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Over the past few weeks the market has been very volatile - my two largest positions - financial guarantors ABK and MBI - have been routinely oscillating as much as 10% a day, implied volatility on both is over 100, very high for stocks that normally would have a volatility of 25 or so. Obviously this type of market action can get you to where you start second guessing yourself, which raises my topic - the importance of having high conviction picks.
To develop high conviction, I am now setting minimum standards for myself, to review a reasonable amount of information and resolve any questions or reservations before I get involved with buying a stock. Beyond that, I look for an affirmative reason to buy, some special strength or business strategy that sets a company apart from others in its field. I should be making decisions such that they do not need to be revised unless new information becomes available.
Some benefits of doing my homework:
Not getting whipsawed. If I am uncertain as to the value of a stock, sudden or prolonged negative price movements may unnerve me, with the result that I will sell the stock just before it starts to go back up. A volatile market exacerbates this type of problem.
Enlarging a declining position decisively and with confidence. If I am clear on value, a price decrease is a welcome buying opportunity. Otherwise, it is an invitation to play double or nothing, perhaps compounding my losses like a losing gambler.
Winning trades executed at a good size level. I don't feel too bright when I take a flyer on something that looks good, controlling some perceived risk by keeping the position small, and then the stock immediately goes up 50%. Additional time spent on research will enable me to control my risk by understanding the company's operations and finances rather than spreading my money out on a bunch of mediocre ideas.
Longer holding periods - long term gains, less turnover, lower transaction costs. By clearly understanding the long term potential of a company I invest in, I will be less tempted to grab quick profits from small moves. I don't have anything against quick and easy profits, much better than round trips, but it is certainly disappointing to look at a stock's current price and realize I took the money and ran on something that has since tripled.
Maintaining high conviction means I need to look at new information on my picks as it becomes available and integrate that information with my opinion on the stock. What that has involved lately has been listening to a lot of presentations or conference calls relating to the Financial Guarantors and including the rating agencies, S&P, Moody's and Fitch.
I also spent quite a bit of time checking out various blogs on the two companies. Blogging seems to rely on taking dramatic positions: in this case, that MBI and ABK are in point of fact actually bankrupt, that their losses will exceed their capital, that the rating agencies will put them out of business by downgrading them, so on and so forth. In point of fact, I found very little useful information, mostly just a repetitious and derivative selection of doom and gloom predictions.
An emerging trend and very helpful is the the amount of disclosures the two companies have on their websites, as well as the easy access to reports from the rating agencies, all in one place. I spent quite a bit of time browsing all that information.
Where that leaves me on ABK and MBI is:
1) losses from subprime will be manageable within their current capital structure. The point is, that these companies have a robust cash flow for years into the future based on the profitability of the existing bond business, and losses, if any, from subprime are going to be paid as interest and princiapl fall due, and before that only when beneficial to the guarantors. The other point is, that the structure of CDOs or CDO squared provides a lot of protection in terms of the subordination or attachment point, which generally exceeds any reasonable estimation of cumulative losses.
2) the rating agencies are upgrading their models for stress testing capital adequacy and are likely to raise questions: some capital may need to be added. CIFG, a competitor, recently added 1.5 billion of capital from its parent company, in order to maintain their triple A rating. A difficult area in revising models is correlation, or the extent to which similar deals can expect to achieve similar performance. If you assume 15% cumulative losses, how do you spread it out over the individual bonds in these large and complexly structured portfolios? The answers make a difference. Fortunately correlation is a factual issue and eventually will be resolved accordingly.
3) financial guarantors have access to capital: from existing reinsurance treaties, also from the ability to obtain addional reinsurance on the 85% of their portfolios that is not sub-prime backed. Writing new business consumes captital, more for some classes than others. By slowing down new business or changing the mix, capital can be increased. Raising capital by hybrid bonds or convertible preferred, like Countrywide did, is another possibility. As a shareholder, I don't like the dilution involved in this sort of thing, and would hope it would be done as a last resort. Mamnagement are shareholders and will not give away the ship. Assuming ABK needed 1.5 billion and got very poor terms on a dilutive deal, the stock is still radically undervalued.
4) The whole issue of mark to market is subject to studious distortion and aggressive stupidity on the part of some critics. Credit insurance is primarily provided by Credit Default Swaps. Both ABK and MBI use forms that do not require them to post collateral and that provide for the payment of principal and interest when due (pay as you go.) A mark to market of the derivative liability so created consists of increasing it to what the insurer would currently charge for doing the protection over again. To assert that mark to market on these liabilities should conform to the mark to maket on assets similar to the underlying that Citigroup, for example, took is just plain ignorant, because ABK and MBI have no liquidity risk.
5) the prices on the ABX are not accurately pridicting cumulative losses on subprime. Mark to market based on assuming they are will eventually be reversed, so that many of the preannounced possible fourth quarter mark to market losses may not be as severe as suggested. The ABX for triple A rated subprime has been predicting about 50% cumulative losses on the underlying, more than three times the highest reasonable projection. Eventually people will notice that the sky is not falling.
6) Insider buys on ABK have been impressive in size, two buys 10,000 shares at 25 each, more or less, a quarter million is not chump change or symbolic to any private investor. I have done well in the past buying at prices similar to those paid by management on large insider buys, as I have done here.
Taking all of this togehter, I am not deterred by my unrealized losses on ABK and MBI. From a time point of view, I can't predict whether they will return to normal values before the end of the SLO contest. They are extremely sensitive to any kind of news either way, and it may require years before their recovery is complete. If it takes three years, my annualized returns will be around 40%, not too shabby.
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