Friday, December 26, 2014

“It's a Wonderful Life” versus "The Interview"

Get serious

Washington and media are all aflutter about Sony's movie "The Interview."  One has to wonder what they are thinking.  No one has ever represented "The Interview" as worthy of serious minds.  Of course, at this point nobody who's talking about it has seen it.  So naturally, they can speak with authority about the political and social implications of the movie’s setbacks.  Such is the thinking of Washington and the media.
One doubts whether anyone, in Washington, the media, or the general public, thinks, even for a minute, that they would be better informed if they were allowed to watch "The Interview."  By contrast, ever since the very first posting on the Hedged Economist, at about this time of the year “It's a Wonderful Life” has provided a source of wisdom relevant to Washington and the general public.  Perhaps, rather than fretting about "The Interview," we should insist that policymakers take a break and go watch “It's a Wonderful Life.”
Just perusing the WALL STREET JOURNAL on December 20th provided two good examples of instances where “It's a Wonderful Life” would have provided policymakers with guidance they clearly need.  As we all know and are constantly reminded by the media, about six years ago we had a liquidity crisis.  Since we haven't had a change of administration since then, we still have a lot of people in Washington running around like chickens with their head cut off trying to fix whatever led to the last liquidity crisis.  Alas, they seem to have learned nothing from the actual experience of that crisis.  So, my hope is that if they view “It's a Wonderful Life,” the experience may help them to understand what happened.
The news is not encouraging.  For example, one of the lead stories on the 20th was “Bank Bailouts Approach a Final Reckoning.”  It summarized the experience of the Treasury as it completed the sale of its last holding from the assets it acquired during the financial crisis bailout program.  One has to love the media that can describe an investment that makes billions of dollars as a “bailout."  It would seem more realistic to refer to it as a low-risk, low-return investment for the Treasury.

To quote the above article: “The U.S. government closed a chapter in financial-crisis history Friday when it sold its remaining shares of Ally Financial Inc. and shuttered its auto-bailout program, ending the last major pieces of a $426 billion rescue package that saved a swath of U.S. companies but never won public support…. netted a small profit, returning $441.7 billion on the $426.4 billion invested in firms.”
“It's a Wonderful Life” contains a classic scene of the impact of a liquidity crisis.  While in the 21st century their form will change, in the 19th and 20th centuries they took the form of bank runs.  Bailey Building and Loan experiences a bank run.  When George Bailey decides to turn back from his honeymoon and go to the Building and Loan to manage the run, he finds the crowd there waiting for their money.

It seems that Washington wants to join the crowd in the lobby at Bailey Building and Loan.  First, remember when TARP was initially raised in Congress, Congress voted it down.  As circumstances would have it, I was on vacation and watching it with a friend as the vote was taken.  My comment at the time was that just the act of voting down TARP would extend the recession by a couple of years.  The vote would have to be reversed, but it was the sheer folly of Congress’s failure to address the “crowd in the lobby” that would extend the recession.  
As has been pointed out by Mr. Obama and Mr. Bush, TARP helped avert an even more severe recession following the financial crisis.  But, by demonstrating their collective ignorance, Congress raised serious doubts about whether that objective would be achieved.  That kind of uncertainty assured that the financial crisis would be deep and have lasting effects.

That's history.  Perhaps Congress has learned from its experience and realizes there is a role for a lender of last resort.  However, I wouldn't recommend getting one’s hopes up.  It seems Congress missed the little back room conference between Uncle Billy and George Bailey.

When George enters Bailey Building and Loan during the panic, he finds Uncle Billy a bit distraught.  Uncle Billy takes a strong drink and pulls George into the back room where he explains, between stammering that “we’re in a pickle,” that the bank called their loan and has drained their entire cash position.  Congress and a number of our national figures seem to have missed the point.  They believe that the Federal Reserve Bank's efforts to provide liquidity during the financial crisis put Wall Street’s interests ahead of Main Street’s.  Perhaps, Congress thinks it would be good to have such loans called. So, Congress outlawed future taxpayer bailouts as part of the 2010 Dodd-Frank law.  One can't find a stupider law or one that will do more to impede the response to the next liquidity crisis.

Since Congress reversed itself on the TARP vote and will come to recognize the stupidity of placing obstacles in the way of future responses to liquidity crises, what's the harm?  Well, as “It's a Wonderful Life” illustrates, liquidity crises are temporary, ephemeral phenomena.  Once George meets the liquidity demands of the first depositor, he then asks the next depositor what he really needs.  The response is $20.  Clearly, with the simple act of demonstrating the folly of the demand for liquidity, George has shifted the mental state of the depositors from one of panic to a more rational focus on what they actually need. 

If George had to wait for Congress to recognize the liquidity crisis before he would meet withdrawal requests, Ms. Davis would never have asked for only $17.50 and Bailey Building and Loan would have failed.  Alas, because Congress will have to scrap the Dodd Frank restrictions on bailouts before liquidity can be injected into the financial system; Congress may have ensured that there will never be a Ms. Davis.
Many of national leaders didn't realize from the start that the so-called bailouts would make a profit.  They didn't hear Bagehot’s advice echoing across the centuries.  Bagehot’s advice, “to lend freely against good collateral during times of financial crisis and you always make a profit,” has been demonstrated to be successful over centuries of experience.  But perhaps, if our leaders can't learn from history and can't learn from the recent financial crisis, they will learn from watching “It's a Wonderful Life.”
Mary and George recognize a liquidity crisis, identify the opportunity to invest, and as a consequence they save Bailey Building and Loan.  More important than saving Bailey Building and Loan is the fact that their action saves their borrowers from foreclosure and results in a wonderful life.

However, as the article notes: “Criticism has persisted that TARP put Wall Street ahead of troubled borrowers whose housing woes were at the root of the crisis….Less than $15 billion of $75 billion promised for homeowner assistance has been spent.”  It is worth noting the subtle change in terminology associated with that quote.  Note that the author presents the $75 billion as “promised.” That's quite different from the terminology used when discussing other parts of the bailout.  The difference between a guarantee to pay and a promise to pay is important.  A promise is much more likely to be viewed as an obligation that must be met while a guarantee is simply a promise that the obligation will be met if needed.
When discussing TARP loans to banks, one should remember that the Congressional authorization was over $700 billion.  The article reports the actual use of the lower expenditure, $426.4 billion.  One can get lost in the details of the accounting, but clearly the cost of TARP would have been far greater if the Fed hadn't essentially guaranteed liquidity.  Witness how European markets responded to the simple statement of their central bank that they would do “whatever is necessary." 

“It's a Wonderful Life” is more subtle as an explanation of why bailing out the banks worked but mortgage relief wouldn't.  One has to remember that many of the people clamoring for mortgage relief didn't lose the equity in their home.  They never had any equity in their home.  One can't lose something one never had.  By contrast, George Bailey can pay the first of his depositors and insist that it is just a loan, because he knows that the depositor has good collateral, the equity in his home.  Similarly, the TARP loans to the banks made sense if they were backed by good collateral.  The fact that the vast majority of the loans were repaid with a slight profit indicates that the collateral was good.  What collateral could underwater homeowners provide?  Using that simple criteria the Treasury lent to banks against good collateral, and as consequence, they were repaid.
That the Treasury demanded good collateral is apparent from the fact that some of the same people who criticize the Treasury for "giving" banks bailouts also complained that it didn't demand enough from the companies.  The contradiction doesn't seem to bother them.  For example, the article quotes Christy Romero, the TARP special inspector general,  as complaining, dare I say whining, that the Treasury did not get concessions from banks taking funds. “There were no strings on the money,” she said.  Perhaps, she forgot what happened when too many concessions were demanded from Lehman Brothers.  One has to wonder at the audacity of those who can feel that the intervening six years have not influenced their perception of the value of the collateral.

There is considerable potential for fault when it comes to the terms banks were forced to accept under TARP.  Bagehot makes the point that during the crisis the lending should be done at usury rates.  It's a legitimate argument that interest and a claim on future earnings in the form of a warrant wasn't adequate usury.  However, one has to wonder whether those complaining about banks receiving the loans would have been willing to accept similar terms.  It's also well worth noting that many banks wanted to opt out of the program.
Nevertheless, one has to admit that attaching a value to collateral during a financial crisis is a difficult task.  It's well worth noting that George Bailey when bailing out Bailey Building and Loan doesn't bother to try.  He does recognize that Potter’s offer of $.50 on the dollar is a disservice to his shareholders.  Potter has just taken over the bank at this point in the movie making him the perfect evil banker for the rest of the movie.  Perhaps, those who criticize TARP as not having inflicted enough pain on the banks view themselves as modern-day Potters.  The point is George Bailey is proved right in that $.50 on the dollar might clear the market but it hardly is justified once the liquidity crisis passes.

A second article in the Wall Street Journal on December 20th illustrates why this will always be a contentious point.  The article entitled “MetLife Vote Wasn’t Unanimous” discusses the decision of the Financial Stability Oversight Council to give the insurer the “systemically important” label.
Insurance does have a role in “It's a Wonderful Life.”  It is the asset (i.e., collateral) that George Bailey can offer to Potter when George is desperate for liquidity because of a lost deposit.

The Financial Stability Oversight Council’s reasoning is designed to explain their interpretation of “systemically important.”  It reveals much more.  It makes clear why regulators are totally unable to assess collateral during a liquidity crisis. 
So, one is left to wonder: what is the concern?  How could MetLife become systemically important?  The Financial Stability Oversight Council cites as reasons for the designation “the scale of MetLife’s investments and also the extent to which the value of that portfolio can fall.”  In other words, they're using mark-to-market accounting during a financial crisis.  Nothing could be less appropriate, unless, of course, they are going to force mark-to-market accounting on MetLife at a time when it's totally inappropriate.  If that's the case, it is the Financial Stability Oversight Council that presents the systemic risk.  Unfortunately, that seems to be the desire of many of the people who complain that TARP didn't impose sufficient costs on its recipients.

In summary, perhaps the next time Ron Paul or Elizabeth Warren are tempted to go into one of their rants about the evils of the bank bailouts they should instead take a deep breath, go to a quiet place, and watch “It's a Wonderful Life.”  The only thing that would be better would be if instead they would restrict their comments to the evils of Sony's decision concerning "The Interview." Wouldn’t that be a wonderful Christmas present?


Wednesday, December 17, 2014

Oil Prices

So, a simple question is what do we now do with cheap oil?  What to sell?  What to buy? 

I would suggest buying gasoline but only if the needle on your dashboard gets close to E. 

The widows and orphans portfolio that was posted on this blog a couple of years ago included Exxon and/or Chevron.  The logic behind holding them is that the dividends would be superior to what one could get in a savings account and would grow faster than inflation or rising interest rates.  The logic still holds.  So, someone who owned the widows and orphans portfolio would not do a thing.  On the other hand, if someone were constructing a portfolio, the current price of Exxon and/or Chevron would present a good entry point. 

As commentators have pointed out, the Saudi's might continue supplying enough oil to keep prices down, what they refer to as “a big sweat.” They have done it before in order to drive out higher cost producers.  If they do, Exxon and Chevron's stock could go down more, but their current prices looks good.  Exxon and Chevron will not be the producers that the Saudi's drive out of business.  It is very unlikely that the Saudi's will even be able to force them to cut dividends.  For a very good analysis of the issue of the dividend safety of various oil companies I'd recommend “Which Big Oil Dividends Are Safe?” published today on

There is one wrinkle.  US is now the second-largest oil producer.  A fair share of the high cost production the Saudi's are targeting is in the US.  Today General Electric outlined the effect of lower energy prices on its energy divisions.  We should anticipate more of those secondary effects on firm supplying the energy industry. 
ECONOMIST magazine had an interesting cover two weeks ago.  The title was "Sheikh vs shale."  It showed a picture of a sheikh and a roughneck standing back-to-back with their gas pumps drawn.  It is an interesting concept.  Shale producers are in many respects the swing supply.  However, unlike the high-cost producers of the past, shale production does not require a huge upfront fixed cost to develop the field.  In addition, although shale may be the swing production, it is not necessarily the highest cost production.  Consequently, shale production can gear up and down fairly easily.  Highly leverage producers may go under and have to sell their fields to that less leverage producers during periods when the industry is gearing back.  But, if prices go back up, those less leverage producers will quickly restore production.

If prices stay down long enough to reduce the drilling activity in shale fields, it may also cause extreme duress for other higher cost producers.  The Canadian tar sands are clearly vulnerable especially given the one-two of the Saudi's unwillingness to support prices and environmentalists success at delaying increases in efficiency of the transportation sector that would allow their production to reach global markets.  However, the greatest risk to the global economy may result from governments that own or have strong links to producers.  That affect is already shifting foreign exchange rates.  The Russian ruble has been an early casualty, but the risk to Venezuela, Nigeria, and to a lesser extent Brazil and Mexico are very real. 

The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.  Today PIMCO’s emerging-market fund is showing the stress caused by significant holdings of Russian bonds.  We should expect more of that.  In fact, a default by one of the government's that has nationalized its oil resources, and thus the risks associated with energy production, is not out of the question.  It is worth keeping in mind that the vast majority of oil reserves are owned by governments.

There will also be many winners and losers among European companies that export to Russia.  For US investors in US corporations, exports to Brazil and Mexico may be more important than Russia or Venezuela.  However, the major risk is not from slower exports.  One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.  That is a far greater risk for European banks than US banks.  However, some US banks, such as Citi, are so global, and the banking system of the developed economies are so linked, that financial dislocation is not out of the question.

Tuesday, March 11, 2014

Does Algorithmic Trading Make Sense for Small Investors?

Should the small investor play Wall Street's game?

Jason Zwieg’s column, The Intelligent Investor, is always interesting.  His book YOUR MONEY AND YOUR BRAIN is a delightful read, both interesting and informative.  The column in the March 8 WALL STREET JOURNAL entitled “The Incredible Shrinking Management Fee” was a good report on a new type of asset management company.  However, it left much to be desired if it was intended as a presentation of the phenomena for potential investors. 

First, the subtitle, “If a new company has its way, the cost of portfolio management could be zero,” reflects the problem.  The article discusses the number of companies, including WiseBanyan, Betterment, and Wealthfront that bill themselves not as portfolio management, but as investment advisers.  One thing to note is that Wealthfront does not seem to be a fiduciary.  The article contains no reference to whether Betterment or WiseBanyan are fiduciaries.  In other words, they do not have a legal obligation to act in the investor’s interest. 

They have a business obligation to do so, but not a legal obligation.  That is true of most investment companies like mutual fund companies, but it is unusual for someone who is taking financial management responsibility not to be a fiduciary.  Turning over asset allocation decisions to a financial manager who is not a fiduciary should make an investor uncomfortable.  However, there are some mutual funds that retain some asset allocation control, and The Hedged Economist has invested in and has recommended some of them when they were appropriate for an individual investor.   They were, however, well-established companies with a track record.  Further, they are explicit about limitations on the variability of the asset allocation.

The second thing to be aware of is that these companies are venture-capital financed.  The Hedged Economist has nothing against startups and has invested in over half a dozen at various times and currently has positions in three.   They have been the subject of a number of postings addressing topics ranging from the important roll they can play in diversification to how they are affected by regulation.  (The most recent posting on the topic was entitled “Angels and friends. When it rains, it pours.”  It provides links to most of the other postings on startups.)

The important thing to remember about startups is that the majority of them will not survive.  Some will go bust, some will just return investors’ money, some will be ho-hum investments, but it is the return on the remaining ones that justifies the investments.  If one in 10 is very successful that is good because they are owned directly by the investor.  So, the one in 10 can return enough to offset all the others. 

Investing through a startup as opposed to investing in a startup is a different story.  There is no potential for that really big payoff if the company is successful because the investor does not have an ownership stake in the company.  At the same time, if these startups do not succeed, that could have implications.  These companies are entering a very competitive industry.  So, it is important to be extremely confident about the success of the business model and the individual company which the investor chooses to have manage the money.  The implications of the failure of one of these businesses would require a lot of research to understand.  That, in-and-of-itself should be a powerful deterrent for some small investors.

Third, whenever one turns money over to someone else to manage, it is very important that the investor trust the money manager.  Since the companies seem to be exclusively web-based, there is less of a basis for establishing a judgment about their honesty.  Plus, because these are new companies, there are no track records on which to base judgments. Not surprisingly, the senior executives at some of the companies have venture-capital backgrounds.  Perhaps, information about whether they made money for investors in their venture-capital firms would be relevant, but even that is only indirectly indicative and would have to be interpreted very carefully.  It should be a concern to investors even though it is more than likely that the senior executives are honest, hard-working individuals. 

The point is that trust is a judgment the investor has to make.  In the case of these companies, there is very little information on which to base the judgment.  One cannot count on anyone else making that judgment.  For example, the Securities Exchange Commission completely missed Bernie Madoff‘s fraud.  Similarly, one cannot rely on the Financial Industry Regulatory Authority, a self-regulatory body commonly called FINRA.  A recent WALL STREET JOURNAL article had the telling subtitle “Analysis Shows More Than 1,600 Stockbrokers Have Bankruptcies or Criminal Charges in Their Past That Weren't Reported.” 

Fourth, given the companies’ descriptions of their investment approaches, the investment will probably work well under normal circumstances.  However, how well it works for an individual investor depends upon the quality of the analysis of the investor’ risk tolerance.  The firms probably have a questionnaire to determine one’s risk tolerance.  What they are trying to do is apply Modern Portfolio Theory (MPT) to the asset allocation based upon the results of the questionnaire.  They use trading algorithms to try to maintain the risk-return level continuously. 

As was discussed in a previous posting entitled “A Core of Mutual Funds: Part 1,” modern portfolio theory has been around since the 50s.  It is a very good theory if one assumes that individuals’ risk tolerances are easily measured and consistent over time.  However, there is considerable evidence that individuals do not have stable risk tolerances.  Jason Zwieg’s book and many of his articles, especially those reporting on the research of behavioral economists, have pointed out that risk tolerance is neither stable nor independent of investment performance.  Consequently, it is a bit surprising that he does not point out this problem with the approach that the companies are using.

One could reasonably argue that the principal advantage of an algorithm over a human adviser is that the algorithm has no emotions.  The problem is when the algorithm, which has no emotions, interfaces with the investor who does.  There is no reason to believe that investors would not systematically move in and out of this investment with detrimental timing.  Investors have shown that they do that with other investments.  That is a problem that no investment vehicle can overcome.  However, ignoring the issues related to measuring risk tolerance is only the tip of the iceberg.

Fifth, there is a basis for suspecting that algorithmic trading encourages an incorrect assessment of risk.  The Hedged Economist has occasionally made reference to an article written by The Numbers Guy in the WALL STREET JOURNAL.  The article entitled “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees, professional researchers and even editors of scientific journals, can be too easily impressed by math.  Since that is the case, it is likely that the investor and the companies offering the service do not understand the limitations of their approach.  Thus, it is unlikely they correctly assess the risk.

Sixth, the marketing pitch that is quoted in the Zwieg article: "Investment management can be more expertly done by an algorithm than by a human adviser," should be cause for concern.  It could illustrate overconfidence and hubris on the part of those developing the services.  It also might represent a cynical willingness to use the tendency for people to be overly impressed with math.  Finally, as discussed below, it represents an incredible level of naiveté on the part of the developers.

Seventh, anyone who works with models is aware that they are models.  They have limitations and are based on assumptions.  The algorithm is simply a model of how the market functions.  All algorithms that stress diversification across asset types are applications of Modern Portfolio Theory.  Modern Portfolio Theory is an excellent theoretical framework for making asset allocation decisions.  It has been referenced frequently in The Hedged Economist and much of the financial literature to justify asset allocation decisions.  It is an excellent theory, but that is all it is.

Asset allocation can be made to sound complicated.  However, it is actually a lot simpler than advocates of Modern Portfolio Theory make it sound.  It is just asset diversification.  The problem with algorithmic application of Modern Portfolio Theory is that it is based upon the correlations and covariances between all asset classes.  It assumes they are stable.  Nothing demonstrated the fact that they are not stable better than the recent financial crisis.  (Technically one might argue that they do not have to be stable.  They just have to be measurable and forecastable.  However, the combination of discontinuities and the tendency for nonlinear models to be unstable – – one has to forecast the derivative; in some cases the second derivative – – which necessitates adding even iffier assumptions than stability in the correlation matrix).

So, the theory works well under normal circumstances, and it results in a theoretical improvement in returns for any given level of risk.  When put into practice, any improvement in return is very, very slight.  Consequently, frequently professional managers try to take advantage of the slight improvement by increasing the leverage.  That, of course, creates its own risk.  However, the most common problem with the approach is that, as the saying goes, “it works as long as it works and then it doesn't work.”

There is an eighth point that was missed in the article. Algorithmic trading is much the rage with many on Wall Street.  What is not clear is whether there is any return to continuous, algorithmic trading in-and-of itself.  The largest firms involved in the activity also are accessing information not available to the general public or only available to the general public with a delay.  Research that separates the returns due to the information advantage from the return due to their trading algorithm is sorely needed. 

Further, and this should be a major concern, if these new firms serving the small investor are trading with an algorithm that is similar to those used by one of the larger firms but only receives the information on which the trades are based after it has been available to the larger firms, there may be no advantage regardless of how rational the algorithm is.  In fact, the trading by these firms may only enhance the returns of the larger firms which have better information.

Ultimately, most individual investors will do better by just avoiding continuous trading as a method of reducing volatility.  Volatility between the beginning date and the ending date of a trade is actually quite irrelevant to the return from the trade.  It is important in Modern Portfolio Theory, but only matters to the individual investor if he or she is willing to accept short-run volatility as the definition of risk. 

Continuous trading strips individual investors of one of their strongest advantages over professional traders.  The individual knows how long he or she intends to hold the asset whereas the professional investor has to continuously worry about the mark-to-market value of their assets.  For the individual investor giving up that advantage in order to conform to the tenants of Modern Portfolio Theory seems like a foolish choice.

Saturday, March 8, 2014

A Different Approach for a Different Objective.

What if it is the stock not the portfolio?

In a previous posting entitled “The Widows’ and Orphans’ Portfolio and US Banks” the composition and objectives of the portfolio were used to identify a particular reinvestment plan for 2014.  However, the portfolio objectives outlined in the article include the diversification of risk to the capital (management of the size of the holdings) and diversification of the income streams they generate through dividends.  They are not the only potential portfolio objectives.

An equally acceptable alternative objective would be growth in the total portfolio based on combined capital gains and dividends.  That approach is particularly appropriate for an investor in the accumulation phase.  Individuals in the accumulation phase are usually younger and may be willing to take a little more concentration risk.  This second approach necessitates more attention to the price of individual stocks and the timing of individual stock purchases.  That will be the topic of this posting.

The portfolio holds a significant position in Verizon (VZ).  While the dividend represents an appropriate portion of the portfolio, the amount of Verizon stock held in the portfolio could be increased without undermining the portfolio’s design.  An investor who is just building the portfolio might want to begin accumulating Verizon now.  The same might be true of any investor with different portfolio weights. 

The portfolio’s design is for all the stocks to be potential long-term holdings.  However, as has been discussed in this blog, the market will occasionally provide an investor with an opportunity to purchase long-term holdings at a discount.  The first thing is to determine whether there is any reason to believe that such an opportunity currently exists in Verizon stock.

After the financial crisis, there was a deluge of books and articles about the investment mistakes made by many of the larger money managers.  Back in April of 2010, The Hedged Economist included a number of postings analyzing some of those mistakes (e.g., “Sometimes Wall Street provides more entertainment than Hollywood: PART1 the winners” and “PART 2 the losers”). Looking at these mistakes was an extremely useful exercise.  It is always more fun to try to learn from other people's mistakes instead of making them yourself.

One thing that was particularly interesting was how often investors were burned because they failed to analyze the motives of their counterparty.  (If they were buying, they forgot to look at why their counterparty was selling, or vice versa).  An analysis of counterparties’ motives has become a frequent and often very useful supplement to the traditional financial and technical analysis.

In the case of Verizon, such an analysis is possible.  One knows that the Vodafone acquisition resulted in the distribution of Verizon shares into the hands of a number of individuals and financial institutions that never explicitly chose to purchase the shares.  More importantly, some of the institutional investors may be operating under portfolio guidelines or institutional charters that require them not to own foreign stocks.  Consequently, it is reasonable to assume that there are sellers of the shares who are not expressing a judgment about the future of the company.  The phenomenon described is sometimes referred to as “post-acquisition blowback.”  If that line of reasoning is correct, the recent decline in Verizon's stock is an opportunity to purchase at a discount.

There is a second reason to believe that a purchase now is appropriate for the long-term investor.  This blog often makes reference to a posting entitled “Wall Street doesn’t run the world.”   The reason is that the posting makes the important point that Wall Street is largely composed of investors with very short-run horizons.  It is not at all difficult for an investor to take advantage of any difference between his or her investment horizon and the typical investment horizon of Wall Street.

It is easy to see how that may apply to Verizon.  With its earnings release, Verizon ruled out stock buybacks for at least two or three years as it aims to slash that debt.  Impatient investors do not like that sort of behavior.  They had bid up Verizon stock based upon the increased earnings expected from their purchase of Vodafone.  Verizon's announcement of what it was going to do with those earnings was accompanied by selling of the stock.

Wall Street's time horizon makes that response totally understandable.  If Verizon used the increased earnings to purchase shares that they issued in connection with the acquisition, it would increase earnings per share.  The increased earnings per share would occur at the time the purchases were made.  It is a reasonable strategy, but not a long-run strategy.

If Verizon purchased back shares it would be influencing per share earnings before interest, taxes and amortization.  However, the interest paid per share would increase.  By reducing debt instead, Verizon does not directly influence earnings before interest, taxes and amortization per share.  Rather, by paying down debt, it decreases the interest expense.  Thus, earnings after interest, taxes and amortization will increase “other things being equal.” Ultimately, in the long run, it is earnings after expenses that the investor should be seeking.  Consequently, foregoing the short-run increase in earnings before interest, taxes and amortization should result in a greater return after interest, taxes and amortization, but it may be a slower process.

Thus, there are at least two reasons to think that Verizon stock may temporarily represent an opportunity: post-acquisition blowback and Wall Street impatience.  The next step in determining whether the stock represents such an opportunity is traditional financial analysis.  Using traditional measures, there is no compelling case for adding Verizon right now.  It is worth noting, however, that acquisitions sometimes create a situation where traditional analysis looks ambiguous.  As already mentioned, Verizon's stock has underperformed.  The Hedged Economist is not an expert in technical analysis.  However, the underperformance could represent an opportunity.  It is an opportunity that could continue to exist or even become more inviting.

Stepping back and analyzing the business, there are both pros and cons.  Verizon operates in increasingly competitive markets.  That is true of the cell phone business and FiOS.  However, Verizon has a long history of being able to flourish in competitive markets.  In addition, the reason the markets are competitive is that they are attractive and growing.  It has been many years since Verizon made any major strategic mistakes in approaching the markets, although future mistakes are always possible.  From a strategic perspective, Verizon made a couple of very forward-looking decisions a number of years ago.  If Verizon can continue to anticipate consumer and technical trends, its business should prosper.

A reasonable conclusion would be that the current period of underperformance represents an opportunity to accumulate the stock.  However, that conclusion is highly dependent upon the investor’s timeframe.  There is no need to do it all at once, and it may best be done by selling cash-covered puts at lower strike prices.

The situation at Exxon (XOM) is, in some respects, analogous to the impact of Verizon's statement in connection with its earnings release.  Exxon’s problem does not relate to debt, but like Verizon’s, it involves details about the company’s use of capital.  Exxon announced that it would be lowering its capital expenditures.   Since Exxon has not been growing reserves, this decision has caused concern, and it resulted in a selloff of the stock.

Given that Exxon is one of the largest companies in America, the decision to reduce capital expenditures received considerable attention.  For a summary of the details and illustrations of the attention it has garnered, see “Are ExxonMobil's Reduced Capital Expenditures Cause for Concern?” or “Is Exxon Mobil Heading for an Inflection Point in 2014?”  Those two articles provide excellent background on the issue while “Exxon Performance, Spending Cuts Rattle Investors' Nerves” is an excellent description of why investors were concerned. 

The bottom line is that the cut in capital expenditures was very minor when compared to capital expenditures over a long-term period of time.  Interestingly enough, the increased capital expenditures in past years brought on an equal number of concerns among investors and selling pressure.  The long-term investor might be very tempted to dismiss both as simply management decisions made in the course of doing business in an area that requires large, long-term investments.  That, in fact, seems like a very reasonable conclusion at this point.  Thus, the current selloff presents an opportunity.

However, a recent article on Seeking Alpha entitled “Exxon Mobil Needs A Big Dividend Hike This Year” touched off a stream of very interesting comments.  As many of the comments on this thread make clear, if Exxon does not raise its dividend, there are large numbers of investors who may sell and present an investor with an even better opportunity to purchase the stock. That could be a wonderful thing. Imagine being on the same side of the market as one of the most capitalized companies in the world, as well as with investors like Warren Buffett.

Although the stocks of Verizon and Exxon presented opportunities, those opportunities should be viewed in the context of the total portfolio and the investors’ objectives for the portfolio.  If the issue were simply to pick the stock that will appreciate the most over the next six months to a year, neither company would probably be the winning candidate.  As discussed in “What is to be learned for 2014 planning?” one would probably want to focus on PPG.  However, current developments in both companies’ stocks present opportunities to those focused on constructing a long-term portfolio.

Wednesday, March 5, 2014

The Widows’ and Orphans’ Portfolio and US Banks

Regulatory Risk.

The “widows’ and orphans’ portfolio” introduced in the January 9, 2011 posting entitled “Investing PART 9: One version of the ‘Unfinished symphony” is intended to be a long-term investment portfolio.  The type of adjustments that one would expect were summarized in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?”  Generally, they should be adjustments in portfolio weights.  However, as mentioned in the January 26, 2014 posting entitled “What is to be learned for 2014 planning?” when a portfolio objective cannot be achieved by adjusting portfolio weights, there is always the possibility of adding a new holding.

The possibility of not being able to achieve portfolio objectives by adjusting weights was made in connection with a restatement of the portfolio objective:  “Stability, simplicity, profitability, and low risk are not the only objectives of the portfolio.  As the name widows’ and orphans’ implies, dividends are an important consideration in the design and objectives of the portfolio.  Dividends interact with stability and low risk, but the more important point is that, for this portfolio, they are an objective in-and-of-themselves.”
“…one would want to … increase the average yield of the portfolio....  Hopefully, that can be done within the portfolio.  If that is not possible, some additional companies could be added to the portfolio.”

Currently, the objectives of stability, low risk, and dividend yield necessitate a significant change in the portfolio.  As the title of this posting implies, it concerns the US bank held as a part of the portfolio.  When the portfolio was initially introduced, the Bank of New York Mellon (BK) was identified as a core holding.  As explained below, that posture is no longer sustainable.

One should not misinterpret this shift in the portfolio.  As was stated in an earlier posting “…the Bank of New York Mellon is particularly well situated going into 2014.”  However, as it also has been noted, “…it has one of the lower yields of the portfolio holdings.”  Consequently, from the perspective of portfolio management, “…one would have to be very confident that it will be able to increase its dividend in order to justify anything more than just automatic dividend reinvestment.” 

It is with respect to increasing its dividend that the problem with holding Bank of New York Mellon as a core holding first surfaces.  However, the problem is broader than just the dividend.  As the subtitle, “regulatory risk,” implies, the US government has introduced a new dynamic into planning any investment in a US bank. 

First, just from the perspective of dividend increases, Bank of New York Mellon is not going to be able to increase its dividend based upon its own assessment of its business.  That is a problem in the short run and totally unacceptable over the long run.

In April it will undergo a round of stress testing supervised by the government.  Based on how pleased the government is with the results, the regulators will determine how much the Bank of New York Mellon dividend can be increased.  A good guess is that the government will allow the Bank of New York Mellon to increase its dividend (or stock buybacks) by somewhere around 20%. A 20% dividend increase is not to be dismissed lightly.  But even with a 50% increase, Bank of New York Mellon would still have one of the lower dividends yields in the portfolio.  Thus, in the short run, the Bank of New York Mellon cannot achieve the dividend yield appropriate for the portfolio.

Over a longer period of time, the dividend will increase, but it will be based upon political considerations to an unacceptable extent for the widows’ and orphans’ portfolio.  The Hedged Economist has worked with regulators and banks for much of his career.  That experience makes one thing very clear: regulators are no better at forecasting and scenario analysis than banks.  What is even more concerning is that the current administration seems to be regulating by whim.  It is unlikely that regulators are sufficiently independent to avoid being drawn into the process of regulation by whim.  The widows’ and orphans’ portfolio should be made up of financial investments, not a political bets.

With respect to the dividend, both the process by which the dividend will increase and the amount of the increase justify looking for an alternative bank investment.  If the dividend were the only issue, supplementing the Bank of New York Mellon holdings with another bank would be a viable strategy (e.g., Wells Fargo—WFC-- was mentioned when the widows’ and orphans’ portfolio was first introduced). 
Second, dividends are only a part of the objectives of the portfolio.  Stability and low risk are also important considerations.  The Bank of New York Mellon had traditionally been a relatively stable bank because of its dependence upon fee-based services like trust management.  Those fee-based services tended to make the earnings and the stock price relatively stable.  In the current environment, that is no longer the case. 

An administration that acts upon whims does not facilitate the stability or low risk sought for the widows’ and orphans’ portfolio.  The Bank of New York Mellon has become a high beta stocks relative to the rest of the portfolio.  In fact, by some measures it is the most volatile stock in the widows’ and orphans’ portfolio, and although its stock may appreciate, on a risk-return basis it cannot justified as a portfolio holding.

Third, lawsuits designed to extort money from the banking system seem to have become extremely stylish.  Led by the state and national regulators who find banks an easy mark, the legal profession has come to realize that all they need in order to make fat legal fees is someone to play the role of plaintiff.  The widows’ and orphans’ portfolio appreciates stylishness, but it missed the memo indicating that wearing a target was stylish.  Put differently, investing in a large US bank involves assuming considerable headline risk, a risk the portfolio does not need.

Fourth, regardless of how one feels about all or any specific regulations that have been enacted, one cannot deny that they have added complexity.  From the very start of this blog, The Hedged Economist has pointed out that complexity creates its own risk.  Thus, the regulations themselves are creating new risks.

At the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31, the Bank of England's Director of Financial Stability, Andrew Haldane, made a presentation entitled "The Dog and the Frisbee."  The speech and the supporting research provide evidence that as regulations become more complex, they also become less effective.  The research also points out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that cannot provide accurate measurements of a bank's health.  So, the additional regulations are not necessarily reducing risk.  At the same time, the regulations are making it harder to identify what risks do exist.

For a brief summary of the speech consult the WALL STREET JOURNAL of September 13, 2012.  The article was entitled “Complexity and Risk Management.”  For an updated discussion of the topic, consult the December 20 WALL STREET JOURNAL article entitled “Andrew Haldane: The Banker Who Cried 'Simplicity’.”  It is based on an interview of Mr. Haldane.  For a non-technical discussion of why the metrics developed by regulators are often counterproductive, consult the January 4, 2013 WALL STREET JOURNAL column by The Numbers Guy.  The article entitled  “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees and professional researchers are too easily impressed by math.  Behavioral economists have been able to show that is true when applied to financial decisions.  However, their focus has been narrower than the generalized statement of the article. 

If one wants a fuller explanation and longer history of how regulation has created risk in the banking system, one might want to read FRAGILE BY DESIGN: THE POLITICAL ORIGINS OF BANKING CRISES AND SCARCE CREDIT by Charles W. Calomiris and Stephen H. Haber.  Despite the title, the thesis of the book is not that regulators intentionally design an unstable system.  Rather, they focus on the political motivations that lead to regulations that have unintended and largely unanticipated consequences.  If history is any guide, the regulators are creating risks that they do not understand.

The net effect of regulation by whim and the regulatory landslide that has occurred is that all US banks now contain a level of uncertainty totally unrelated to the economy or their operation.  A quote from the conclusion in a previous posting is appropriate: “… about the nature of the relationship between politicians and Wall Street. It isn’t always easy to tell who is using whom. That implies that avoiding situations with Washington-based headline risk is an effective risk reduction strategy for most investors.”

The unavoidable conclusion is that Bank of New York Mellon has to be replaced in the portfolio.  To summarize in terms of the objectives: 1) Dividend yield --The dividend yield is too low and the company's performance cannot be relied upon as a basis for increasing the dividend.  2) Stability-- The price of the stock has become far less stable and is exposed to considerable headline risk.  3) Low risk-- The Company is exposed to significant new risks, some of which are identifiable and others are not even known.

From a portfolio perspective, finding a suitable replacement is problematic.  While many of the arguments for dropping Bank of New York Mellon applied to any US bank, not all banks have experienced the effect to the same extent.  For example, Wells Fargo, mentioned when the widows’ and orphans’ portfolio was first introduced, has been more successful at maintaining its dividend, and the price of the stock has been more stable (e.g., it has a lower beta).  If it were used as the banking component of the portfolio, dividend reinvestment might be all that would be required.  However, that would still leave the portfolio exposed to regulatory risk.  Put differently, it is impossible to guess when our government or a group of trial lawyers will decide that Wells Fargo would be a nice target for extortion.

Fortunately, an investor does not have to be exposed to the types of risks that have been introduced into the US banking system.  Our northern neighbor, Canada, has a far more stable banking system than the US.  Thus, Canadian banks provide excellent candidates for substitution for the Bank of New York Mellon.  Further, many of the Canadian banks have US subsidiaries.  Consequently, the investor does not have to give up exposure to the US economy totally in order to reduce the exposure to regulatory whim and legal extortion.

One of the nice things about focusing on Canadian banks is that there are not too many of them.  One can fairly quickly narrow the field of consideration down to two or three banks.  The Hedged Economist’s screens narrowed the field to The Royal Bank Of Canada (RY) and Toronto Dominion (TD).  As stocks, both pay healthy dividends, have histories of raising the dividends, and have betas that are lower than Bank of New York Mellon.  Both have healthy financials and strong businesses.

For the widows’ and orphans’ portfolio, Toronto Dominion was selected.  Its dividend is slightly lower, but not significantly lower.  By contrast, its beta is significantly lower, and that is an important consideration for this portfolio.  Both are financially strong banks, but TD Bank seems to be more successful at building a strong brand around the “America's most convenient Bank” theme.

Investing in any company that operates in multiple countries involves some currency risk.  That is true of the TD investment.  It would also be true of an investment in the Royal Bank of Canada.  A totally domestic US bank would not involve currency risk to any appreciable extent.  However, any large bank whether US or Canadian embodies some currency risk because of the nature of the assets it holds.  Thus, it would be easy to overestimate the extent to which the purchase of TD Bank increases the portfolio’s currency risk.  When compared to the currency risk involved in the investments in the other multinationals held in the widows’ and orphans’ portfolio, the currency risk embedded in TD is acceptable.

In order to acquire the Toronto Dominion shares, all shares of Bank of New York Mellon were sold.  In addition, the small position in Newmont Mining, discussed in a previous posting as primarily held as an indicator, was also sold.  The combination of the two sources provided adequate funds to achieve a more desirable dividend yield for the portfolio (2.5%) and brought banking as a portion of the portfolio (4.9%) closer to the desired level.  At some future date, dividends from the portfolio will be used to bring both the dividend flow and portion of the portfolio completely up to the desired levels.

The effect of this trade is to bring the portfolio much closer to balance.  Only minor adjustments should be required for a fairly long time.  The stock portion of the portfolio is summarized in the table below.  The first column is the stock symbol.  The second column is the portion of the portfolio represented by that stock.  The third column is the dividend yield (i.e., the rate at which dividends are paid based on current prices).  The third column shows the portion of the total dividends derived from the specific stock identified in column 1.

The price appreciation in PPG has brought it to a level that some investors view as an upper bound for a portfolio weight.  By contrast, PPG is not overly represented as a portion of the dividend yield.  The inverse situation is characteristic of Verizon (VZ).  As a portion of the portfolio, Verizon shares do not represent a very large portion of the holdings.  However, because of its higher dividend rate its contribution to dividends is about appropriate.  GE and TD Bank are the two portfolio holdings where both the portion of the portfolio and the contribution to dividends need to be enhanced.  Unless something unanticipated arises that will be a principal focus for the balance of the year.

A disclosure, as mentioned in “A Core of MutualFunds: Part 2,” a number of mutual funds are also held as a core portfolio.  Thus, the portion of the portfolio and the portion of dividends attributable to any individual stock are both allowed to fluctuate within fairly large bands.  However, in keeping with the idea that the portfolio is a source of income, the portion of dividends attributable to any individual stock is more tightly monitored than its portfolio weight. 

However, since some people prefer stocks and others prefer mutual funds, in The Hedged Economist’s postings, core portfolios of either are presented as standalones.  When that is not the case, it will be quite explicitly stated (e.g., “Funds for Asset Class Diversification”).  When the discussion is about acquiring or selling non-core holdings, there will be no reference to how they fit in a portfolio (e.g., “Without the Glitter, An Alternative to Trading Bonds”).  It should also be understood that references to a position as core or non-core should be viewed as relating to a portfolio.  A non-core holding referenced in a posting may be held for multiple years (e.g., the Kimberly-Clark stock purchased for reasons discussed in “Wall Street doesn’t run the world” has been held continuously since March of 2010) or it may be sold very shortly after acquisition (e.g., some of the alternatives to bonds mentioned in “AnAlternative to Trading Bonds”).