The Don’t-Buy/Sold List

My Don’t-Buy/Sold list performed in line with S&P 500. I had the habit to keep tabs on the stocks I looked at but didn’t buy as well as the stocks that I sold. There are 63 of them on the list today. A reckoning shows that they performed in line with S&P 500 for the last twelve months, if equally weighted. In other words, my sell list has been a waste of time.

Going through the list, I wouldn’t have guessed it. If I had to make a prediction, the list upended would be more like it. The one that tripled is HWK, a friction material company.

Lessons Learned:

The Market seems to overvalue growth, or grant premium on certain stocks. If a stock grows at above market average, the market would value it at more than I consider it should be. Sometimes the P/E would shoot up to above 30X, or even 50X if the stock is really hot. I have not learned on how to play with those types. The takeaway is that hyper-valuation alone is not a good reason to sell—hold on to the choppers until there’s reason not to. Of course, it would be difficult to get out right on time.

Sold too early for lack of patience, valuation, or bad news. There are several stocks I sold, when it stopped moving for a while, or moved too much than expected, or when there’s bad news and selloff. Those several outperformed the S&P 500 30% plus afterwards. The motto is not to fret about short-term performance, but to recheck the thesis—easier said than done. Bad news could be opportunities to buy more. Of course, the turnaround may come really slow.

Fear would keep you from the best opportunities. I have missed several REITs that doubled. Looking back, I was overloaded with concerns on the sector—after all it was the epicenter of all the problems. But it turned out that it was one of the best places to be. Of course, I may well have had been trying to catch a falling knife.

Valuation would go nuts for no particular reason. There are ones without much earning growth, on an average growth forecast, but the price just went through the roof. Is there anything someone knows but I don’t? This is when you don’t learn.

Portfolio Notes, Oct 2010

The Economy

The world economic growth is experiencing a so-called decoupling, with a tepid growth in the U.S. and Europe recovering from the financial crisis, but a higher growth in emerging countries, particularly India and China.

The inflation of the emerging market is picking up, for a complicated basket of reasons, including a closing output gap and increasing price of food, which is a good portion of consumption in the emerging world. For the developed world, the inflation is low, or too low in the U.S., considered by the Fed.

Fiscal deficits increased across the globe as a result of the stimulus packages. The Euro area shows a debt/GDP ratio of 80%, up from 65% at the beginning of 2008. Those of Greece, Ireland and Italy reached close to 100% of GDP, well above the 60% level commonly considered acceptable. Losses in the asset market deteriorated pension funds, further adding to the fiscal pressure.

Unemployment rate is sky-high, especially in the developed countries hit hard during the crisis. The reverse would take two years at least or longer given the lukewarm growth.

U.S. housing price stabilized at 25% below peak of Case-Shiller Index, a level that still makes default rational.

The U.S. private sector is deleveraging to repair the balance sheets. The U.S. household sector has reduced debt for 9 consecutive quarters—it never did since 1976 until this recession, having always growing at 5%-12% range annually. In amount, it was borrowing at $1 trillion annual rate from 2003 to 2007, now at $-300 billion.

Rates

Policy rates are at record low globally and going ZIRP at major economies.

We are in the phase II of QE, after the Fed, ECB, and other central banks have dramatically expanded their balance sheets during round one. BOJ just went out purchasing everything including even REITs. The Fed has already hinted and the market widely expects it to be the next, rolling out QE II in November. ECB seems would not join the action.

Currencies

USD has kept going down against other currencies, during the so-called currency war. In my opinion, the weakness of USD comes from low rates in the U.S., QE, and weak growth of the U.S. economy.

JPY has been surprisingly strong, due to weak USD, anecdotal pulling back of domestic investors, and diversification of Chinese foreign reserve. After a small-scale intervention to no avails, the Japanese authority is hoping the recent QE would ease the export pressure on the ailing economy.

EUR is strengthening, on the relative unwillingness of the ECB for another QE.

Emerging currency basket is going up against USD, mounting pressure on current accounts, inflation and growth.

Portfolio

Key Theme: EM growth, monetary expansion, weakening USD, if-slow recovery instead of double-dip

All stocks, since low 10Y rates everywhere, closing spreads, and no seen risks of a double-dip.

Buy Russia, for: good value/energy concentration; against: the reason for low valuation is unclear.

Buy India, for: long-term growth story; against: a possible rate hike to curb inflation?

Buy Peru, for: commodities, capital inflows; against: ?

Buy Korea, for: good value; against:?

Buy Malaysia, for: huge current account surplus, energy focus; against: ?

Buy oil stocks, commodity stocks, for: QE, weak USD, recovering IP; against: reversing USD, rate hikes, unfavorable economic data, historically high inventory

Buy gold stocks, for: QE and weak USD; against: reversing USD, rate hikes, market correction

Buy tech, auto, industrial, financial stocks, for: cyclical recovery; against: weak economy/housing

Watch Ireland, for: at trough, possible upside risks

Key Risks/Questions

What if the Fed’s QE is perceived to be of a lesser scale than expected, or economic data disappoints after QE II?

What if higher commodity prices add pressure to the inflation?

What if for some reason USD reverse course?

What if one of the EU countries defaults on its sovereign?

A Flow of Funds Analysis of the Housing Bubble

Some facts gleaned from the Federal Reserve’s Flow of Funds Accounts (the Z.1 releases) on the housing bubble.

An obvious credit boom, in hindsight

There was clearly a credit bubble, as shown in the above figure that depicts the flow of funds of the Financial Sectors, starting in the middle of the last decade, right before it imploded into the still-lingering financial crisis.

A massive leverage-up could be seen on the aggregate balance sheets of the financial institutions. The total net lending of the financial system ranges around $500 billion annually from 1985 to 2001, fluctuating along the business cycles. From 2002 on to 2007, however, the amount of lending suddenly shot up to $2,200 billion annually. 

All excess went in mortgages

Almost all the abnormal, “excess” lending went into the mortgages, which trended upward by $1 trillion per annum. Just think about the amazing phenomenon of such scale and efficiency for a moment: somebody have been churning out mortgages in whatever manners for an additional $30 billion per day, over 100,000 medium-priced houses worth.

Source of funding remained an interesting issue

So where did all the money, over $1 trillion per year, come from? It had to be somewhere.

An item-by-item review showed that the major source of funding seemed to be time & savings deposits, up $350 billion from previous period, and GSE-backed securities and bonds issued by financials (probably ABS issuers, as we will see later), which made up another $400 billion, and whatnot.

Types of funding sources being clear, you still have to wonder who purchased all those securities that made up the liabilities site of the mortgage binge. And the time & savings deposits?

A collaboration of banks, GSEs and ABSs

Banks, GSEs and ABS issuers accounted for 1/3 each in the trillion-dollar mortgage production line in 2002-2007. All came out with significantly higher productions/holdings of mortgage assets than previous, almost seemingly orchestrated. The production lines must be worth looking at.

The doomed crash would have dried up the mortgages, if w/o intervention; Financial crisis ensued

The reverberation of the destined crash has been much written about and could be easily imagined, particularly with hindsight.

Key Takeaways

Modern financial distribution network is highly efficient; A credit bubble would come out of nowhere, and there’s no obvious workable policy responses to prevent it from happening again unless cool heads prevail; A bursting bubble, usually sudden and vehement, is no fun. It is a wealth destructor collectively, although someone got rich from it.

Port Notes: HAMP@$4, buy

A sweater company—$5 per share in cash, $7 in equity, debt free. Traded $4 per share. Yes, probably would lose a bit this year.

A tiny company, though not tidy—a lot of stuffs going on. See the filings.

Anyway, 75c for $1, and then some last year’s sweaters.

Pink sheet. Illiquid.

Port Notes: FR@$4.51, buy

First Industrial holds and rents a portfolio of industrial properties—factories, warehouses, etc. The book value of the properties was $2.7 billion, financed partly by $2 billion debt. The book equity was $1 billion, or 3X market value. There was unexpectedly no write-downs in assets.

Cheap as it is, what’s interesting is its profit model. As the I/S shows, in recent years it had scant gains from the renting business. Instead, all its profits came from selling properties for higher prices.

It rolled over 30% of its properties and made $250 million from price appreciations, and 20% for $180 million. Such an earning stream stopped in 2009 together with a single-digit drop in rent revenues, pulling the company down into read.

CRE usually lags and its bottoming is hard to predict.

If you want to buy its shares, it would be the very reasonable price. If the valuation recovered to only half of current book value—not a scenario unthinkable—the stock would jump 40%.

Cash from operations would be positive before the revenue is cut by half.