The S&P Bank Downgrade

Today, just a day after I wrote an article supporting the purchase of US banks (see below), Standard and Poor's downgraded several of America's largest financial institutions, including Citigroup, Goldman Sachs, Morgan Stanley and Wells Fargo.

At first I was taken aback by the move, and even - just for a minute - slightly concerned.  Standard and Poor's said it had changed its ratings system ("with new criteria") for banks, resulting in the sweeping downgrades.

I thought, "Standard and Poor's changed its rating system, and downgraded the US banks?  What if their ratings system is actually correct now?  That's not good."

Then I read that Standard and Poor's had actually upgraded its rating for the crappy China Construction Bank - an overextended lender in a grossly overpriced market.  My concerns melted away.

Generic formulas still can't rate risk.

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"If merely looking up forward financial data would tell you what the future holds, the Forbes 400 [richest people list] would consist of librarians."

Warren Buffett

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See also:
Forget Greece and Italy


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Dick Bove's Apology

On CNBC this Monday, Nov. 28th, analyst Dick Bove apologized for the failure of his foremost recommendation of the year: US bank stocks.

The official apology ran like this: “I failed to understand that the fears in the market concerning banking were so great that the fundamental improvements in the economy, the industry, and companies like Bank of American and Citigroup would simply be ignored.”

In other words, Bove's "apology" consisted of telling investors that they are foolishly selling excellent stocks that are a great value, simply out of fear.  He didn't quite call them idiots, but pretty close.

The reason I mention all this is because I agree with him.

Back in March (US Banks to Rumble), and again in August (Buffett and the Beautiful Banks) and I'm sure a few times in between, The Frost Report has recommended buying US bank stocks.  But after a short-lived pop, bank stocks kept dropping.  And dropping some more.  And a bit more yet.  So what have I been doing?

Why, buying more bank stocks, of course!  Instead of trying to guess which particular bank will fare the best, I have been purchasing the KBW and XLF bank index funds.  Every time the market has a 2-4% correction I buy more, since each "correction" misprices them just a little bit more.

The view that bank stocks are a great bargain is clearly an unpopular one.  Every time someone recommends bank stocks (like Dick Bove), their article is overwhelmed with comments calling them a loser/screwball/dope/idiot, or ranting about bank bailouts and world domination.  Fortunately, my goal is to make money, not to make popular decisions.

Bank stocks will recover because they are highly profitable, and an economic necessity for which there is no replacement (contary to popular sentiment, credit unions are not equipped to handle large-scale multi-national banking).

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See also:
Bill Miller vs Instant Gratification
Bank Debt is Near Record Low

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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Are Hedge Funds Safe?

Many people now regard hedge funds as an alternative to mutual funds.  Marketed as the “rich man’s mutual fund,” hedge funds are supposed to be safer than mutual funds but with higher returns.  Is it true?

In the past, most hedge funds hedged.  That is, hedge funds positioned themselves so that whether the markets went up or down, they would make small but consistent returns.  One strategy, for example, was to buy stocks, but also buy put options on those stocks in case the market dropped (put options go up in value if stocks drop).  The end result would be a slightly lower return than the general market in boom times, but also a small return in panic times – overall, a small return that is more reliable and steadier than the market.  But that is the past.

These days, virtually all hedge funds make money from extreme leverage – investing with borrowed money.  Using borrowed money and derivatives increases (not decreases) risk, which can lead to both spectacular gains and spectacular losses.

The average life span of a hedge fund is approximately 5 years.  By the five-year point, most hedge funds have either failed (lost most or all of their money), or closed down.

Hedge funds tend to fail most often within the first 30 months of their existence.  After 30 months they are less likely to fail, but more likely to shut down due to mediocre returns.  As a hedge fund investor, you are screwed either way.  If you invest in new hedge funds you risk losing everything; if you invest in an established fund you probably won’t get the returns you are looking for.  Some say that the way to avoid this minor inconvenience is to invest in a "fund of funds": a single fund composed of a number of hedge funds to reduce risk.

The expected annual return on a “fund of funds” is about 7-8% per year (a 9% return on the funds, minus 1-2% management fees), vastly lower than most investors imagine.  For comparison, a typical balanced mutual fund also returns between 7-8% per year.  Some longstanding balanced mutual funds - such as the Fidelity Balanced Fund, available since 1986 - have returned more than 9% annually.

In 2008, Protégé Partners bet Warren Buffett - the most famous investor of all - that hedge funds would outperform the S&P 500 over a 10-year period, as Buffet himself has done.  In the first year of the bet hedge funds vastly outperformed the S&P (dropping only 24% compared the market drop of 37%).  In the following two years the S&P outperformed the hedge funds.  Time will tell the final result.

If you are looking for safe and steady returns, my advice is to forget about hedge funds. Take the easier route: create a balanced portfolio or buy a balanced mutual fund consisting of about 30-40% quality bonds and 60-70% stocks – the time honored strategy for consistent returns with lowered volatility.

If your primary purpose is to show off that you are rich and have money to burn, invest in a hedge fund and tell all your friends.

If you are keen to risk everything to get rick quick, try poker.

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"We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed."

Burton Malkiel and Atanu Saha

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See also:
Hedge Funds: Risk and Return (the pdf presentation)

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Bill Miller vs. Instant Gratification

From 1991 to 2005, value investor Bill Miller headed one of the most successful investment funds in the world, beating the S&P 500 (“the market”) for 15 consecutive years.  On November 17 2011, however, Bill Miller stepped down as superstar manager for the fund he made famous.

It is said that Bill Miller has lost his touch.

During 2008 and 2009, Bill bought “horrible” companies like U.S. financials.  Many of these picks lost large amounts after his purchases (some up to ¾ of their value), and are still now languishing as losers.

Phil Pearlman said this of Bill Miller and of mutual funds in general: “Mutual funds remind me of AOL dial-up (Internet service): a dwindling collection of old people who don’t know better, contributing monthly to a comically inferior product.”

What many consider to be the new and superior product is the Hedge Fund.

Hedge Funds assets have grown dramatically, from just $38 billion in 1990 to more than $1600 billion in assets today.  Hedge funds are hip, cool, young, exciting, and promise to make you more money with less risk - even if they have higher fees (see the next Frost Report article for more about this).

In many ways, Bill Miller is the latest victim of a worldwide phenomenon – lack of patience and the desire to get rich quick.

The very word “investing” implies buying an undervalued company, then waiting for the company to improve and grow and the stock price to improve along with it.  Virtually no one does this anymore.  People want instant gratification.  They think that if a stock doesn’t rise in 6 months or a year (or, god forbid - that it drops even more), the stock pick must have been “wrong.”  Others believe that the market is so rigged against them there is no point investing at all.

For value investors of the world, the societal shift from value investing to stock trading and hedge fund purchasing is a blessing.  The fewer the number of people who believe in value investing (picking great, out of favor companies and holding them for years), the more successful the strategy is.

Bill Miller was ruined not because his value picks were bad, but because they didn’t bounce back fast enough to prove the quality of his convictions; and, his investors didn't have the patience to find out.

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"The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don't always accurately reflect your weight, the markets don't always accurately reflect that information. Usually they are too pessimistic when it's bad, and too optimistic when it's good."

Bill Miller

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Forget Greece and Italy

Greece and Italy have been stealing economic headlines these days.

The media has been so focused on Greece and its pint-sized economy, that they have completely missed what should really be headlining world economic news…the slowdown of the world’s second-largest economy.

China’s government-induced GDP growth and red-hot housing market have both stalled.  Ironically, the government itself caused the slowdown, as it introduced prudent anti-bubble measures throughout the year.  Such measures were an unfortunate necessity: without them, inflation was turning rampant.  But now the slowdown may turn out to be just as devastating.  And, it seems that the largest companies in the world are well aware of what is coming.

Last week, Goldman Sachs sold $1.1 billion worth of its shares in Industrial and Commercial Bank of China (1398.HK).  This week, Bank of America announced it was selling the remainder of its shares in China Construction Bank (0939.HK) – $6.6 billion worth.

Today, the International Monetary Fund announced that Chinese banks could suffer “huge losses” on the very extreme case that credit shock, currency shock, and yield curve shocks were to occur together.  Interestingly, this “slim and rare occurrence” appears to already be starting.

The IMF's Jonathan Fiechter stated rather bluntly stated (as far as economist-speak goes) that "while the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and formation of bubbles, especially in real estate." In other words, the current government’s financial policies force people to invest in real estate (since buying other asset classes in China is considered too risky), and, banks are lending too much to capital projects with no economic future (again based on government direction).

One could say that the Chinese economy is a centrally-controlled “our government knows better” economic marvel mess.

It is my advice - stated on several occasions previously - that you follow the lead of Morgan Stanley, Goldman Sachs, and Bank of America; that is, sell all but your very best Chinese holdings.

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See also:

China faces grim foreign trade outlook

China's property cost curbs to remain despite home price drop

China’s CCB Plays Down BofA Share Sale Impact

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Chinese Con Companies – A Warning

REVERSE MERGER RULES TO TIGHTEN

Back in June, The Frost Report wrote about the sorry state of Chinese companies listed on North American exchanges.  Namely, that many such companies are rife with fraud (The Sick Man of Asia).  This week, both Canadian and American securities regulators began exacting their revenge.

The best way to understand this story is from the perspective of a Chinese con-artist/short-term entrepreneur, whom the new rules are designed to thwart.  And so, both the initial problem and the solutions are presented here in letter form:

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Dear North American Securities Regulators,

A few years ago, I had it made.  Through reverse mergers (buying out American companies listed on stock exchanges), I had a quick and easy way to become rich - fast!

Merely by listing on a North American exchange, putting together an impressive website, and manufacturing some nice accounting numbers, it was easy to get investors excited.  Most of them thought that because my company was listed on a North American exchange, it must be legitimate - the idiots!  Ha ha.  It was easy money.

Then the problems started. 

Savvy North American investors started questioning things - like my receipts and accounts that don't match, the ridiculously spectacular sales numbers, and the head office that doesn't exist (I didn't think anyone would go to Central China to check)!  And, I certainly didn't think anyone would check my resume to see that I actually did graduate from business school.  In China, buying a degree is no big deal: everyone does it - it only costs a few bucks for a degree from Harvard.

So now, it's all going to hell.

This week in the US, the Securities and Exchange Commission (SEC) announced stricter requirements for foreign companies that become listed on American stock exchanges through reverse mergers (buying out listed American companies).  Under the new rules, foreign companies like mine will be traded on the “over-the-counter” (highly risky, restricted) market for a full year before being allowed to trade on a larger exchange.  How am I supposed to make my fortune?  I need to have investors trust me immediately.  I need to take my cash and buy an overpriced house in Vancouver or Sydney right away, before I get arrested.  One year is too long.

Then I heard that in Canada, the Ontario Securities Commission (OSC) accused Zungui Haixi Corp and two of its executives of failing to cooperate with their special investigation.  The company’s auditor, Ernst & Young LLP, suspended audit of the company’s financial statements just because of a few “inconsistencies” in bank documents, assets and invoices.  How dare they!

Now, the OSC is saying it will be unveiling “a number of cases” in the coming months.  My friends are all worried that this is the end of the easy life.

So, I am asking you - the employees of the securities exchanges - to please back off.  If you do, there is a nice fat red envelope full of cash waiting for you in locker number 6 at the local train station.

Sincerely,
"Entrepreneur"

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Certainly, the vast majority of Chinese companies are legitimate business enterprises.

However, small-cap Chinese companies must be investigated fiercely before being bought as investments - fantastic sales numbers and low debt levels don’t mean much if the numbers are simply fabricated.  For the majority of investors, your best bet is to simply stay away.

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Time Machine - 1111 and the US National Debt

INVESTOR PSYCHOLOGY

Recency Bias is the tendency for people to remember recent events more than past events, and to believe that the most recent situation has always been so.  Put another way, people tend to frame their memories based on recent events, and to remember what they want - and likewise, to forget what they want.

I mention all this because it seems like lifetimes ago that the US national debt was not only in control, but people were actually talking about paying it off.  That moment was 11 years, 1 month, and 1 day ago today.

Bill Clinton had just finished his term in the White House, stained by political scandal (ie. the Monika Lewinsky affair).  Many viewed Clinton as a very unpresidential, even embarassing president.  Yet, no one could deny the positive economics of his term.  At the end of the Clinton presidency, the National Debt stood at 5.73 trillion dollars - a relatively small sum for the massive US economy.  After three straight years of budget surpluses, economists were estimating how long it would take to pay off the National Debt completely.

Presidential hopeful Al Gore, for example, outlined an economic plan that would eliminate the National Debt by the year 2012.  When candidate George W. Bush was asked if he had a similar plan, he said that although he agreed with paying off the debt in principal, he would not commit to a specific date.

Soon thereafter, Bush was elected as President.  He immediately began a series of tax cuts for high-income families, which he (and his economic advisors) believed would stimulate the economy so much that the end result would be an overall increase in tax revenues (known as "trickle-down economics."); unfortunately, it didn't work .  Tax revenues declined drastically with each cut.

Bush ran a budget deficit (increasing the national debt) in 7 of his 8 years in office.  In 2003,  he set a record for the largest annual debt increase in US history.  Due to a combination of tax cuts and expensive foreign interventions, by the end of the Bush term the US National Debt had nearly doubled - from $5.73 to $10.69 trillion.

People now talk about the National Debt as if it was meant to be, always was, and always will be.  Many cannot remember the time - not so long ago - when there was talk of the United States of America having no debt at all.

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"I've abandoned free market principles to save the free market system."

George W. Bush, 2008

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Canada's next Gold Rush

Vancouver is home to many of North America's newest and brightest mining companies, and at last  weekend's Stocks 2011 Conference, mining companies were well represented.

Talk to anyone about mining in Canada, and inevitably the conversation will turn toward the excitement about Canada's Yukon territory, which some say will spark the next great gold rush.

The Yukon Territory is, many believe, the location of a massive Carlin-type gold discovery.  Traditionally, hard-rock miners looked for veins of quartz or minerals that can indicate the presence of gold.  In contrast, a carlin-type deposit is composed of extremely fine-grained particles of gold, stuck to other minerals (such as pyrite) and spread deeply throughout a large area.  Carlin-type gold can be mined cheaply by large open-pit mines.

Kaminak Gold (TSX: KAM), for example, has hit upon a large area of mineralization (trendily dubbed the "coffee project") with mind-blowing numbers, ranging from 1.08 to 17.1 grammes per tonne over an area 14 kilometres long.

Companies like Kaminak Gold, Northern Tiger, Golden Predator, ATAC, and Ryan Gold are all generating excitement, sitting within the Carlin-zone.  This December to January, soil sample results from last summer's prospecting will start rolling in.  If results are as good as expected, the whole area (and all the junior miners in it) could be caught in a speculative frenzy.

Make no mistake - junior gold investments are really educated gambles.  But, when the risk-reward ratio is in your favor, gambling is sensible.  As always with speculative investing, risk not a penny more than you can comfortably afford to lose.

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"It is in men, as in soils, where sometimes there is a vein of gold which the owner knows not of, and in your nature, there lies hidden rich mines of thought and purpose awaiting your development."

Jonathan Swift

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See also:
http://www.kaminak.com/

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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Occupy Vancouver – No Party

While attending the Stocks 2011 Conference in Vancouver, Canada (more on that later), I decided to stop by “Occupy Vancouver,” an offshoot of the Occupy Wall Street protests occurring in NY and elsewhere.  I expected to see a party.

From what I can tell, “Occupy Vancouver” is basically a large collection of dirty tents and cardboard huts resembling a refugee camp.

When I first showed up at 10:30 am, no one was awake yet.  When I came back several hours later, I didn’t see unemployed accountants or disenfranchised schoolteachers; instead, I saw a small group of professional protestors – the same raggedy-looking, unshaven youth who show up at G7 meetings and WTO summits.  I also didn’t see any protests.  The few people who ventured outside their tents were clasping cups of soup with both hands, attempting to keep warm in Vancouver's cold and wet winter weather.

A security guard on site told me that he believes “Occupy Vancouver” will soon fade because the protestors are not having fun anymore - many look tired, and more still are developing colds and coughs from walking around barefoot on muddy ground.

When I told the security guard that the protest site looks like a garbage dump, he replied, “When rats come, of course that’s what it looks like.”

No agenda, no demands, no conclusion…how long can this last?

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“Welfare's purpose should be to eliminate, as far as possible, the need for its own existence.”

Ronald Reagan

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