Diversification: Why is it not working?

It is  a core belief in finance that investors should diversify. Whether they should diversify across all stocks or a few is what is debated, and what you think about the efficiency of markets or lack thereof determines which side of the debate you will come down on. If you are a believer in efficient markets, you would have spread your money across index funds investing globally. If you believe that markets systematically misprice classes of securities (and realize their mistakes later), you would still diversify across these securities (low PE stocks, beaten down stocks etc.)

This market has tested the core belief in diversification. Even the most diversified investor in the universe would have lost a big chunk of his or her portfolio over the last 3 weeks. Why has this happened and why is diversification not paying off like it was supposed to? The answer lies in the fact that we have sold investors too well on the "diversification" idea. Twenty years ago, when the sales pitch for adding international stocks and real estate to portfolios was made, the gains seemed obvious. Equity markets in different countries were not highly correlated; what happened in Turkey had little impact on what happened in Brazil. Having stocks in both markets therefore dampened risk in the portfolio. Real estate seemed to move in directions unrelated to equities, thus making a portfolio composed of the two asset classes less risky. As investors(individuals, private equity funds, hedge funds) diversified across markets and asset classes, there are two things that have happened:

1. The correlation across equity markets has risen dramatically. A crisis in one emerging market seems to spill over into other emerging markets. A crisis in a developed market spills over across the world. As market moves mirror each other, having your money spread out across markets has a much smaller diversification benefit than it used to.

2. Securitizing real estate and bringing it into portfolios has made risk in the real estate market more closely tied to the overall equity market. Diversifying across asset classes has a much smaller impact.

Don't get me wrong. I think that not diversifying is a deadly mistake for most investors, and I am still firm believer in diversification. However, we need to temper the sales pitch. Diversifying can create benefits for investors, but those benefits are much smaller in the global market place that we are now.

Is it time to make the move?

Yesterday was a momentous day in many ways. The market meltdown was global and there were moments during the day when the first 1000 point drop day seemed possible for the Dow. However, there was something about yesterday that seemed different (at least to me) from the market tumult over much of the last 3 weeks:

1. The drop in the market, at least in the US, was caused more by concerns about economic growth than by fear. Put another way, while much the volatility in the markets of the last 3 weeks could be attributed to shifting equity risk premiums, yesterday's drop was caused more by more conventional concerns about an economic recession.

2. The implied equity risk premium in US equities hit 5% for the first time since October 20, 1987. That is a full percentage point higher than the average implied equity risk premium over the last 50 years. We are seeing either a structural break in equity markets or markets are oversold.

I could tell you that my gut feeling tells me that we are close to the bottom, but I frankly don't trust my gut (or anyone else's, for that matter). However, I think that I will be doing some bottom-fishing today, focusing particularly on companies that have the following characteristics:

1. Products/services that are part of everyday consumption and not particularly discretionary. 

2. Low debt ratios (and I will check for lease and rental commitments) and large cash balances.

3. Solid earnings numbers over the last 12 months.

4. Low price earnings ratios (and low EV/ EBIT)

5. Double digit return on capital

6. Medium to large market cap

I am trying to recession proof (1) and pay a reasonable price (4) for a well-run company (3 & 5) that also faces little danger from the credit squeeze (2 & 6). I don't want to put myself in the position of touting individual stocks on this blog but I will be looking globally. You are welcome to join in!

Explaining the Market....

The last three weeks have been a boon for financial reporters. All of a sudden, they get the front page stories in their newspapers, a little akin to being the weather forecasters in the middle of a hurricane. At the end of each day, after another violent market move, they go to the experts (academics, practitioners) and ask them for reasons. They get the obligatory: "The market went up (down) because...." I have always been skeptical of this Monday-morning quarterbacking, and last week illustrates why.

On Monday, the market was down 778 points and the culprit was so obvious that experts were not even consulted. The bailout bill failed to pass in the House, and the market fall was attributed to this failure. The rest of the week was less explainable. On Tuesday, when there was little news about the bailout, the market bounced back up almost 500 points. On Wednesday, when things looked rosier for the bill's success, the market was down again. On Thursday, after the senate had passed the bill, the market did nothing. (Boring never felt so good.) On Friday, the bill finally passed around midday. Good news, right! The market promptly swooned. 

There are several reasons why the market is so difficult to decipher. First, all events have to be measured relative to expectations. There is no good news or bad news in absolute terms but only in relative terms. An earnings increase of 50% at Google may be bad news, if investors were expecting an increase of 75%. A drop in earnings of 30% at Ford may be good news, if investors were expecting a drop of 50%.  Second, there are so many events swirling around markets that it is difficult to pinpoint exactly what caused the market to move on any given day: Was it the weakening dollar? Higher interest rates? Unexpected inflation? Third, a great deal of what happens on any given day cannot be explained; putting a reason on a big move after the fact allows us to feel better about ourselves (as investors) and a little more in control of our destinies. 

Do I think that experts should stop trying to provide explanations for market moves? Not at all. In addition to their entertainment value, these explanations may help markets put the past behind and move on... 

The Buffett Gambit: Buying (Selling) Credibility

In the last two weeks, Warren Buffett has made news by taking multi-billion dollar positions at Goldman Sachs and GE, two companies that would have topped the list of most admired firms a couple of years ago (and perhaps still). The fact that he is getting a good deal from both companies has been well publicized. In effect, both companies have given him a discount on his investment, thus giving him the potential for higher returns in the future. While part of those higher returns can be attributed to the fact that he is providing liquidity in a market where it is in short supply, that alone cannot explain the nature of the deals. After all, Goldman and GE, notwithstanding current financial problems, have recourse to other equity funding. So, why did they choose to deal with Mr. Buffett?

I think the answer lies in the mythology. As investors lose faith in the institutions that they thought were the foundation of US financial markets, from the investment banks to the Fed, Warren Buffett remains one of the few icons with any credibility left in this market. In my view, both Goldman and GE are buying a share of that credibility with these investments. They are, in effect, telling the market to trust them because Buffett is now watching over them. I should also add that I do not begrudge Mr. Buffett trading on his credibility to generate higher returns for Berkshire Hathaway stockholders. He has invested a great deal in his reputation over the last few decades and he is the ultimate capitalist!

The Market Solution!

As a believer in market solutions/mechanisms, the last few weeks have been trying, to say the least." How, in the face of all that has happened, can you still trust markets?" is a question that I have been asked. I could give you all the facile answers - it is not the market's fault... imperfect regulatory frameworks are to blame... errant traders are the reason.. but my heart is not in any of these explanations.

I think that markets did fail, at least partially, in this cycle, just as they have in other cycles in the past. The costs are being borne by all of us. Notwithstanding the failure (and others like it), here is why I still remain a believer in markets. Markets exaggerate the best and worst aspects of human nature. At their best, human beings are creative, innovative and capable of bouncing back from the worst of adversity, and markets allow them to have maximum impact. From the Model-T Ford to the Google search engine, financial markets have allowed entrepreneurs to reach beyond their local markets, reach a broader marketplace and change the world in the process. At their worst, human beings are short term, greedy and not particularly rational, and markets feed into these emotions. When markets are good, we exalt them and when they are bad, we detest them.

So, here is the question. Would we be better off without financial markets? The good of markets, in my view, vastly outweighs the bad. While that may seem debatable at this point in time, consider two of the fastest growing economies in the world - India and China. For centuries, the people in the two most populous countries in the world stagnated under controlled economies (with colonial powers, royalty and central governments - socialist or communist- all promising a better future, but not delivering). In two decades, markets have done more to bring the the poor out of poverty in these countries than the rulers from prior generations. I may be an optimist but I do trust markets more than experts, when it comes to the big issues of the day!

Step away from the ledge!

Let's get the bad stuff out of the way first. It was an awful day for investors in every market. There was no safe haven today. I am sure that you are convinced that the end of the world is coming but let me offer you my take on the market.

First, the bad news. The credit crisis is spreading beyond mortgage backed securities. As banking failures in Europe illustrate, the problem is a much wider one. Banks lost their perspective on default risk and lent money at rates that were far too low to borrowers who did not meet the creditworthy test - individuals, corporations and businesses. As borrowers default, loan portfolios are being savaged around the world and the banks that were most aggressive about seeking out growth are facing the consequences.  Banks spread their pain around and there is no way that the global economy will not feel the pinch. At this stage, the question seems to be no longer whether we are in a recession but how deep and long the recession lasts. The failure of the bailout bill also illustrates the precarious state that markets are in: we are really in trouble when traders on the floor are watching  congressional vote tallies and reacting to the success and failure of legislation.

Second, the neutral news. So what do I think will happen next? There will be congressional action, though I am not sure whether the action will be necessarily in the long term best interests of either Wall Street or Main Street. The market will have its relief rally, just to show that it is playing along. 

So, what is the good news? Investors, consumers and economies are a lot more resilient than we give them credit for. While the great depression seems to increasingly be a theme in business news stories, I think that the modern global economy can weather the storm and come out of it intact. My suggestion to you is to think long term (if you can afford to) and invest in companies with healthy balance sheets and solid products. The Coca Colas, Apples and Nestles of the world will still provide long term value.

II. Why did it happen?

The blame is being spread around for the current crisis:  securitization, lax regulation and the housing bubble have all been fingered as culprits, but I think that these were contributing factors. I would attribute what has happened on financial markets to two phenomena, one of which is age-old and cannot be easily cured by regulation or laws and the other of which can be remedied.

1. Over optimism and hubris: Through history, we (as human beings) have always exhibited these traits. In good times, we become complacent and under estimate the likelihood of their ending, and we also tend, when successful, to attribute that success to our skills (rather than to luck or good fortune). It does not surprise me that there was a housing bubble and I do not believe for a moment that this is the last bubble that we will see in our lifetimes. There will be other bubbles in other markets, just as there always have been through history.

2. Risk taking and risk bearing: I know that risk is viewed as a bad word now. Rather than viewing excessive risk taking as the problem, we need to examine why it occurred in the first place. I believe that the separation between risk taking and risk bearing is at the heart of this crisis. Our risk takers (traders, bankers, mortgage brokers) sought out risks because they shared in the lucrative upside (with compensation tied to profits from activity), but the downside of risk was borne by others (the deposit insurers, taxpayers, other banks and investors). To fix this asymmetry we need to do two things: 

(a) Reform compensation systems to make them less tied to outcomes in short periods. A trader who receives a large bonus in the year in which he makes a large profit on his trading position is receiving encouragement to take the wrong types of risk. Compensation should not only be tied to more long term results but should also be linked to process (as opposed to outcome). In other words, a trader who makes money by taking the wrong types of risk should be punished and not rewarded. 

(b) Price risk correctly: A system that systematically subsidizes excessive risk taking by charging the same price for insuring all risk takers, no matter how much risk they take, is a system designed to fail in the long term. Charging all banks the same price for federal deposit   insurance, while allowing them to have very different loan/asset risks, will result in some banks gaming the system for profit. Prudent banks and taxpayers should not be providing subsidies for imprudent risk taking.

I am not suggesting that either of these actions will be easy to implement, but the task is laid out for us. It is time to get to work!

I. What happened?

This is the first of three posts that I hope to put up on my thoughts on what we see unfolding in financial markets. Here is my take on what happened:

1. The ultimate sources of this turmoil are the real estate market and the bond market. Between 2002 and 2007, housing prices increased at rates unseen in decades and well above the inflation rate. At the same time, default spreads on bond markets converged on historical lows.

2. As housing prices increased, funded by cheap mortgage financing, the mortgages themselves were bundled into mortgage backed securities, entitling buyers to different layers of the collective cash flows on the mortgages, with the first layers having the least risk and the last layers of the cash flows having the most risk.

3. The same optimism that pervaded the housing market (about future housing prices) and the bond market (about future default spreads) led to the mispricing of every layer of these mortgate backed securities, with the mispricing being greatest at the riskiest (or top) layers of the cashflows.

4. Financial services companies (banks, investment banks, insurance companies) were the primary investors in these mortgage backed securities, with the former using debt to fund much of their holdings. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.

Here is how it unraveled:

1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.

2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.

3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around. 

4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms. 

5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).

6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.

7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation. 

8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall. 

9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).

I am hoping that the next phase is a happier one but we are watching financial history get written as we speak!

GE's aborted buybacks...

In news that was overshadowed by the bailout debate, GE announced today that it was suspending its stock buyback program. While the suspension was precipitated by declining earnings and worries about GE Capital, there are some general comments that I want to make about the action that relate to stock buybacks in general

1. Flexibility: One of the biggest reasons for the shift among US companies from dividends to buybacks was that firms can respond much more quickly to adverse circumstances with the latter. GE's announcement on buybacks was greeted with sanguinity by markets today. If GE had cut dividends, the market reaction would have been much more negative than it was this announcement.

2. Announcement versus Action: Investor should take stock buyback programs announced by companies with a pinch of salt. Many company announce buyback programs with fanfare but do not carry through all the way.

3. Valuation: Last year, companies in the S&P 500 returned twice as much cash to stockholders in the form of stock buybacks than dividends, resulting in a total yield of 5.34% on the index (about 1.9% from dividends and the rest from buybacks). One measure of whether the equity market will be able to sustain the body blows it is receiving now will be in how well the buyback number holds up for the next year or so. A bunch of companies, including Microsoft ($40 billion), have announced buyback programs.

The Bailout

The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution?

1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It is very unlikely that this optimistic scenario will unfold. What is far more likely is that there will be defaults, and how much this bailout will cost us will depend upon how quickly housing recovers.

2. There are two keys to making this not a "bailout". The first is to pay fair value (See below) for these mortgage backed securities, rather than an optimistic value or face value. This fair value may still be a bargain for banks that face the problems of having to mark these securities to market every period. To the extent that liquidity has dried up in this market, these securities may well have to written down below fair value. The second is for taxpayers to get something in return for taking these problem securities off the books. I would use the Buffett model (from his Goldman acquisition) and ask for warrants or equity to compensate for at least a portion of the difference between the fair value and the current value (which will reflect the illiquidity).

(What is fair value? It is the present value of the cumulative cashflows on these mortgage backed securities, discounted back at a rate that realistically reflects default risk. This will be well below face value, since these securities were misvalued using default risk estimates that we too low.)

3. I know that the zeal for punitive measures is strong and that people want to punish the bankers who have put us in this position. While I will not defend sloppy valuations and poor oversight, I also believe that there is plenty of blame to go around. In fact, anyone who bought a house in the last 5 years and traded up, using a cheap mortgage to fund the move, participated in the benefits of the boom. I am not eager to seek out these homeowners and punish them either.

4. Regulation is not the answer. After all, this problem was created by a patchwork of regulations that left loopholes to be exploited. What we need is a consistent regulatory environment that covers all types of risky assets, rather than different regulatory environments for real estate, mortgage backed securities,  corporate bonds and equities. In fact, I think trying to regulate trading and restrict risk taking in a global marketplace is akin to trying to stop unauthorized downloads of movies on the internet... A waste of time and money!

I think that the bailout will not end the troubles at banks, but it is a solution to the liquidity crisis that is haunting this market.