This Time It's Personal Finance

I have taken some time to clarify my investment style for this blog and for myself without making any specific investment recommendations.

• Value, concentrated investing – While many seek the diversification of the full market portfolio, I speculate on a few investments I believe to be a great value. Growth companies have historically underperformed value stocks as investors systematically overestimate growth. Earnings growth regresses to the mean, and value typically is a better investment. A purely quantitative black-box strategy could evaluate the entire market and find value stocks. However, I am examining a company’s strategic position, financial statements, and conference calls. A portfolio of a small basket of investments that are in different sectors will get most of the benefits of diversification.

• International exposure – Most investors in any given country have a home bias. While there are barriers in understanding and in regulations to investing in other countries, it seems excessive. I seek to invest a high percentage of my investments outside the United States in emerging markets. In the cases where I cannot buy individual stocks, I buy exchange traded funds that give exposure to a particular country or region.

• Liquidity is not all that important – Most of my investments are fairly liquid at this point in time since I am unable to invest in private equity and venture capital. However, I am willing to make illiquid investments if I am compensated for that illiquidity. You can maintain liquidity on tap with credit lines at a very low cost to maintain.

• Leverage – At this time, I have cheap access to credit to borrow against investments in my portfolio. While leverage increases risk, I am in a great position to assume that higher risk. With a greater base of assets, my return on equity will be higher assuming my asset’s returns are greater than my borrowing rate.

Thanks to Dave Albrecht for asking me to write about my investing philosophy

Famous Last Words

So often it seems an executive or government official says there is no crisis or utters some "famous last words" before everything collapses. I am sure there are countless examples. If my readers have some examples leave them in the comments.

Great Depression - Many people including President Hoover said things like "Recovery is right around the corner." With better policies, it might have been, but that's a topic for a different post.

Bear Stearns - Tells investors that two of their hedge funds lost all of their value in July 2007.

CEO Jimmy Cayne says, “Most of our businesses are beginning to rebound." - October 2007

President Alan Schwartz - “We don’t see any pressure on our liquidity, let alone a liquidity crisis.
"We are in constant dialogue with all the major dealers, and I have not been made aware of anybody not taking our credit. None of that speculation is true.” March 10, 2007

Receives a bailout from the Federal Reserve and JP Morgan March 14, 2007

Uno Pizza Grill
The pizza chain, Uno, is in serious financial trouble. They have a $7.1M interest payment due on August 15, 2008. Despite their talk otherwise, they may not even know where the money is coming from the pay the interest and certainly even less so on the next payment. They are facing the possibility of a downgrade of their bonds to D.
Psallidas(CFO) - "We have a productive active dialogue going on with our bondholders"
Read the news stories on Bloomberg.


So readers, if you have any other good examples of 'famous last words' post away.

Hedging the End of the World

I recently saw a chart of the price of a credit default swap on the US Treasury. http://ftalphaville.ft.com/blog/2008/07/16/14538/unmitigated-disaster-in-chart-form/

For those of you that don't know anything about credit default swaps, basically it is a contract that says I will pay you if the underlying creditor defaults. So, I substitute my credit for the underlying.

1. Company or government issues a bond
2. I write you a contract that says I will pay you if that company or government defaults (doesn't pay up)
3. The company or government defaults I pay you the value of the bond. Typically, I would pay the value of the bond minus the recovery amount from selling the firm's assets to satisfy creditors.

The notional value of credit default swaps in the world is huge; it is estimated to be $62 trillion and most people have no idea about credit default swaps. Granted most traders in CDS probably do not have huge exposures, since they are in offsetting position. Let's suppose an investment bank writes a swap on a US Treasury. The idea of this leaves me wondering what event makes the Treasury default and leaves the investment bank(counterparty) able to pay. Since the credit default swap can be seen as a form of insurance, and insurance is only as good as the insurer. We have seen trouble with the municipal bond insurers, "By January 2008, many municipal and institutional bonds were trading at prices as if they were uninsured, effectively discounting monoline insurance completely." (Wikipedia) The credible rumor of a default by the US Treasury would damage any counterparty and a default would be the financial equivalent of the end of the world.

If you buy a credit default swap on the US Treasury, it is like you are buying insurance on the end of the world. How do you price this and should you really assume anybody will be around to pay up?