April 26, 2007
Notes to Grant's Spring Conference 2007
Very often I write these notes as a future reminder to me for what I found interesting, or perhaps items I would like to save for future reference. These notes could be error filled, and I apologize for any inadvertent errors.
I. Grant's Spring Investment Conference April 24, 2007
I have been a subscriber to Grant's Interest Rate Observer since around year 2000. I find James Grant's work to be thought provoking, honest and often hilarious. I enjoy his sense of humor as much as I enjoy his financial Insight. I was thrilled to have him autograph my book of his on the financial life of Bernard Baruch. Here is a link to his website http://www.grantspub.com/conference/
A. The first speaker was David A. Rosenberg, Chief North American Economist from Merrill Lynch. I have read his works for years, and really enjoy his writings and thought process. His presentation was titled, "Soft Now, Hard Later." His first words were, "I just wanted to get things out of the way. I did not steal this title from our Pfizer analyst." I enjoyed how James introduced David, "David is from Canada, hence he must be a nice guy." He wouldnt comment on the mark to market of commercial paper and potential aggressiveness, as he cited his compliance department present, and didnt feel comfortable answering. His body language, to me, expressed an affirmative to the question.
1. I have a note to myself to monitor the following ratio, which David thought was quite important. "GDP Growth / Population Growth." That is a natural ratio, and material long term deviations from such, could prove interesting. I think David mentioned that future population growth in USA is expected to be 1.0%. I am not certain of that, and I do not know what the past population growth was.
2. Claims that "Inventory / Sales ratio is at a 4 year high. The remainder of this paragraph are my thoughts and not mentioned by David. I have been a fan of this ratio for a long time. Here is what I wrote in regards to Peter Lynch mentioning the ratio http://www.rbcpa.com/Understandablestocks.html . "Inventories: Are inventories piling up? This is a particularly important figure for cyclicals. Lynch notes that, for manufacturers or retailers, an inventory buildup is a bad sign, and a red flag is waving when inventories grow faster than sales. On the other hand, if a company is depressed, the first evidence of a turnaround is when inventories start to be depleted." The importance of this ratio is that when goods are produced, a company expects to sell their inventory. As inventory grows, earnings will grow as well, via Cost of Sales being reduced by ending inventory. If that inventory does not follow with a sale, then future profits will fall or cause potential stress. This stress could be lower profits, inventory impairments and cash flow concerns. Hence, one of my favorite indicators.
3. David claims that USA mortgage and home equity withdrawal, has a lag of 4 - 6 quarters on the consumer. He said to watch employment, as it follows capital spending with a lag. I had a question mark next to my notes, and just didn't follow the theory, or I wrote it down wrong.
4. He showed 2 graphs. David claims that the "Index of Leading Economic Indicators," is the most important indicator. He said the reason it is his favorite, is because "it works really well, watch this forever." He claims that the current reading of "The index of Coincident Economic Indicators" is a lagging indicator and shouldn't be focused on. He claims that the Coincident indicator has always shown the economy being okay, even when the economy was going into a recession. He cited the years of 1990/1991 and 2001 in contrast to the leading indicator for the same years. As of March 2007, the coincident indicator is at a level of 2, whereas the leading indicator is at a level of 0, and has been dropping since 2004.
5. He claims, "When the fed tightens....bad things tend to happen." He cited various incidences since 1972 and how the stock market lagged after these incidences. Examples were bank failures in 1974 and 1981, and New Century Financial in 2007.
6. He cited the mortgage delinquency rates of Prime mortgages to be at a 3 year high and Sub-prime a 5 year high. He insinuated that if you had a pulse you would qualify for a mortgage.
7. The next set of graphs he presented was very interesting. He claims that employment growth at collection agencies are at a 4 year high, and growth at credit bureaus an 11 year high. He calls this "counter cyclical charts." It makes sense, if things were so dandy, why would collection agencies be having strong employment levels?
8. Claims that residential mortgage credit was a huge stimulus to GDP. From 1980 through 2000, the average ratio of "5 year change in residential mortgage liabilities relative to nominal GDP" has been on average a touch less than 0.6. The current average is 1.6. He feels that this has added 1% to GDP growth.
9. He feels that "housing inventory situation is rapidly deteriorating." He feels that sub-prime situation will aggravate 14% or more of all mortgages.
10. He cited Alan Greenspan's mention of "froth" in the housing market form July 20, 2005. I looked it up and found it here http://www.federalreserve.gov/BOARDDOCS/HH/2005/july/testimony.htm
"....Whether home prices on average for the nation as a whole are overvalued
relative to underlying determinants is difficult to ascertain, but there do
appear to be, at a minimum, signs of froth in some local markets
where home prices seem to have risen to unsustainable levels. Among other
indicators, the significant rise in purchases of homes for investment since 2001
seems to have charged some regional markets with speculative fervor."
"The apparent froth in housing markets appears to have interacted with evolving practices in mortgage markets. The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market."
He discussed that Greenspan didn't label the housing market as a bubble, but used the word frothy. He mentioned, and I looked up froth in www.dictionary.com Here is what they cite the definition as, "an aggregation of bubbles,.." David laughed as he said something like, "Greenspan didn't see a housing bubble, he saw a series of bubbles."
If you are further interested in reading about potential housing bubbles, you could look at some of the following links.
a. http://www.realtytrac.com/ - monitor foreclosures
b. http://rbcpa.com/housing.html - a page I haven't updated in a long time
c. http://rbcpa.com/richardrussellonhomeprices020904.html - an interesting article on the 10% rule.
11. He claims the "US Debt-to-Income Ratio Rose as much in the past 5 years as it did in the previous 39 years". In 1962 the ratio of "Household Debt / Income" was 63%, it stayed under 100% until 2001, and now stands at 137%. His argument is, that it sure appears that increased debt has led the consumer spending surge of the last 20 years. As I thought more about this, I related it to my own situation. I bought my house in 1991 for under $230K, well if I was to buy the same house today, at a good price, it would be somewhere between $650K and $900K. Hence, my household debt / income levels would increase dramatically. Nevertheless, something to ponder.
12. He claims that mortgage standards are the tightest in 16 years (1991).
He ran out of time to talk, as he was allotted an entire half hour ;-), but here are some notes of the handout.
13. Claims we are barely halfway through the housing recession.
14. "Housing completion always converge upon housing starts.....nine-months later."
B. The second speaker was introduced as a nice guy as well, "as he is from Canada." Bruce Flatt from Brookfield Asset Management (BAM)(57.06).
I really don't have much to say on this. I have seen him speak once before, and just wasn't swayed to investing in his company. Granted the last time I saw his presentation was at some point in the Spring of 2005, and the price has risen almost 200% since then. BAM is loved by many a value investor. Last year, Adam Weiss from Scout Capital spoke at Grant's conference. Scout Capital has a large position in BAM. They apparently love the company. I really have nothing to add on BAM (sorry).
C. The third speaker was introduced. James said something like this, " The next speaker is from Russia, yet he is probably a nice guy, Simon Mikahailovich, front and center." Simon started with an explanation that there is an old Russian saying, "In Russia they say, nice guys is not a profession." Simon, like David was so informative and presented in a flawless, exceptional manner. His presentation was titled, "Collateralized Debt Obligations: A coup of financial engineering or a triumph of hope over experience?"
1. I made a note to myself to search the speaker in depth. What a wealth of knowledge and half an hour is not enough time for me to comprehend this difficult area.
2. He feels much of the economy is being held up by a source of abundances from CDO's. He feels this will soon stop, and perhaps has stopped already. He mentioned that "defaults and downgrades will start the action."
3. He mentioned a subject I just don't understand. He said that "synthetic protection is cheap." He suggested buying a put on credit side. I just don't know how to do that, especially in my situation, and my broker dealer.
4. He was hilarious when he presented a slide of 4 very complicated formulas. He said something like, "okay, I can review these formulas of diversity score, expected loss, adjusted diversity score and Gaussian Copula, but we only have a half hour, so let me show you this slide instead." He then showed us a slide with a 5 lb. Purdue chicken versus 5 lbs. cut up and packaged. He explained that the cut up and packaged chicken, still totals 5 lbs, but because of buy what you want, you pay a premium price. That is a traditional "repackaging value proposition." He then showed us a "repackaging value proposition - Structured Credit Version." This he compared to the CDO market. You thought you had 500 lbs of chicken, but now you have 515 ++ lbs of chicken and various other rated poultry derivative products.
5. He then showed the definition and structure of CDO's, "very complicated" he said with a sarcastic Russian accent. What followed was a series of complicated descriptions and so forth, and I still need to study it, and don't ever expect to write about it. Yet, he pointed out that CDO growth since 2004 appears exponential. A common theme of Rosenberg and Simon, would be the pain of liquidity being tightened.
6. He claims that current credit analysts have not lived through difficult periods, they have only modeled them. He hinted that inexperience has caused pricing errors. He mentioned that inexperience will turn into experience, the hard way. He said that "historical loss experience is not priced into the lower tranches of CDO's.
7. He claims that downgrades will come of CDO's and that margin calls from Basel II will come. Under Basel II, he claims "risk weights for High Yield Structured Securities will rise sharply." He mentioned there will be new Ratings Based Approaches (RBA) under Basel II.
8. He calls many second lien loans and LBO's to be "covenant-lite loans."
9. He quoted Grants June 2006, "...financial engineering is the science of structuring cash flows; credit analysis is the art of getting paid."
D. I skipped a bunch of speakers, just not my gig. David Swensen, Yale's Chief Investment Officer spoke on, "The Folly of Active Management." I don't have a lot to write here.
1. He said that "asset allocation is investors most important tool." Sometimes I lose sight of that, and for that comment alone, I am thrilled he reminded me of such.
2. A question was asked about Charlie Munger. David said, "I don't like Charlie, for some reason he compared me to a serial killer." I searched this and found this link http://boards.fool.com/Message.asp?mid=10485033 " "Some foundations, following the lead of institutions like Yale, have tried to become much better versions of Bernie Cornfeld's "fund of Funds". This is an amazing development. Few would have predicted that, long after Cornfeld's fall into disgrace, leading universities would be leading foundations into Cornfeld's system." In regards to Munger and Swensen, I also found this, http://www.fool.com/news/foth/2000/foth000919.htm "Coincidentally, the issue of investing discipline was an indirect theme of a speech about institutional investment management given a few years ago by another old pal of Buffett, Berkshire Hathaway (NYSE: BRK.A) vice-chairman Charlie Munger. In it, Munger singled out Yale's investment philosophy as an example of what institutional managers should avoid doing, taking particular exception to the complexity that has moved the university's endowment toward becoming an institutional version of the so-called "fund of funds" investment model." As I searched "Bernie Cornfeld," I found that Cornfeld was perhaps a thief, but not a serial killer. I wonder if Charlie ever called Swensen "demented" as he did Wharton professor Jeremy Siegel. http://en.wikipedia.org/wiki/Jeremy_Siegel ""At the 2006 Berkshire Hathaway annual meeting, one of the firm's executives, Charlie Munger, called Jeremy Siegel "demented" for "comparing apples to elephants" in making future predictions."
E. What follows is a haphazard lousy attempt to describe what awesome speaker William Ackman had to say. He had to speak quickly, and he had so much to say. He had no handout, hence everything moved along so quickly. After the program, I asked him for a copy of his presentation. He explained he wasn't ready to distribute it, and in time, he might send it to James Grant to distribute to subscribers. I hope so, as his discussion was incredible. William is founder of Pershing Square Capital Management. His speech was titled, "Who's holding the bag?"
1. In regards to securitization industry, CDO's, borrowers, lenders, etc, he said, "There will be a wholesale downgrade of the entire industry. This could make the process of downgrading slow." He mentioned that ratings agencies have so much on their plate, that they might hold off on downgrades until they can batch them all together.
2. He thinks defaults will be higher than predicted. There will be a lack of new CDO's. Banks will start pulling warehouse lines. Ratings will adjust (see 1. above) and there will be tighter lending standards. Additional credit enhancement will be required.
3. He said the companies holding the bag will be MBIA and Ambac, as well as reinsurers who reinsure MBIA. Who else?, the major securitizers. He mentioned shorting MBIA (MBI 67) and Goldman Sachs (GS 220)
He presented a very quick short thesis on MBIA. He claimed they are over leveraged, aggressive and have had mass management departures. He went so quick, I lost so much, and really have little to write on it. As I write this, I realize my notes seem to lend a serious injustice to such an excellent thesis.
F. The last speaker was our host, James Grant. His speech can be found here http://www.grantspub.com/conference/spring2007/presentation.pdf I wont repeat the speech, since you can read it for yourself. Here are some notes I took, during the discussion.
1. Gulf equities are in a bear market. He claims the plunge has been in price and not earnings. There has not been an earnings contraction. Earnings and outlook appears robust. He would look at Saudi Arabia, Kuwait and the Gulf Cooperation Council. http://www.gcc-sg.org/index_e.html
2. He mentioned Orascom Telecom http://www.otelecom.com/ and Orascom Construction http://www.orascomci.com/index.php?id=home . He didn't think either could be bought from USA broker. Maybe, I will research.
3. He is not calling a bottom in residential mortgage finance.
4. "Downgrades are just beginning." He claims that recent downgrades seem to be occurring on Friday's at 6:03pm, when everyone has gone home.
5. He feels high grade bonds will be down graded to junk or near junk.
Thank you for reading this. I apologize for sloppiness, and perhaps misrepresentations. If there are any or many errors, they were all unintentional.
Ronald R. Redfield CPA, PFS.