SharperDingaan

Keep in mind that a DB pension plan typically runs with a duration mismatch of between - 11 to -14 on its bond portfolio; & low yields have forceably increased the absolute size of that bond portfolio. A 400bp rise (inflation bite) would make the average DB plan look very different! SD

Agreed long-term money is cheap but for most firms in the current climate (near-term) you extend term, increase the term/revolver debt ratio, & reduce carry cost - you dont borrow more. You're rewarded for improving the D/E ratio & using the carry saving to reduce debt. If you increase debt, you do it to buy back equity & increase EPS. Agreed there is growing bias towards acquisition, however its only those with allready reduced D/E ratios & longer-term outlooks (exclude market makers). If you intend to hold the target for the long-term, the bigger risk is in not getting the prize versus what you paid for it. View todays P/E paid - as P/E(1+g)^n, & its not hard to see why the major names are in the market. But notice that in both cases it would work a lot better, & more reliably pull in the 'I' spend, after a 'descent'. Assume a bumpy drop, & deliberate 'walkaways' to restablish the penalties for moral hazard, & the incremental cost of QE2 would also fall dramatically. Some of the existing commitments would simply recycle, & the last 18 months of treasury enhanced earned lending spreads in the banking sector would get used. Why would you NOT do this ? SD

If we want the 'I' spend, we need either a crash or a 'managed descent' - & its highly likely that the cummulative 'I' spend would be much larger than any QE2 could be. If the QE2 eased the damage in starting the 'I' spend, no one could argue that it was not a legitimate and effective use of policy. If the 'I' spend also produced employment (new plant) & either increased consumer spending, or reduced bank loans (investors using their sale proceeds), most would suggest that it was also very smart policy. We allready have the 100% writeoff (US) on new plant investment, & the 2 biggest US proprietory traders volunteerly closing their trading desks. How long can it really be untill we start to see QE2 ? SD

Apply the well known economic demand function of D = C + I + G + (X-M) to today’s economic environment & most would argue that the majority of incremental demand (D) can only come from new Investment (I). Hence the repeated calls for business to step up to the plate. As a business you can buy someone else & layoff/consolidate to reduce unit cost, replace/build new plant to reduce unit cost & sell additional widgets, or buy back shares to increase your EPS for a given level of business. Net of inflation, most folks expect the level of business to essentially stay flat over the foreseeable future. Buying someone else to increase market share & reduce cost is good for the ego - but a risky proposition. Buying back your shares is low risk - & makes you look like a hero. Most believe that many businesses (outside of banking) are sitting on excess liquidity – relative to the debt/equity levels of yesteryear. The fact that yesteryears debt/equity levels were probably inflated is a convenient oversight. Assume a business had 100M of debt capacity available, & used it to buy back its outstanding securities. They would want to buy at the lowest cost possible, & whatever common they bought would reduce their debt capacity - as it would reduce their equity base. They would want to buy after a market crash, offer a modest premium, & they would want to buy back their debt & prefs for less than what they issued them at. The business would demonstrate confidence in its long term outlook, recognize gains on the securities retirement, & bonuses would be forthcoming. ....... But nothing would happen until after we have a crash, & the possibility of a crash has been removed. If I’m the investor holding those shares; I’ll simply use the cash to either buy another investment in the secondary market, or retire debt. Both the business & I gain, but in either case the $ don’t go back into the economy. I didn’t invest in a new offering, & companies are repaying debt – not borrowing anew. The unemployed stay unemployed. If you take this view - a crash is largely a given, & there is a preference for sooner versus later. Bonuses pay out at year end, & year-end write-offs are OK if you can show you’ve bought back securities at a premium, & at a gain. The fed has been repeatedly stating in more aggressive tones that they’ll do whatever it takes. The BOC has been repeatedly stating that they have concerns with the near-term prospective outcomes for the US economy. Powerful people expecting difficulties, & incentives to fulfill the prophecy – cannot be a good thing. What are we missing here ? SD

The reality is that all PM’s are adept at both the long & short - & you’d fire them, if they weren’t. A ‘conservative’ portfolio may be 130/30 long/short, with the ‘short’ achieved through an option or futures position. To borrow physical & sell is to actively drive the short, to use an option/future/cash is to passively short (hedge). To actively short, you need the complicity of long shareholders. The longs gets the loan fees, reduced cost base from buying at the low, & realized gains as they squeeze the price back up. The short gets the spread. The bystander gets hit with whipsaw, & the target collapses if you can cut off its market access. Higher gains for both longs & shorts, but when the longs do it well - the shorts get bled white. Short an entire market, & you force passive hedgers to help you - as they can’t sell their underlying physical. They have to buy the options at whatever price, & with the fear in the market – the only option seller is you. The target market gets hit with whipsaw, & the underlying economy collapses if you can cut off its access to cheap money. But to do an entire market you need to spread the short risk (gang approach) & the longs are the globes central bankers. To short at all - you need large amounts of risk seeking capital, you need to tie it up, you need it away from regulators, & you need it tax-free (off-shore). You maintain discipline through the law of the jungle, & you ‘store’ your wealth in trading positions that can only benefit from your actions. You get bigger, you squeeze out your competitors, & you get forced to hold something non fiat – as you’re destroying currency values. Collapse the Euro$ off-shore market, & you squeeze the short capital in jurisdictions where laws are lax. The bigger they are, the more they’re forced to sell which collapses the market – except that this time the market is flooded with off-shore liquidity, & all of it flowing through the globes central bankers. Buy up the market & we’re suddenly back to the old fashioned model - & the ‘right’ shorts getting bled white in some very unfriendly neighbourhoods. The non fiat stores of value collapse as there are too many sellers, & there’s a rush for state protection when the only one selling is the state. SD

Isn't the 'real' logic here that its either 'buy & hold forever', or stay in cash ? Nothing wrong with a flyer here & there but you've got to recognize that its a gamble - not an investment. SD

Beyond wife & nephews, we spend most of our free time physically active; hiking, biking, canoeing, x-country skiing, & some volunteering. Time is short, so we use a list as to where we'd like to hike/bike & how we're going to do it. Works fairly well; so far we've done the Klondike Trail (Yukon), West Coast Trail (BC), Bruce & Grand Valley Trails (Ontario), & the Route Vert (Quebec). East Coast is a work in process. Vacations we travel. Another list of the 7 ancient (& modern) wonders, & we're pretty much following the old silk road as the various national conflicts die down. In the old days we'd have done London-Kathmandu on the back of a truck - but alas we don't have 6 month chunks of time anymore. Learning to fly & work tall ships. Have in mind crossing the south pacific in a tall ship, & flying around Africa (esp around the pyramids) in an old bi-plane. Investing is pretty far down the list! SD

Lets just say that while there are some attractive possibilities, Oct-Nov has something of an unhealthy reputation. Insurance is cheap, we dont forsee any sudden massive rally over the next 2-3 months, & we really question whether most companies will post Q3 earnings that were better than Q2. Hopefully we're wrong, & we see evidence that the economy is improving - good news all around. If we're right, we'll at least be able to afford a couple of rounds of beer to cry into. Seems a pretty good win-win. SD

Look 6 months out & honestly ask yourself if its likely to be better for the average joe. If you can't see a compelling reason why it should be, you're really saying it can only be more of the same or worse. Buying insurance (holding cash) is simply prudence. Graham may have bought well, but he was forced to sit on cigar buts that went nowhere for years. In todays world, most would argue that he would have done better by either buying less, or waiting longer before buying. SD

The reality is that the heirs interest is in spending the money, not making it. For most people the practical solution for each heir is a deferred life time annuity. The money essentially comes to them as an old-age pension, & it does not corrupt how they choose to live until their old age. Because of the deferral, you also need materially fewer $ to reach a given level of payout. The philosophical questions are how much is too much, & what to do with any excess. There's a lot to be said for simply investing it entirely in the shares of a microbank (ie:Garmin), & placing the shares in a pepetual trust in the expectation of an eventual total loss. The $ do a lot of good, & the trust eventually dies a natural death. SD

Cash, FFH, PD, FBK (Deb + common), MEW.UN + 2 others we will not disclose at this point. MEW.UN recently sold itself to a competitor at a 100%+ gain, & all our positions are fully hedged. Except for FFH, all are long term buy & holds. We expect each to at least double over the next 2-3 years, & generate a minimum compound ROE of 30%. FFH is a long term seasonal buy & hold on which we expect at least 20%. 15-25% in tax free/tax deferred accounts, in low quality equity, in the expectation of some precipitating event. Generally no more than 1 years expected return, & primarily practice in liquidity management. We essentially act as a market maker, & take the view that if we loose the entire investment, we will have recovered the $ loss/cash flow within 1 yr. Acceptable risk, comparable to the traditional practice of the old Lloyds names. We have recently permanently withdrawn 40% of the portfolio as cash, to retire UK family mortgages. 1) A wise man should periodically withdraws chips from the casino, 2) Application of 'money as servant', & not master. SD

You might want to ask that when you're range bound, why is it not better to be out entirely? P/E shrinkage, a falling market tide, and any kind of sudden panic work in your favour - & most would argue that over the forseeable future a market fall is more likely than a rise. SD

Only because we’re waiting for a suitable entry point. MFC’s basic business is relatively straight-forward & reasonably well run. The problem is the MTM accounting impact on the ALM of their seg fund liabilities, & the fact that they took on a material quantity of new seg fund liabilities near the top of the market. Unrealized gains/losses on the guarantees are immediate P&L hits, but realized gains/losses on the liabilities are actuarial gains - amortizing forward & over the remaining life of the actuarial liability. Yes it sucks today, but it will be very useful tomorrow. Should the market suffer a 10% drop, there will be another big hit to P&L. At a 15% drop, it is highly likely that equity dilution & a total dividend cut also come into the picture. While hedging will reduce the impact, & there is very little ‘real’ possibility of insolvency – if there is a 10-15% drop, Mr Market is unlikely to perceive it that way. Obviously there are positives as well, but we’ll decline to comment until we have our position. SD

The guy with the 80% cash is just continually buying enough burgers for the next week or so. The freezer gets filled up when they hit 30-35 cents; & he can afford to wait for those 30-35 cent burgers with relatively little adverse impact. The 'aggregate' consumer aggressively repaying debt, is essentially that guy with the 80% cash. And if those 30-35 cent burgers are 'sirloin' burgers ... the basic burgers are only 20-25 cents; the highest price you could charge the hurting burger eater. The 30-35c burgers are selling because they're replacing the 70c T-Bone steaks. Quality (BMW, Mercedes, cars etc) & junk (GM cars [no disrespect to GM]) both sell; but the quality sells because its become cheap, the junk sells because there's no other choice. The paradox of thrift. SD

Not so sure its improved; just looks different. - Absent trading gains & US bank earnings are essentially flat; ie the artificial spread income (FED intervention) has been covering mortgage write-offs as the banking sector de-leveraged. Very smart policy, but the problem is that seriously deficient mortgages have tripled over 2010 YTD, & that spread can now no longer keep pace. When they go, some of the banking sector will either go with it - or get another bailout. - The UK deficit has forced drastic cutbacks on the UK civil service. Either the US, with a similar problem is somehow immune, or the same thing starts happening in the US in 2011. We're with the cutbacks. - Graham was right, but he also ran out of money before he could prove his belief; ie value investment works - IF you pay attention to liquidity. That great deal is actually a loss to you if you cant hold it. - If you hedge & you're wrong, you stay alive. If you don't hedge & you're wrong, you're in a very deep hole. SD

Most folks would suggest a reasonable S&P P/E in the current climate is 10-12x. If the `consensus`earnings estimate of 760 is reasonably accurate;the S&P should be around 7600 to 9120 - yet it closed on friday at 11,528. We should see a S&P drop of at least 21%. QE2 would not be initiated were there no pressing reason. Most would suggest it has more to do with boosting market liquidity than lowering interest rates. When liquidity is high price levels are high; when it isn`t, prices drop (liquidity discount prices in). Yet the day after the QE2 announcement the S&P dropped 200+ points (2%); if anything the market should have risen, and the additional liquidity reduced the drop over what it would otherwise have been. Dodging a bullet is one thing, but when the other guy has a machine gun you will eventually lose. SD

There is a different way of seeing this. The reality is that FBK is rangebound in a turning pulp cycle. It can not go up materially or change its structure unless FFH agrees to the divestment, take-out, restructuring, etc. It can not go down materially as the illiquidity discount will cripple any material seller. Therefore its stay as they are, improve the cost structure to reduce the break-even, & maybe a tuck-in acquisition here & there where there is clear & immediate benefit. If there were no changes & they made a base 30M next year, EPS would be $0.23. Interest savings of 4M would add $0.03, 50% realization on the anticipated 7M of Quebec pulp savings might add another $0.025. 2011 earnings of maybe between $0.23 & $0.285. Were you to offer 5X earnings, at best - the price could only get to $1.15 to $1.43. At $1.29 average; roughly a 30% one-year return, or not that bad. The reality though is that its worth far more `restructured`; so its really a 30% one-year return with a cost free call option on any gain from an intervening event. It may not be the investment you thought it was, but if you have the liquidity - its certainly not the worst investment either. SD

Interesting US tidbits from the last few weeks: (1) Absent the census impact & US employment has essentialy been flat for all of 2010 YTD. Head-count is constant, but retirements & firings are being replaced with part-timers. Most would suggest that is unlikely to change much over the next 6 months. (2) Since Dec-2009, the total $ of seriously deliquent mortgages have tripled over 2010 YTD. These are mortgages that are in the advanced stages of foreclosure, & which will trigger significant write-offs when they go under. (3) Municipalities & state governments are starting to enter their 2011 budget processes. Most would suggest that the collective 2011 impact is going to be the widespread use of wage freezes, 4-day workweeks & job sharing to minimize layoffs. All this if there are NO additional economic shocks. Most would suggest that if there is a shock it can only get worse. Hence it should not be a surprize that the worsening condition is not being broadcast, or that QE2 is increasingly getting traction. SD

Technically the rights proceeds are after the Jun-30 close date of these financials. Therefore dont count. The reality though is that the extra $ are there as of today, so the net cash cost of a share (yesterday)is even lower. You should another $.31 to the projected minimimum values - the $1.69 becomes $2.00. SD

Agreed. The 42.94M of cash is $.33/share; at $1.06 you're getting FBK for $0.73 net - or 21% of BV. More noticeable is the Q2 vs Q1 2010 incremental change. The incremental EBITA margin was 34% - 2.5x the average Q2 EBITA margin of 13.5%. Should have paid up for that extra 200,000 shares ;D A cheap bastard might try to buy at 1/3 of BV, or 1.45/share [.333 x $3.40 BV + $.33 cash/share]. Most though would recognize that they would bid up to at least 40%, or 1.69/share [.40 x $3.40 + $.33 cash/share]. We thought $1.50 + maybe 15% for Q2 earnings was a reasonable guess, or $1.73. That same number seems to be coming up an awfull lot ;D Should be an interesting few days SD

Modern finance asserts that you can sell any asset at a low enough price, there is liquidity. VaR is so sure of it that it can assert with 95% probability that you cant lose more than $X, 19 times out of 20. And because JPM & pretty much every CFA has had this drilled into them - it can only be so! Long Term Capital blew up because they forgot about credit risk. Credit default swaps got invented to hedge the risk ... but everybody missed that you`re reliant on the liquidity of the counter party. That mistake blew up all 5 US I Banks. GS proved that if you could stack all the gold on the floor, & get yourself blessed (WEB), you could survive a run. But ... regulators don`t let you count 100% of the MV of a CCC asset for regulatory purposes. Basel II & III now have much higher VaR capital multiples than they used to. ..... because even they recognize that liquidity is a problem. Heat water from 99C to 100C and it takes a lot of additional energy to overcome the latent heat of evaporation & get the liquid to turn to steam. In the financial market that `latent heat`is central bank provided liquidity. When you don`t have it you get a collapse (UK in 2009) SD

Imagine you have $41 of asset supported by $40 of debt & $1 of equity. In grossly basic terms you have 40:1 leverage ($40 debt/$1 equity). Now imagine that you manage to 'de-lever' by selling $18 of asset for a net gain of $.10 - you now have $23.0 of asset, $21.90 in debt, & $1.10 in equity, or 19.91:1 leverage. You`ve reduced debt by 50% but not really improved your equity - which is what actually increases your economic responsiveness. Redo the calculation iteratively, but assume that on every $2 of deleverage you make a progressively larger gain (as you can progressively afford to wait for a higher bid). Plot equity (highest on the bottom) on the Y axis against leverage on the X axis. The shape should look familiar. The unusual Y axis is simply to make the plot more obvious. SD

Assume that you & everyone other western PM is convinced that Europe is done for, & the emerging market is where its at. The western $ inflow is 5x the local demand for the EM stock, the price goes up, & rapidly. Why? the market is flooded with idiots willing to give up increasing amounts of cash for a diminishing float of stock. It is liquid, it is overliquid. One year on, & our western PMs are convinced that Europe is where its at & EM is done for. But the market is populated with only a few local people, that are willing to give up progressively less cash for the increasing float of stock. The price drops like a brick because it is illiquid. In very simple terms, the liquidity discount is the (price paid - price received)/price paid. The discount occurrs because a seller has to get out, you're the only bid, & you're willing to give up cash. If you were to simply exchange one turd for another (to establish a 'market' price for valuation purposes) there would be either no discount, or something very nominal. SD

Nothing like a contoversial comment or two! Keep in mind that the optimal hedge is 50% cash. Go above or below this & you're taking a directional position. You get zero P&L impact, and a change in both cash and cost base. The cost of cash is the T-Bill rate + the liquidity discount on whatever you want to buy (not in the textbook). Yes a central bank can reduce the T-Bill rate to near zero, but removing the liquidity discount is a lot harder; as the very high TED & euro spreads of last year proved. Liquidity is also very like the decay on a call option where the X axis is leverage and the Y axis is economic responsiveness. Reduce from 40x to 20x and leverage goes down, but economic responsiveness doesn't improve by much. In the real world we mostly are not liquid. Lots of bids but you cant sell the asset (will your spouse really let you sell the house?). It is because we can't sell that the option markets exist. Understand liquidity, & much of the 'angst' instantly dissapears. SD

We're probally exceptionally unusual, but some things we've learned. (1) All boats sink in a crash, the quality of the boat is irrelevant. If you think there might be a material adverse macro event within 'X' months, why are you holding the boat at all? (2) At 100% cash, the worst that can happen is that you miss a run up and suffer an inflation loss. If you see the market rising, are you really going to do absolutely nothing for an entire year? And if inflation is maybe 1-2% at best, does it really matter? Were you a PM I'd fire you for doing this. As individual investor inflation is my, & not my PMs 'do nothing' cost. (3) When everyone owes money & needs cash to repay, shouldn't that demand make cash the pricey asset? I have it, you don't, & you have to sell your asset to avoid a default? And then why should I not use that opportunity? Dont be afraid of cash. SD