Tom A's Stock Picks

Quantifying Risk/Reward

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Investment risk can be quantified - so can reward. It sounds so simple, obviously you just compare the two and the decision makes itself. In practice it involves various assumptions, more of an art than a science but still worth doing. The past few weeks have featured fantastic gyrations by my two largest positions, MBI and ABK, so I decided to quantify the risk/reward for MBI, as a way of keeping my eye on my long term objectives rather than being distracted by the stock's market action.

As a procedural matter, working with a spreadsheet, if you can label the rows and columns then the rest is an exercise in filling in the blanks. In this case, column A is possible outcomes, B is estimated share price under that outcome, C is the odds of the outcome, and D is the weighted value (B x C). Totaling D gives you the probability weighted value of the shares considering all outcomes, which can be compared to the share price.

MBI Risk/Reward

A) Possible Outcome B) Price/Share C) Probability D) Probability weighted price

White Knight -
acquired for 1 x Adjusted
Book Value/Share 80.08 .05 4.00

Ratings affirmed, losses
manageable, reverts to midpoint
of Price/Adj Book Value range 67.50 .65 43.88

Stays at current price 28.39 .05 1.42

Downgraded, cannot raise
capital, liquidated for 50%
of Adjusted Book Value/Share 40.04 .10 4.00

Downgraded, Mid point price
after raising 2.5 billion by
issuing convertible preferred 61.67 .10 6.17

Downgraded, losses
unmanageable, shares become
worthless 0.00 .05 0.00

Total for all scenarios 1.00 59.47

With the stock trading at 28.39, and the probable outcomes yielding 59.47, I will hold the stock until I get an outcome. Price going to zero is always a possibility, however remote, so position size has to be kept such that the maximum possible loss is within my risk tolerance.

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The True Moral Hazard

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A while ago there were quite a few references to the "Bernanke Put" as a source of moral hazard. The theory was that the belief there would be a bailout encouraged excessive risk taking among investors, lenders, etc. They were protected from the possible negative results of their actions, which created moral hazard. I believe the real moral hazard is created by a financial system which permits the use of insurance-like mechanisms to make leveraged bets in favor of negative outcomes by persons who have no other stake in the matter.

I am talking about the mortgage/credit crisis.

To provide a little background: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance would create an active desire for a loss to occur. An example would be if someone were able to buy insurance on a house he didn't own, or to purchase life insurance on an enemy or a complete stranger. Moral hazard is created by the lack of an insurable interest in the life or property insured.

What does that have to do with investments? Both futures and credit default swaps are insurance-like mechanisms, created to permit hedging or protection by those who are exposed to loss because of an interest in the subject matter. An airline is exposed to fluctuations in the price of fuel: and Southwest Airlines, as an example, has been careful to hedge this exposure, stabilizing and at times improving their financial performance. An organization holding notes of ABC company is exposed to loss caused by default on the notes, and a credit default swap will provide insurance.

Buying a credit default swap on a security backed by sub-prime is insurance, a very good idea if you actually own the security.

But I would submit that these mechanisms create moral hazard when used for speculative purposes. A determined group of negativists can short a companies stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors. Speculation in energy futures at times harms ordinary citizens who must buy energy.

Similarly, if a large enough group bets that sub-prime mortgages in the aggregate will be worthless, their actions can exacerbate an already troublesome situation. It is in their interest for a crash to occur: that creates a motivation to use all available means of communication to promote the belief that we are headed for a Depression. Because of the ABX index, the impression is created that all sub-prime mortgage backed securities are worth pennies on the dollar. Banks mark them to market accordingly. Liquidity vanishes. Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard.

As a fix to the system, I suggest that Congress and/or the SEC establish some sort of a watchdog unit to monitor and suppress speculative activity in the futures and credit default markets. Perhaps anyone buying such instruments should be required to file a statement of insurable interest. If you would like to buy credit defaults on ABC company, just list the bonds you own. You want to buy futures, explain the exposure to loss that you are trying to hedge. Free markets is one thing, moral hazard is another.

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Incredible Mismanagement

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My hopes were high when they halted trading on MBI - now, for sure, managment would show their prowess, raising capital in an affordable way, with great results for my positions. Soon the news arrived, Warburg Pincus would provide 1 billion...what were the terms?

So sorry, to raise capital they are selling 16 million shares for 31.00 each, after buying 10 million shares over a period of years at prices averaging 66.30. Talk about a half price sale. Then they pass out the warrants to buy shares at 40.00.

The adjusted book value of the company at 9/30/2007 was 80.08 per share. By my compuations, it cost them a billion to raise a billion. They could have just accumulated the capital instead of buying back shares over the years.

Clearly I do not understand this company. My methods rely on the assumption that management is reasonably competent. Sold my entire position with a combination of market and limit orders. My loss at 9,000 was a bargain, the stock is up 4.50 on the giveaway, I have received very nearly a full refund of my tuition.

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Broken Thesis? - Financial Guarantors

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Recent developments for bond insurors MBI and ABK have me reviewing my thesis on these picks, to decide whether to take my losses or to hang in and await additional information. Over the past week, their triple A ratings have been affirmed by S&P with a negative outlook, and by Moody's with a stable outlook for ABK and negative for MBI. Now Fitch has put MBI on credit watch negative, with the requirement that they produce an addional 1 billion of capital, above and beyond what Warburg Pincus will be providing. Fitch has yet to speak on ABK.

ABK seems to be standing up to the latest rounds of stress test analysis better than MBI. My position for ABK is still showing a small profit. On MBI, I sold out at 35 and went back in at 31, on the grounds that a savvy 3rd party became involved at that price: also, Marty Whitman, a guru I follow, remarked favorably on the Warburg Pincus deal that the dilution was OK, it removed his biggest risk which was massive dilution. So MBI got down as low as 18.84 yesterday, and now stands a little over 21,based on Fitch's rating action and a clarifying (re)disclosure of the size of their CDO portfolio. The previous disclosures had a certain degree of opacity, not something to be all that happy about.

My original thesis on these two was that losses from sub-prime would be manageable within the context of the existing capital base: that they would not need raise capital at the expense of excessive dilution in order to retain their triple A ratings. I felt MBI was a much safer investment than ABK, more conservative. ABK I went in on the assumption they would probably need to add some capital but it was already priced into the shares, with ample room for profit.

ABK so far did a reinsurance deal with AGO that seems to have been motivated by the need to retain its ratings. When Fitch reports their findings, then I should have more clarity. If Fitch does not require immediate additional capital, or if the amount is small, ABK should have very substantial upside potential. Strangely, S&Ps projected stress losses were much smaller for ABK compared to MBI, although the two are more or less the same size. Perhaps ABK is doing a better underwriting job. I bought into ABK at more or less where management made big buys, and I regard ABK as an excellent if somewhat specualtive investment. If the number 2 player becomes number 1, good results will follow, particularly if the former number 1 is seriously weakened.

For MBI my thesis is broken. The company has yet to respond to Fitch's announced credit watch negative. They were scheduled to hold a conference to discuss their capital situation on 12/14. That was cancelled because the rating agencies had not reported as of that date. Presumably it will be rescheduled and management will discuss their options - reinsurance, mix of business, reduced new business, borrowing, or equity. Also, the Warburg Pincus deal includes a shareholder rights offering, terms unknown. The terms could have a significant effect on dilution. My normal strategy is to exit when my thesis is broken, but in this case the stock is still well under adjusted book value per share, even treating hypothetical max stress losses as real and raising 2 billion equity capital at today's price.

What I have learned from this is respect for the power of dilution: it is very bad if a company is forced to raise equity capital under adverse market conditions. That was the risk I underestimated here, the risk of actual bankruptcy is nominal, the risk of massive dilution is not. The need to retain the triple A rating gives this issue a lot of power.

What I have relearned is that in crisis investing you need to wait patiently - I almost always start buying while the stock is still going down.

This is probably my last entry for the contest. Thanks to everyone who graded or commented on my posts. I enjoyed reading dishwasher, Doc A, eileenteska, Russ, kbarton, Viking Warrior etc...it is impressive also how many constestants beat the S&P or other indexes with a variety of strategies...

Merry Christmas,

Tom

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A conversation with Warren Buffet

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Brrrng...

I dialed, the phone rang, and Warren Buffett picked up.

WB: "Buffett."

TA: "Good Morning Sir, how are you, this is Tom Armistead at Homestead Investment Services...

WB: "Who?"

TA: "Tom. Armistead. Homestead Investment... Services."

WB: "Go ahead."

TA: "Mr. Buffet, Sir, I have an insight so penetrating, an idea so powerful, that by putting your idle cash to work I can..."

WB: "Tom, do you have any money?"

TA: (miffed) "Yes I got money, I got money in stocks, I got money in bonds, I got 932 thousand in SLO..."

WB: "Good Good Good. With your money and my ideas we'll do just fine. Maybe you could afford a few "B" shares."

TA: "Perhaps if I present this to you from a slightly different angle, maybe it will be clearer to you... You see, I have money, but it's invested in my penetrating insight, an idea so powerful...this is about cities and states needing insurance, to guarantee their bonds. By insuring their bonds, they can sell them at a lower interest rate. Providing this coverage is very profitable - they let you use 120 times leverage - you could get away with 180 - it's a license to print money. The firm I have in mind is MBI..."

WB: (sounding bored) "I talked to them last year, also ABK, ACA, SCA, CFIG, FGIC... They were all looking for reinsurance - but, they had done some things that were not prudent. (Pause) The less prudent others are in managing their affairs, the more prudent we will be in managing ours. Now I really must get back to work..."

TA: "Admittedly they have done some things that were not fully thought out, insured a few CDOs of mezzanine ABS, a few CDOs squared, some sup-prime RMBS, but I think these are minor blemishes, all we need to do is spiff up their risk management a little bit, apply maybe 1 billion, maybe 2 billion at the outside, additional capital, just to get Fitch off their back. As a matter of fact, I have a capital plan that involves reshaping their portfolio with reinsurance." Here I made an eloquent gesture with my hands, like a potter shaping a lump of clay - of course he couldn't see it from Omaha, Nebraska.

WB: "Well Tom, thanks for calling, but I really need to get off the phone. I drink so much Coke, it goes right through me..."

TA: "Warren, this may seem a little risky, but I think it is a wonderful profit opportunity to provide them some reinsurance. You could use that NRG thing you bought from ING. I was thinking of some excess of loss over a few CDO squared. If you do a drill down analysis, in the weeds, so to speak, right down to the underlying CUSIPs, then roll it up, it's not all that bad. Anyway, as you yourself have said, you could make money selling life insurance in an emergency ward, as long as they would let you charge a high enough premium." At this point I was playing the air violin, an old habit - of course he couldn't see me.

WB: "That's true, but it doesn't work in a mortuary. I 'm not interested in the reinsurance: I think I can do better writing the insurance myself. I have started up my own company to insure municipal bonds. It is going to be run on very prudent principles, no ABS, no CDOs, no RMBS, no MIC, no KEY...just plain vanilla municipal bond insurance, triple A rated, admitted in NY, CA, TX, maybe a few other states. I shall call it - Berkshire Hathaway Assurance Corp."

TA: "I don't see why you should bother with a start-up, wouldn't it be easier to buy a going concern? I know a number of them that are very affordable right now. They have the goodwill, the connections, the credibility, the underwriting expertise, the risk management skills, competent management in place..."

WB: "Its been nice talking to you Tom, you have a good day, don't go out in the hot sun in a wool suit..." click.

TA: (muttering to myself) "What's this hot sun stuff? It's December. Maybe Carl Icahn, maybe Ralph Whitworth..." (a flash bulb goes off in my head) "This is going to work. Ackman. William Ackman. Bill Ackman. I know he made billions shorting the thing, maybe he could just throw a billion or so back into the hopper and go long on it...then he'll have more money to give to charity." (I start going through the Rolodex)

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Value vs. Crisis Investing - 2008

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Most commentators that I have read are noting that value investment did not work well in 2007 and suggesting that it will not work well in 2008. At the same time, various articles on the subject, and interviews with well-known value investors, seem to have the common theme that 2008 will be a year where there will be extreme bargains available - the chance to make investments which will earn fabulous 3-4 year returns as recovery develops.

This brings me to the topic of crisis investing. The situation with housing/mortgages/credit is a crisis. Price behavior of affected stocks is that they get down to extremely attractive levels, based on long-term metrics, then they keep going down, sometimes another 30 or 40%. Prices go from the basement to the sub-basement. The question comes up, will this or that sector, industry or company survive as we know it? Every week an article in the WSJ, Barron's, or whatever you read examines the possible dire implications and consequences.

The value investor feels like Floyd Patterson fighting Ingamar Johansen - he takes a hit, a nine count, gets back up, and takes another hit. Maybe it would make more sense to just get out of the ring, throw in the towel, say "no mas", and do something easier, perhaps real estate in Florida. Sometimes I feel like that.

After watching and participating in this process for a while, I have come up with the following advice for myself, which you could share if you like or add to it if you want to make a comment.

Make commitments in small increments of your total permissable position in any given stock.
Remember, your bargain may have another 30 or 40% decline still to come. You need room to add to your position without being overlined.

Develop an opinion on as many stocks in the affected sectors as you can. All stocks in a given industry are not peas in a pod. Sometimes bad news on one stock carries the rest of the sector down, creating opportunities to buy less severely affected merchandise at a discount. As an example, last year JNJ and AMGN traded up and down in unison as the bad news on Procrit/Aranesp/Epogen came out. But JNJ only had a 4% of their sales involved, while for AMGN it was 46%.

Hold ample cash reserves. If your treasures go down that final 30 or 40%, you want to have resources available to back up the truck. Margin is not permitted on SLO and is a no no in my personal portfolio. Remember a margin call (or a panic attack) with your treasure in the sub-basement can expeditiously get you out at the very bottom.

Have a watchlist and monitor it regularly. Often a good stock dragged down with its sector will recover relatively quickly - the window of opportunity may not stay open very long.

Diversify. Much of the bad news is real and some of the fear is justified. If you have too much on one of the losers, you could incur serious losses. As an example of how not to do that, I have too much of my SLO portfolio in two bond insurers - I would (and will) do better to spread the sum out over other bond/mortgage insurance companies, also various banks and other financial stocks are or sooon will be trading at steep discounts, not to mention building materials, etc.

Have a measure of value. Some investors are using normalized earnings, some are using book value, tangible book value, or adjusted book value. As long as you are reasonably confident that your value is intact, today's price is meaningless. If your value diminishes, whether by dilution, unexpectedly larege writedowns, or permanent change in long term prospects, take another look at the holding and make any changes needed.

Pursue some amount of alternative strategies. Many successful SLO participants use a mix of growth, value and core strategies, weighted according to their natural style or preferences. I am going to be adding some growth to my mix for 2008, on the grounds that if it works for others it will work for me.

Do a little short-selling, if you're comfortable with it. In my case, I went over my short-selling results for the past three years (a wash) and noticed that where I made money it was more market timing than an accurate call on the stock's long-term price movement. SLO does not permit short-selling per se, although ultra-shorts are legal and since my results have been market timing anyway I might dabble in short-selling.

Do not panic. All of us know that emotional control is important, at least when real money is involved. Fear when properly harnessed is Prudence. A sense of humor helps. So on and so forth.

Some of this applies insights gained from reading (and rereading) Chapter 12 of David Dreman's book, "Contrarian Investment Strategies: The Next Generation." It is on crsis investing, includes a discussion of banks, and contains ideas that are very helpful in today's environment. I notice other people cite gurus by referring you to a website or a blog, but most of the gurus I follow have good old fashioned hardcover books in print, or available used. In favor of the websites or blogs, they give info on what your guru (if still living) is buying or selling today.

I'm looking forward to hearing who are the finalists and (suspense, suspense) who's the winner...also to competing in the next round. I guess we can all just keep blogging along until then...

Happy New Year,

Tom

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