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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