Archive for October, 2008

Over the years I have had a number of clients ask me about the multiplier effect of borrowing to invest. Often a friend or relative has bragged about the improved returns and tax benefits and our clients want be to see if it applies to their situation. There are many good uses of leverage and in principle it can be good strategy to consider. However leverage should not be used to offset a high cost investment approach.  The first step is to make sure you have built a low cost, efficient portfolio  that captures the returns to the markets in which you are investing.

Think of your investments as a private company . If you are a high cost producer your margins are lower than your competitors and your bottom line will not look as good. You can improve the numbers by borrowing and adding more capital and volumes to the business and turn say an 8% return into a 12% return. The problem here is not all 12% are created equally, there is much more risk to the downside for the leveraged company and in a downturn your leveraged company is the first to go under. It is far better to get your costs and efficiencies in place and then add leverage. The lowest cost producer in a market plus leverage can be a very good thing indeed.

Portfolios with high cost mutual funds and or aggressive trading strategies are expected to underperform the markets in which they invest. Adding leverage may mask the problem in good markets but mostly you have simply added much more risk to the approach.

Market volatilty is a true test of the merit of an investment approach. Recent market performance while not probable, may help us to build better future portfolios.

1. Leverage turns a big problem into a life altering event.

2. Diversification works and importantly having a series of maturities to cover cash-income requirements really helps. If you have had a well diversified portfolio and do not have to sell your equities to meet income requirements your chances for success are greatly increased.

3. Individual stocks capture significantly more risk than the market as a whole.

4. Active managers of mutual funds and pension plans as a group have an expected return that is less than the return to the markets in which they invest.

5. The sense that active management outperforms in declining markets has been challenged.

6. Stocks outperform bonds - just not every month.

7. After a market crash, a big diffentiator for future success is those companies that need external capital vs. those that can look internally for financing needs. High dividends increase the likelihood of requiring external capital.

8. When risk manifests itself and markets drop rebalancing programs lose you more money than a buy and hold strategy.

9. Diversification includes and requires that we diversify by currency as well. Hedging out the currency reduces return and cost additional fees.

10. Volatility ia a measure of long term experience so that average volatility can be somewhat meaningless as an assessment of risk. In general “average assessments of risk” don’t work when you need them.

11. Liquidity providers win in the end.

12. Stock prices have no memory. If a stock is down 20 or 50% the risk of ownership is increased even if expected return is greater.

13. Fear sells media products at a much greater rate than greed.

The recent drop in global markets resembles an Atlantic hurricane. The immediate impact of a storm is obvious and sometimes frightening. Life courses can be altered, usually for the worse. Most storms don’t capture our attention and there are many each and every year. But when a category 4-5 hits everyone is watching.  Storms in 2008

We just had a category 5 financial hurricane. There is some good evidence to suggest that the storm has passed. At this point governments across the financial world have guaranteed inter-bank receivables. As a direct result, In my opinion, it is unlikely that we will see another large financial insolvency as a result of this credit crises.

 The TED spread measure is the ratio of 90 day US treasury Bill to LIBOR, the London inter bank offered rate of interest.

The spread has now narrowed to 248 today and continues to fall. Banks are much more likely to lend to each other with a federal government guaranteeing the contract.

Financial storm damages are borne by investors across the world. Unlike an Atlantic hurricane the largest losses are experienced by those that sell and run.

Raising money right now is expensive. For corporations, the ability to get credit is shrinking while the price, or interest rate is rising. The public stock market decline has also made selling shares to fund expansion and or general operations less likely. All companies, private and public are now working on this problem. The biggest pressure will come to bear on new ventures and expansion plans. This new challange will relate directly to economic growth rates in the next few quarters. Good companies will need to find ways to reduce their reliance on outside, expensive capital.

Investors face the same issue. A balanced asset allocation may allow you to avoid selling equity investments in this environment. Drawing down on cash and fixed income assets eventually results in a riskier portfolio but can afford you the time to make a more informed decision. In general, portfolios with sufficient cash flow have much greater financial flexibility during this difficult period.

What a difference a weekend can make on investor confidence. Sharp rises in equity markets indicate some traction for worldwide efforts to promote corporate lending. A measure of current monetary policy effectiveness is the TED spread. This spread measure the difference between US 90 day treasury bills and Libor or the rate at which you can lend to commercial banks.  When rising this is an indication of a reduction in liquidity in the general economy. The equilibrium rate is expected to be somewhere between 50 and 100 basis points or below 1%. As you can see from the chart below we are at unprecedented levels more than 445 basis points. So while we are all thankful for this recent stock market reprieve, a healthy worldwide economy will be in a large part subject to a follow through in the reduction of the TED spread.

For Canadians, this long weekend is very timely. We get to pause and give thanks to all that is still good in our lives and in the world. While we can’t control the larger issues, we can control what we do in our own small sphere, so I suggest everyone turn off the news, put down the newspapers, and enjoy time with family and friends this Thanksgiving. I am presently in Mont Tremblant with Shelley celebrating our 27^th anniversary, and we plan to hike up the mountain, take lots of pictures, have a great meal this evening, and then head back to Ottawa tomorrow to spend time with our daughter, family, and friends, play some touch football, eat too much turkey and pumpkin pie, and rejuvenate before I hit the ground running again next week. Enjoy.

Some Facts – all in US dollars

54.62 Trillion: the size of the world Gross Domestic Product (GDP)

51-55 Trillion: Estimated peak size of Credit default Swaps Market

36.90 Trillion: World stock market value as of 31 December 07

1.4 Trillion : IMF estimate of total total probable losses from credit crises

700 Billion: US Bailout package

This is the financial story of our lifetime. It can be difficult to get your mind around the complexity of the problem. Here is my take:

Issuing mortgage debt to people who cannot pay is the source of the problem. It became everyone’s problem once it passed through to the corporate debt market. Lehman Brothers went bankrupt and a couple of money market funds in the US lost investor capital. “Breaking the buck” is a big issue since the only stipulation investors give to money market managers is – do not lose any money.

These money market fund managers turned a dollar into 97 or 98 cents. The industry took notice and either sold or did not roll into new corporate debt. They were, and are, afraid to lend money to the corporate world since size and debt ratings don’t seem to predict solvency. As a group, money market managers went safe and bought government debt only. The net result is now there is no access to capital for worldwide capitalism. New issuance of corporate debt market in the US is worth many billions each day. If companies can’t get a ready source of capital they can’t expand, reinvest, hire people or perhaps pay employees. This de-leveraging is devastating to world wide economies. The money didn’t disappear. Governments have the cash. That’s why we need government intervention to fix the problem.

Credit default swaps (CDS) are insurance policies. Banks issue them and holders pay a premium which historically amounted to a couple of percent per year. If the debt issuer defaulted on the debt the premium holder received money from the issuer to make up the loss. Buyers of CDS reduced risk and passed it on to issuers. Think of them like life insurance policies. You buy a policy to reduce the risk to your family after your death. The insurance company collects the premium and pays out at death the benefit to your family. Banks like premiums and here is where it gets weird. A decision was made that it was OK to collect premiums on the bond many times over. People who held the bond got coverage and many people who didn’t hold the bond got coverage and paid a premium. One bond, many premiums works well for the bank since earnings are juiced. The probability of default is calculated as a small reserve. Profits go up without bound. Until a catastrophic small probable event occurs (see black swan). The reserves are many times smaller than the benefit owed. Goodbye Iceland.

Welcome. I have been providing investment advice to clients for more than 20 years beginning just before the crash in 1987. As a portfolio manager my clients depend on me to distinguish between investment fact and fiction in our effort to capture positive investment market returns.  To that end the training received through the CFA (Chartered Financial Analyst) program was a good start but nothing beats the experience of living and working through a series of market cycles. This blog is dedicated to providing clarity on the financial services industry. We will follow the evidence and highlight the incentives of the players in what has been the source of the greatest riches on earth. I expect to post a new entry a couple of times per week and look forward to your comments.