Finance – Page 61

Not a heck of a lot happening

I’ve been relatively happy with my portfolio, although the market performance has been less than thrilling. About two-thirds of the portfolio is trading well less than tangible book value, while the speculative components are fairly well positioned and I am just patiently waiting for the market to come to the conclusion that there is some serious undervaluation. Just eyeballing it, these companies are roughly at 55-70% of book value with strongly positive earnings.

Such suppression of market value can continue for some time but inevitably I will get paid – either through a dividend payment or a boost of market value. Buying back shares under tangible book value is also one of the rare times that I like to see share buybacks.

As prices have gone down, I have nibbled more of a position. This is probably the deepest value position that I have taken for my portfolio in quite some time.

Throughout the year it is always good to keep in the back of the mind if unrealized losses in the portfolio should be taken, and over the past couple months I have liquidated the losers and what is remaining in the portfolio is a substantial sum of deferred capital gains for 2013 and beyond.

I expect to see these unrealized capital gains get larger with the current portfolio. It is just a matter of being patient and hence, the general lack of observations here lately.

Twiddle thy thumbs

While one should always be vigilant at looking for opportunities, sometimes there are none and that sticking to your existing portfolio is the best thing you can do.

In order for any investment to be successful, you need to make two critical decisions. The decision to buy, and the decision to sell. If you get the buy correct, but ruin it by an incorrect sell decision, the results are quite depressing. Just look at those people that bought Apple at $50/share and thought it topped out at $100. Sometimes those decisions are good – if you dumped RIMM at $60 a couple years ago, you’d be laughing.

Traditionally in my own investment history, my entries have been quite good, but most of my sell decisions have been early to the game. I have been trying to improve this.

RIMM upcoming quarterly report

RIMM’s (Nasdaq: RIMM) expectations have finally been driven deeply into the red – an expected loss of 46 cents for this upcoming quarter, 1.49 loss for the current fiscal year and 71 cents for the next fiscal year (year ended February 2014).

I earlier suggested that potential investors in RIMM should wait until these estimates go deeply negative. They are now currently negative and I would suspect after this quarterly report, the company is going to get expectations to the point where the risk has been correctly priced in if not already there.

While I am not buying RIMM shares, people that believe in Blackberry 10 and its potential probably have a correctly timed entry point in the remainder of this year – especially as most institutional investors will be sitting on tax losses and would likely want to clear it out of their portfolio or risk embarrassing themselves.

There is still obvious technology adoption risk for the company – if they execute well then you might be sitting on a double or even more if they are able to regain market share (and perhaps the more important mind-share of the developers). If they don’t, well, then you get a Nokia (NYSE: NOK) where you start pricing the company based off of salvage value.

Does High Frequency Trading add value to the market?

Reading Mark Cuban’s post about High Frequency Trading (HFT), indeed, I agree with him that it provides little value to the marketplace.

The incentives are completely geared toward having it, however – the stock exchanges make money on volume and have no incentive to stop it. The traders themselves are able to do it profitably and have no incentive to stop.

The easy solution to fix this problem is to simply transform the stock market into one second auction windows – i.e. every second that the stock market is open (6.5 hours, which translates into 23,400 seconds) bids and asks are aggregated and transactions are appropriately processed.

This would also undermine the value of sub-penny quotations and seriously reduce the value of phantom quotations that try to “probe” what hidden support there is in the order book.

There would be a decrease in volume, but most of the volume you see today is “phantom liquidity” – it is liquidity that would never be truly accessible for somebody wanting to accumulate or distribute shares at a certain price level.

This change is unlikely to be enacted, however, since it does nothing politically for those that control the securities commissions – the regulators’ incentive structure is favoured toward higher complexity, and thus more requirements for regulation.

More specifically, securities regulations has little to do with “investor protection” – rather, it is about entrenchment of established interests.

Generating synethic performance – catering to yield chasers

Finance is a very funny industry. The primary way of keeping score, change in cash, is not really used as a performance measure. Instead, the performance measure is return on investment, which is a proxy for change in cash, but not the same. Return on investment is a flawed metric because it does not take into account risk.

A clever formula to weighing historical risk and performance is the Sharpe Ratio, but I will leave that mathematical dissection (and the weakness of the Sharpe Ratio) for another post.

If I told you that I made 2% this year, an observer in an “up” market environment would say that is a horrible return on investment and bad performance. If I then said that my portfolio was 100% cash, then the performance would be fantastic. You might chide the decision to be all-cash in an up market environment (missing the wave) but at least the performance in the constraints of a 100% cash portfolio was great (given that the most you can do these days is less).

However, if you wanted to juice your performance, the drug of choice in the finance industry is leverage. And in today’s interest rate environment, the rate on leverage is cheap. Even retail investors can get into the action by loaning money from Interactive Brokers (depending on how much money you actually borrow – the first US$100,000 is at 1.65%, the next US$900,000 is at 1.15% and the next US$2,000,000 is at 0.65% and everything above that is at 0.5%).

Assume you get a 1% borrowing rate, which makes the arithmetic easy. So if you manage to earn a 2% average on cash, why not borrow cash at 1% to invest it at 2%? So I will set up a mutual fund. All I will do is invest at a risk-free rate of 2%, and apply some leverage. I invest $100 in my own fund, but borrow $900 at 1%. What happens financially?

Interest income: $20
Interest expense: $9
Net income: $11
Return on investment: ($11 net income / $100 equity investment) = 11%!

So I have magically transformed what was a 2% return into a 11% return with the magic of leverage. Using this technique, and unlimited borrowing power, I can generate any return on investment you desire. Want 101%? Easy – borrow $10,000 instead.

This concept is introduced in introductory level finance courses across the world, but most people fail to appreciate how the rate of return figure that is being advertised in a lot of cases is simply a synthetic return. The use of leverage creates this return. Parenthetically, a similar way of generating “synthetic yield” was used in the mid-2000’s when income trusts were raising equity capital and just giving back cash to unitholders as a return of capital to generate false yield when they weren’t really making any money to justify their distributions.

Where do you see synthetic performance currently occurring? Mostly in the US financial REIT markets like Annaly (NYSE: NLY) and others. They borrow money for cheap, invest them in mortgage-backed securities, and then skim the spread. They goose their performance with leverage.

While this is a valid way of making money, the danger is on the reliability of returns – even if the asset you are investing in inevitably gives out the desired return (both of interest and principal), if the asset value itself has severe variations, funds will be forced to liquidate such securities for losses because they will have lost borrowing power. If you have enough capital being driven into these financial structures and they keep leveraging the capital to generate high returns, there will be some blowups along the way simply because the asset pool they are investing in will be well above true vale. One blowup will likely cause others to blowup since they are essentially invested in correlated products.

Yield-chasers are going to get crushed. I am not sure when this will occur, but the current trend toward yield chasing is crystal clear. I’m not going to be shorting such securities presently since I think the momentum still has quite some way to go, but when this insatiable risk reaches some sort of crescendo, that would probably be a good time to sell everything and wait for a 2008-style crash in asset values. Maybe in 2013 or 2014?