Australia is caught in a credit crunch and the banks just made it worse, not better.

Banks' rate moves reveal system cracks

David Llewellyn-Smith

February 13, 2012

The media reaction to the banks' Friday rate hikes has been dominated by a schoolyard binary construction of the problem: the banks versus the government.

Some have taken the side of the government, that the banks are a greedy bunch of so and sos. Most have taken the side of the banks, that the government has no right to interfere in private business decisions.

Laudable sentiments if the banks are private. Which they are not. But let that pass.

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This columnist has already written that what's really at stake here is the political economy of banking and the government's failure to openly address that fact is now coming back to haunt it.

Instead this column will argue a much simpler point: Australia is caught in a credit crunch and the banks just made it worse, not better.

How so? To understand you have to have a handle on the basic tenets of banking. Like all businesses, banks have a balance sheet. There are two halves to the balance sheet: assets and liabilities.

For banks it's a little confusing because outgoing loans - for houses, cars etc. - are in fact assets. They are the stuff from which banks draw an income.

The bank's liabilities are also loans, but those taken from others, like deposits or bonds. The difference between these two is the bank's equity or capital base.

The ratio between the amount of capital and total assets is called the leverage. It's the number of times against which the bank's capital has been multiplied in its outgoing lending book.

That's it, not so hard.

Trouble triggers

There are two ways in which a bank can find itself in trouble. The first and most common is when its assets - the loans it has given to its clients - deteriorate in quality.

This problem happens when the folks who borrowed the money struggle to repay it. They might have lost their job, or the asset they offered as collateral against the loan - say, a house - may have lost value and their own balance sheet is under pressure.

If they sell, they can't repay the whole loan amount. You can see how this process can feed upon itself as distressed sales leads to more falling prices.

At a certain stage the banks themselves get into trouble as enough assets are impaired and their capital begins to decline. They must then restrict lending and the problem gets worse again. This is called a credit crunch.

This is what happened in the US. Australia is also in the early stages of such a process with falling house prices, rising unemployment and rising impaired loans at the banks. It's difficult to judge how far into this we are and whether it can be reversed.

The jobs generated by the mining boom offer the hope that it is possible to arrest the decline and instead of a credit crunch we get a stall in housing and a redistribution of capital elsewhere.

The primary protection against the process getting out of control is monetary policy, or interest rates, which can be lowered to alleviate the borrower stress at the heart of the problem.

Nervous creditors

The second way in which a bank can find itself in trouble is on the other side of the balance sheet: the liabilities. This happens when the people lending money to the bank - depositors or investors - get nervous and want a higher interest rate to give the bank their money.

In the past this was not much of a problem for Australian banks as they relied upon steady deposits. However, after the new millennium began, the banks went a bit nuts borrowing less stable money from investors here and abroad and loaned that money largely to punters betting on houses.

Now, through a combination of the troubles in Europe, the fact that the process of deteriorating assets is under way, and through their own incompetence in the mishandling of covered bonds, investors want much higher interest rates to lend our banks money.

So yes, they need to raise interest rates to extract more money from the other side of the balance sheet to compensate. If they don't then they'll not be able to lend money on unprofitable loans and the credit crunch still transpires as the banks limit the supply of credit.

In short, whichever way the banks turn right now, whether they pass on their borrowing costs to mortgagors and put downward pressure on their assets, or they absorb the higher funding costs and stop making unprofitable loans, we edge further into a credit crunch. And indeed, as you can see, the two halves of the balance sheet aren't at all separate.

Credit crunch

As risk builds in one then it has a deleterious effect on the other and so another feedback loop threatens. This is systemic stress and is exactly where we are now, whether you want to blame the government or the banks (or, in this writer's case, the politico-housing complex).

So, the only question that matters right now is this: can the RBA arrest this developing feedback loop by cutting interest rates?

To my mind it is now clear that the central bank, which handled its actions flawlessly last year, erred dramatically last week in staying on hold.

By pushing the banks to hike unilaterally, the first time in history, the banks have shaken the foundation of the one commonly (and sensibly enough) held truth in Australian asset markets, that when asset prices decline, unemployment or other economic adversity threatens, the RBA will save us by cutting interest rates.

The insurance is still there but a nasty crack now runs through its base and this commentator can only see this making asset markets worse.

We're into a credit crunch all right.

David Llewellyn-Smith is the editor of MacroBusiness and co-author of the Great Crash of 2008 with Ross Garnaut. This is an edited version of a longer article available free at MacroBusiness.

Read more: http://www.smh.com.au/business/banks-rate-moves-reveal-system-cracks-20120213-1t0ce.html#ixzz1mIsQMilO

All the Big Banks lift Rates

Eric Johnston

February 13, 2012 - 5:46PM

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The Commonwealth Bank and National Australia Bank have become the latest banks to raise their variable lending rates outside the Reserve Bank's regular monthly cycle.

National Australia Bank this evening said it would lift its standard variable home loan interest rate by 9 basis points to 7.31 per cent.

• ANZ to cut 1000 jobs by September

Earlier, the Commonwealth Bank, Australia's biggest mortgage bank, announced that its standard variable mortgage rate will rise 10 basis points to 7.41 per cent from February 20.

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Commonwealth Bank and regional lender Bendigo and Adelaide Bank become the latest banks to break ranks with the RBA. Photo: Jessica Shapiro

The moves round out the out-of-cycle rate rises among the big four banks.

Also today, Bendigo and Adelaide Bank increased its standard variable mortgage rate 15 basis points to 7.45 per cent.

Westpac and the ANZ defied Treasurer Wayne Swan and lifted variable rates 0.10 and 0.06 percentage points respectively, on Friday, despite a decision by the Reserve Bank to hold its cash rate steady. The ANZ bank today announced it would cut 1000 jobs by September 30 to cope with weaker demand for banking services.

Rising costs

As with other banks, CBA blamed today's rate increase on rising funding costs, adding that greater uncertainty emanating from Europe was exacerbating the situation.

“In making this decision, we have been cognisant of our total funding costs, of which the official cash rate is only one factor,’’ said CBA group executive of retail banking Ross McEwan.

‘‘The Commonwealth Bank believes Australian banks should continue to price sensibly, taking into account factors both on and offshore, rather than experience similar problems to those that many banks overseas have experienced,’’ Mr McEwan said.

"Whilst we understand that any increase in interest rates is not favourable to borrowers, our millions of deposit customers are favoured and since the commencement of the GFC we have seen significant competition in retail deposits pricing," he said.

CBA said it would raise the interest rate on its six-month term deposit account by 20 basis points, also effective February 20.

National Australia Bank, the last of the four big banks to announce its interest rate stance, said it is reviewing its rates.

Commonwealth Bank shares rose 41 cents, or 0.8 per cent, to $50.29, slightly less than the overall market's gain. Bendigo and Adelaide Bank shares rose 6 cents, or 0.7 per cent, to $8.19.

Bendigo move

Bendigo, like ANZ, has also said it would review interest rates independently of the Reserve Bank. Westpac's new variable mortgage rate is 7.46 per cent and ANZ's is 7.36 per cent.

Bendigo managing director Mike Hirst said current banking margins are not sustainable and adjustments to interest rates must be made.

“This is not a popular move, we know that, but it is the right thing to do to restore a proper balance between depositors, borrowers, the Bank’s shareholders and our community partners. At current funding cost levels that balance is out,” he said.

At current pricing levels banks were “subsidising mortgages,” Mr Hirst said.

“If you look at the traditional role of a bank this makes no sense and is unsustainable,” he added.

Mr Hirst said banks had a fundamental choice to make: adjust the pricing on loans or restrict lending. He added the latter option would have significant implications for the economy and would not be the right thing to do at this point in time.

He also said many staff at Bendigo have taken unpaid leave to help reduce costs, while no new back office staff are being hired.

Bendigo’s new mortgage rate will apply from February 21.

ejohnston@theage.com.au, with Chris Zappone

Read more: http://www.smh.com.au/business/all-the-big-banks-lift-rates-20120213-1t1ae.html#ixzz1mIuF0oCu

Smarter people own shares, study finds

January 19, 2012

Share ownership is linked to intelligence, researchers have found. Photo: Reuters

The smarter you are, the more stock you probably own, according to researchers who say they found a direct link between IQ and equity market participation.

Intelligence, as measured by tests given to 158,044 Finnish soldiers over 19 years, outweighed income in determining whether someone owns shares and how many companies he invests in. Among draftees scoring highest on the exams, the rate of ownership later in life was 21 percentage points above those who tested lowest, researchers found. The study, published in last month's Journal of Finance, ignored bonds and other investments.

Economists have debated for decades what they call the participation puzzle, trying to explain why more people don't take advantage of the higher returns stocks have historically paid on savings. As few as 51 per cent of American households own them, a 2009 study by the Federal Reserve found. Individual investors have pulled record cash out of US equity mutual funds in the last five years as shares suffered the worst bear market since the 1930s.

"It's what we see anecdotally: higher-IQ investors tend to be more willing to commit financial resources, to put skin in the game," said Jason Hsu, chief investment officer of Newport Beach, California-based Research Affiliates LLC. "You can generalize a whole literature on this. It seems to suggest that whatever attributes are driving people to not participate in the stock market are related to the cost of processing financial information."

'So Strong'

While intelligence influenced things that might naturally increase equity ownership such as wealth and income, the authors said IQ determined who owned the most stocks within those categories as well. Among the 10 per cent of individuals with the highest salary, "IQ significantly predicts participation" in the stock market, they wrote. For example, people in the highest-income ranking who scored lowest on the test had a rate of equity market participation that was 15.7 percentage points lower than those with the highest IQ.

"If you look at the significance of IQ related to other factors like income or wealth, certainly it plays a very large role," Keloharju, a finance professor at Aalto, said in a phone interview. "It's very difficult to get around that problem, but the results are so strong here. We are playing with lots of different controls and lots of different specifications, and all the time things work really well."

Financial Education

Hsu of Research Affiliates said an explanation for why draftees with lower test scores owned less stock is that they found it harder and more expensive to receive financial education. Getting people information on investing at a younger age may help limit the disparity, he said.

"The costs to achieve that are certainly higher if someone isn't providing that at an earlier stage in one's education," said Hsu. "If we could provide advice, or provide education, to help reduce the cost of acquiring financial knowledge, that would seem like a good thing."

The paper is part of a broader debate about the role individual characteristics such as affluence and education play in investor actions. In the 1980s, so-called behavioral economists broke away from theorists such as Sharpe, who tended to think of all investors as rational.

Greg Davies, head of behavioral finance at Barclays Wealth in London, said his team tries to gauge clients' risk tolerance with personality profiles and investment strategies that appeal to "emotional needs."

Implications

"As advisers, of course, we see our role in overcoming the irrational, emotional, inaccurate elements on behalf of our clients," said Davies. "But the implications of this for the mass markets are much greater."

Markowitz said the argument that intelligence and personality sometimes trump rationality in guiding investors has little bearing on his work. His theory comes down to the view that anyone hoping to get the highest payout at the lowest risk should broaden their asset ownership.

"It's advice for the individual investor," Markowitz, 84, said in a telephone interview. "I am delighted to learn the more intelligent a person is, the more likely they are to act in the spirit of what I wrote."

BLOOMBERG

Read more: http://www.smh.com.au/business/world-business/smarter-people-own-shares-study-finds-20120119-1q7lz.html#ixzz1mImsSYrJ

Risk and Return - Find Investments offering High Returns with Low Risk

A positive correlation between risk and return would hold consistently only in an efficient market.  Any disparities would be immediately corrected, this is what would make the market efficient.

In inefficient markets it is possible to find investments offering high returns with low risk.  These arise 

• when information is not widely available, 
• when an investment is particularly complicated to analyze, or 
• when investors buy and sell for reasons unrelated to value.  

It is also common place to discover high-risk investments offering low returns.  Overpriced and therefore risky investments are often available

• because the financial markets are biased toward overvaluation and 
• because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying.  
• Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy, they are not legally required to sell at a fair price.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns.  Risk and return must instead be assessed independently for every investment.  

In point of fact, greater risk does not guarantee greater return.  To the contrary, risk erodes return by causing losses.

It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.

By itself risk does not create incremental return; only price can accomplish that.

Value investing is simple to understand but difficult to implement.

Value investing is simple to understand but difficult to implement.

Value investors are not super sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value.

The hard part is discipline, patience, and judgment . Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing

Value Investors are absolute-performance oriented and are willing to hold cash when no bargains are available

Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that be come more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative-performance orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market.  Since the goal is at least to match and optimally be at the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

• Cash is liquid and provides a modest , sometimes attractive nominal return, usually above the rate of inflation. 
• The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. 
• Finally, unlike any other holding, cash doe s not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Three central elements to a value-investment philosophy.

There are three central elements to a value-investment philosophy.

• First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities.
• Second, value investing is absolute-performance,  not relative performance oriented. 
• Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return)

It is hard to prove an overly optimistic investor wrong in the short run

To some extent value, like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone. It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable and since stocks can remain overvalued for a long time. Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while.

Ironically, many true value investors fell into disfavor during the late 1980s. As they avoided participating in the fully valued and overvalued securities that the value pretenders claimed to be bargains, many of them temporarily underperformed the results achieved by the value pretenders . The mos t conservative were actually criticized for their "excessive" caution, prudence that proved well founded in 1990.

Even today many of the value pretenders have not been defrocked of their value-investor mantle. There were many articles in financial periodicals chronicling the poor investment results posted by many so-called value investors in 1990. The top of the list, needless to say, was dominated by va lue pretenders

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Fantasia Barrino - Summertime

Avoiding loss should be the primary goal of every investor

Warren Buffett likes to say that the first rule of investing is "Don't lose money," and the second rule is, "Never forget the first rule." I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

A loss-avoidance strategy is at odds with recent conventional market wisdom. Today many people believe that risk comes, not from owning stocks, but from not owning them. Stocks as a group, this line of thinking goes, will outperform bonds or cash equivalents over time, just as they have in the past. Indexing is one manifestation of this view. The tendency of most institutional investors to be fully invested at all times is another.

There is an element of truth to this notion; stocks do figure to outperform bonds and cash over the years. Being junior in a company's capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments. In a corporate liquidation, for example, the equity only receives the residual after all liabilities are satisfied.  To persuade investors to venture into equities rather than safer debt instruments, they must be enticed by the prospect of higher returns. However, the actual risk of a particular investment cannot be determined from historical data. It depends on the price paid. If enough investors believe the argument that equities will offer the best long-term returns, they may pour money into stocks, bidding prices up to levels at which they no longer offer the superior returns. The risk of loss stemming from equity's place in the capital structure is exacerbated by paying a higher price.

Waiting for the Right Pitch

For a value investor a pitch must not only be in the strike zone, it must be in his "sweet spot."  Results will be best when the investor is not pressured to invest prematurely.  There may be times when the investor does not lift the bat from his shoulder, the cheapest security in an overvalued market may still be overvalued.  You wouldn't want to settle for an investment offering a safe 10 percent return if you thought it very likely that another offering an equally safe 15 percent return would soon materialize.

An investment must be purchased at a discount from underlying worth.  This makes it a good absolute value.  Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available.  A stock trading at one-half of the underlying value may be attractive, but another trading at one-fourth of its worth is the better bargain.  This dual discipline compounds the difficulty of the investment task for value investors compared with most others.

Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available.  Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings.  In other words, no investment should be considered sacred when a better one comes along.

Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation also grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines. When attractive opportunities are plentiful, value investors are able to sift carefully through all the bargains for the ones they find most attractive. When attractive opportunities are scarce, however, investors mus t exhibit great self-discipline in order to maintain the integrity of the valuation process and limit the price paid. Above all, investors must always avoid swinging at bad pitches.

Be willing to hold cash reserves when no bargains are available

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation.

The liquidity of cash affords flexibility, for it can quickly be channelled into other investment outlets with minimal transaction costs. 

Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines

Value Investment Philosophy

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. The number of available bargains varies, and the gap between the price and value of any given security can be very narrow or extremely wide. Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden.


The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds . It can be a very lonely undertaking. A value investor may experience poor, even horrendous , performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

A notable feature of value investing is its strong performance in periods of overall market decline.

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

• Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 
• Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. 
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them.

Example:


In early 1987 the shares of Telefonos de Mexico, S.A., sold for prices as low as ten cents. The company was not doing badly, and analysts were forecasting for the shares annual earnings of fifteen cents and a book value of approximately seventy-five cents in 1988. Investors seemed to focus only on the continual dilution of the stock, stemming from quarterly 6.25 percent stock dividends and from the issuance of shares to new telephone subscribers, ostensibly to fund the required capital outlays to install their phones. The market ignored virtually every criterion of value, pricing the shares at extremely low multiples of earnings and cash flow while completely disregarding book value.

In early 1991 Telefonos's share price rose to over $3.25. The shares, out of favor several years earlier, became an institutional favorite. True, some improvement in operating results did contribute to this enormous price appreciation, but the primary explanation was an increase in the multiple investors were willing to pay. The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.




Ref:  Margin of Safety by Seth Klarman

Should investors worry about the possibility that business value may decline? Absolutely.

The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient?

Should investors worry about the possibility that business value may decline? Absolutely. Should they do anything about it? There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. 
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. 
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Ref:  Margin of Safety by Seth Klarman

Investments that involve risk are superior only if the return more than fully compensates for the risk

Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate.  Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.

Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value' investing.

Risk avoidance is the single most important element of an investment program

Another common belief is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk. Why do I believe, conversely, that risk avoidance is the single most important element of an investment program? 

If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss? Probably not.  Would you risk your entire net worth on such a gamble? Of course not. Would you risk the loss of, say, 30 percent of your net worth for an equivalent gain? Not many people would because the loss of a substantial amount of money could impair their standard of living while a comparable gain might not improve it commensurately. If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy.

Greedy, short-term-oriented investors may lose sight of a sound mathematical reason for avoiding loss: the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling.

Perseverance at even relatively modest rates of return is of the utmost importance in compounding
your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

Lessons from the junk bonds debacles of the 1980s and their collapse in 1990

Contrary to the promises of underwriters, junk bonds were a poor investment. They offered too little return for their substantial risk. To meet contractual interest and principal obligations, the number of things that needed to go right for issuers was high while the margin for error was low. Although the potential return was several hundred basis points annually in excess of U.S. Treasury securities, the risk involved the possible loss of one's entire investment.

Motivated by self-interest and greed, respectively, underwriters and buyers of junk bonds rationalized their actions. They accepted claims of a low default rate, and they used cash flow, as measured by EBITDA, as the principal determinant of underlying value. They even argued that a well-diversified portfolio of junk bonds was safe.

As this market collapsed in 1990, junk bonds were transformed into the financial equivalent of roach motels; investors could get in, but they couldn't get out. Bullish assumptions were replaced by bearish ones. Investor focus shifted from what might go right to what could go wrong, and prices plummeted.

Why should the history of the junk-bond market in the 1980s interest investors today? If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money? The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behavior of most financial-market participants. The overpricing of junk bonds allowed many takeovers to take place at inflated valuations. The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk. Cash received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market. As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely.  We may confidently expect that there will be new investment fads in the future. They too will expand beyond the rational limitations of the innovation. As surely as this will happen, it is equally certain that no bells will toll to announce the excess. Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them. And as we shall see in the chapters that follow, avoiding losses is the most important prerequisite to investment success.

Ref: Margin of Safety by Seth Klarman

Collateralized Bond Obligations - a pile of junk is still junk no matter how you stack it.

Collateralized Junk-Bond Obligations

One of the last junk-bond-market innovations was the collateralized bond obligation (CBO). CBOs are diversified investment pools of junk bonds that issue their own securities with the underlying junk bonds as collateral. Several tranches of securities with different seniorities are usually created, each with risk and return characteristics that differ from those of the underlying junk bonds themselves.

What attracted underwriters as well as investors to junkbond CBOs was that the rating agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating. This means that an issuer could assemble a portfolio of junk bonds yielding 14 percent and sell to investors a senior tranche of securities backed by those bonds at a yield of, say, 10 percent, with proceeds equal to perhaps 75 percent of the cost of the portfolio. The issuer could then sell riskier junior tranches by offering much higher yields to investors.

The existence of CBOs was predicated on the receipt of this investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment grade securities. As usual these yield pigs sacrificed credit quality for additional current return. The rating agencies performed studies showing that the investment-grade rating was warranted.  Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancings. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it.

Window Dressing

Window dressing is the practice of making a portfolio look good for quarterly reporting purposes.

Some managers will deliberately buy shares of the current quarter's best market performers and sell shares of significant under-performers in order to dress up the portfolio's appearance in the quarterly report to clients.  They also may sell positions with significant unrealized losses so that clients will not be reminded of major mistakes month after month.

Such behavior is clearly uneconomic as well as intellectually insulting to clients; it also exacerbates price movements in either direction.  Even so, as depressed issues drop further in price, attractive opportunities may be created for value investors.

Seth Klarman and Margin of Safety

Seth Klarman

Brief Biography

Seth Klarman is a leading value investor. Mr. Klarman is the President of The Baupost Group, a Boston-based private investment partnership which manages over $7bn in assets on behalf of private families and institutions. Founded in 1983, the firm has achieved investment returns of 20% compounded annually. The firm invests in equities, distressed debt, private equity and real estate. Mr. Klarman is notable for his willingness to hold significant amounts of cash in his investment portfolios, sometimes in excess of 50% of the total. In 1991, Mr, Klarman authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000. Before founding Baupost, Mr. Klarman previously worked for Max Heine and Michael Price of Mutual Shares. Mr. Klarman is a graduate of Cornell University and Harvard Business School.

http://valuestockplus.wordpress.com/seth-klarman/

Click here for a pdf copy of this book.
http://www.my10000dollars.com/MS.pdf