of the company. The value of debt should be compared to the value of equity which is better reflected by market values than accounting values.

Third, debt should be adjusted for other debt items not reported as debt on the balance sheet. Capital leases and net pension liabilities, for example, should be added to the debt on the balance sheet to get a more realistic estimate of a companies debt level.

While the level of the debt used by a company in it’s operations should be closely evaluated because debt adds risk and can disguise low returns from operations, the evaluation of a companies debt level should involve more than a quick glance at their balance sheet.

Free markets are great, in theory. In practice, they are much closer to good.

The idea is that free markets allow people to advance their own self-interest, which in turn advances society at large. While this theory is oft-quoted and works better than other systems we have come up with, the truth is more complicated.

Free markets do not form in isolation. A series of laws creates the market. These laws can act as constraints or can encourage inefficient outcomes.

For example, making one form of compensation tax deductible (or off-balance sheet) in the case of base compensation under $1 million (or stock options) can create sub-optimal compensation schemes. These two pieces of the tax code encourage the use of options and discourage high base salaries. In other words, the equilibrium reached in such a market may not be optimal.

Recently, I experienced firsthand a law that created some perverse incentives. I was in Minneapolis this weekend for a wedding. The rehearsal was supposed to last until 3:45 but ended up lasting until 4:10. The problem was that my parking spot was only legal until 4:00.

As my pregnant wife walked out to our car with our son, a tow truck driver looked at them as they tried to stop him and drove away. My son’s car seat, diapers, and medicine were in the car. Needless to say, this was a costly inconvenience for us and could have been much worse. All because we were parked in a spot ten minutes over the limit!

After talking to the towing company, other stranded motorists at the impound lot, and the workers at the impound lot I pieced together the problem. Tow companies are paid based on the volume of cars they bring to the impound lot and they can only tow a car once a ticket has been issued. At least three of us stranded at the impound lot, including me, received a ticket and got towed within ten minutes.

It’s obvious what is going on here: Tow companies are following around ticketing officers and loading as many cars as they can as fast as they can. But do we really want people to be towed if they are parked ten minutes over the legal limit? It seems to me that the punishment does not fit the crime.

The problem is that the incentives created are encouraging an inefficient process. First, extra resources are wasted by creating excessively large towing and impound industries. Second, the people without cars have to find a way to reach the impound lot. Third, had my wife not seen the tow truck I probably would have wasted police resources assuming my car was stolen.

In short, it more efficient for people to be ticketed for minor violations of the law. Confiscation of property should be reserved for gross misconduct. In English, if you outstay your legal rights by a couple minutes you should receive a slap on the wrist; if you blatantly disregard the law, then other more dramatic remedies may be useful.

It is easy to see how this market, created by a legal structure, is far from optimal.

It’s surprising to think that people think that the markets are efficient. After all the bubbles and crashes, all the fortunes won and lost, people still think one security is as good as the next.

If markets are efficient, then there should be no excess returns. That is, after adjusting for risk, every stock should have the same expected return. The problem is, they don’t.

Usually, people try to disprove this theory by finding people who beat the market. While those people can be found, it is more instructive to look at the ones that fail. If markets were efficient people should get the same risk-adjusted return before transaction costs and taxes. However, that’s not what we see.

People have a tendency to buy high and sell low. The returns people earn on their investments often trail the return they would earn by not trying to time the market by even more than transaction costs would suggest.

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.

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.

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.

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.

I thought that it goes without saying that past results is no indication of future results. But, as is too often the case, I am disappointed and wrong.

In fact, a much worse “analysis” in the WSJ made me go nuts today. The “Act One” column asked financial professionals what people in their 20s and 30s should do with $2500. Normally, I skim pass such articles, but I found myself, for some crazy reason, skipping instead to the end of the article.

At the end of the article, they compare what would have happened if you would have “invested” the money in certain specific investments. Unreal! So the “best” investment is the one that already gave good returns. Wouldn’t it be nice if we could all invest like Marty McFly in Back to the Future!

Not only is the article apparently advocating using past results as a proxy, but it also gives credit for past returns. What a wonderful world it would be…

It’s hard to know where to start after such a long break from writing. Since I last wrote my wife has changed jobs, we bought a house (no, not the house we we talking about building in earlier blogs — more on that later), we bought a dog (from the local humane society), we went on vacation to Europe (my first time), I passed the third and final CFA exam, and I started an investment partnership. Needless to say, we have been very busy. It appears that things are finally settling down and I will again have time to blog.

In the meantime, there is a new link on the site, to CramerWatch.org. While I would never support a site dedicated to a maniac screaming “booya” instead of doing real analysis, I love a site that compares a Harvard grad with a monkey. (Maybe it’s just my lesser, public school, upbringing.)

A very long but good list of the top 100 April Fools Jokes. Nothing to do with finance, but even finance dorks have to have fun every once in a while.

http://www.museumofhoaxes.com/hoax/aprilfool/