Archive for the ‘Investments’ Category
Friday, October 8th, 2010
A common model to calculate the future value of a company’s stock price (represents the future value of the company’s market value), is the discounted value of the expected future cash flows to the shareholder. The discount rate (the denominator or number on the bottom) used in this model moves in the same direction as interest rates. If the US Treasury Bill or 3 month US LIBOR rate move up, the discount rate used in modeling future stock price values will also increase. The discount rate is currently a heavily influenced number. If it were to return to a non-artificially suppressed rate, that would severely impact the derived valuation from the discount cash flow model.
Existing studies (FAMA/Schwert 1977) found stock returns move in the opposite direction as interest rates. Nissim/Penman (2003) found that interest rates and operating income move in the same direction (remember: free cash flows are included in the operating income calculation which makes up the numerator or number found on top of the discounted cash flow model). Their studies found that interest rates affect both the numerator and denominator in the discounted cash flow model calculation, but the denominator (discount rates) were affected more by interest rate moves. Davis (2010) studied the interest rate changes against large and small stock returns. His focus was on what type of stocks, small, large, value and/or growth have a higher correlation to interest rate changes. The research showed small and value stocks are more sensitive to interest rate changes. A portfolio manager or investor would need to decide what type of interest rate should be applied to the discount rate. In Davis (2010) study, AAA corporate bond yields, 1 Month US Treasury bills, and 10 Year US Treasury bond yields were used as discount rates. Each provided varying degrees of predictive power and explanation of stock returns.
Bottom line: Stocks do not have a fixed maturity. Bonds do have a fixed maturity. Using the discounted cash flow model to determine a stock’s future value is sensitive to the type of discount rate used. This is another example that stock analysis is not a science.
Always Asking, Never Assuming™
Christopher Holtby
Tags:correlation, dallas, Davis 2010, discounted cash flow, Fama/Schwert 1977, fee-only, financial planning, fort worth, interest rates, investment advisor, Nissim/Penman 2003, operating income, p/e ratios, stock analysis, stock returns, texas, wealth management
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Friday, August 27th, 2010
An economic bubble that can occur for any investment is an example of the greater fool theory. It assumes that the price of an investment (no matter how ridiculous) can be justified, eg. A buyer believes that there is another future buyer who will pay an even higher price for the same investment. Recent examples are the tech boom in 2000 and the residential property boom in 2008. These asset purchases were all about return on investment and speculation. Bonds, on the other hand, are typically purchased (excluding junk bonds in normal environments) for return of investment. In addition, bonds are not normally purchased using leverage.
Is there currently a rush into bond investments? It depends. US households hold 6% in bonds versus 27% in stocks and 27% in real estate. Are these households re-balancing their asset allocation to “capture more income, limit their risks and preserve their capital?” Will those goals change materially over the next 10 years? The average baby boomer is in his/her mid-fifties and requires a different investment asset allocation than when they were in their 40s. Are investors allocating money to bonds because of the uncertain economic environment? Yes. Are investors allocating too much too soon into bonds, based on their future needs? Nobody knows. Are some investors chasing after higher yielding bonds without a complete understanding of the credit quality and interest rate risks over various economic cycles? Yes.
A bond is a contractual agreement between a lender and borrower. The borrower/issuing entity must pay interest and repay, at maturity, the par value of the bond. A stock represents ownership in a public company. The investor or owner of this stock “hopes” or “expects” that the investment over the long-term will be worth more in the future. In a bankruptcy, stock owners get wiped out, loose everything, while bond holders get at least something. Bond and stock investments have different mandates and purposes.
Whether an investor purchases a bond with a yield of 10% and rates go to 20%, or an investor buys a bond with a yield of 2.5% and rates go to 5%, the losses are the same. In 1999, the US had a fiscal surplus, and US Treasury bonds had one of their worst years. In 2010, the US has a ridiculous sized fiscal deficit, and US Treasury bonds have had a great year, so far. The US economy is dealing with deflation challenges without the Fed talking about increasing rates. Even inflation, on a year-over-year basis (setting aside the difficulty of calculating it), shows no sign of an uptick. Eventually these facts will change. That is why investment portfolios should not be directionally structured one way or the other.
Bottom line: Investors purchasing bonds today “expecting” or “hoping” prices will increase (and yields decrease) are bubble investors. Investors purchasing bonds today as part of a diversified asset allocation strategy to reach their short and long term goals are not bubble investors. The latter will make proactive changes to their portfolio as the economic and financial facts change to ensure that their short and long term goals are reached. But the former will react, because they had unrealistic expectations when they originally purchased their bonds.
Always Asking, Never Assuming™
Christopher Holtby
Tags:bonds, bubble, bull flattening, credit, dallas fee-only, deflation, financial advisor, finanical planning, inflation, investment management, quantitative easing, wealth management, yield curve
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Thursday, August 19th, 2010
Over the last few months, the stock and bond markets have moved rapidly up and down. There are days when a bellwether company releases good historical earnings with a reasonable future outlook, and yet the financial press and stock market almost arbitrarily move up or down. In the bond market, the US Treasury 10 Year bond can easily move 4 to 6 basis points in either direction. Investors should expect these “sharp risk-on/risk-off swings” considering the current and future economic and political issues.
A few weeks ago, Federal Reserve chairman, Ben Bernanke, talked about the “unusually uncertain” outlook for our country’s economic prospects. Money managers discuss the same issues. Investors base many of their decisions on a bell curve of outcomes (thin tails, large average). The expectation is that most outcomes will be within 2 standard deviations from the mean. It appears our world is moving toward a flatter distribution curve – large tails, smaller average. Historically, this has meant that short-term news can have an unusually large influence on asset prices. For example, inflation was the rage this past March (US Treasury 10 year bond was trading at 4%) and beginning around July, deflation has become the rage (US Treasury 10 year bond is trading around 2.64%). These are HUGE swings.
Bottom line: As our economic and financial systems grind their way through the credit excesses of the past 25 years, markets will react sharply on short-term news. History and behavioural psychology have written about this fact. This environment requires investors to balance their investment strategy between the return of their money and the return on their money. What is your game plan to balance between these two competing strategies?
Always Asking, Never Assuming™
Christopher Holtby
Tags:bonds, dallas, distribution curve, fee-only, financial planning, investment management, north texas, risk, standard deviation, stocks, tails, volatility, wealth management
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Sunday, August 1st, 2010
Air balloons can move in three directions: up, down and sideways. So can stocks, bonds, commodities, real estate, hedge funds, etc. Unlike a balloon though, a portfolio of different investments can have some that zig and others that zag. Since the outbreak of the financial crisis (August 2007), most investments have all moved in the same direction (excluding US Treasury bonds in 2008). Since March 2009, individual stocks are showing a higher degree of correlation. Value stocks (investors looking for cheap companies relative to their fundamentals) and growth stocks (investors looking to pick companies during a growth spurt) are also moving in the same general direction (look at June 2010 results especially). The process of carefully combing through balance sheets and income statements does not offer a great added value, yet.
One of the spurious reasons for this like-minded movement in investments is that the largest companies in the world are all affected by the same issues. For example, Samsung and Texas Instruments are at the mercy of more than their own countries’ economies. Another reason is the macro issues overhanging investors minds. For example, the US deficit, sovereign debt issues, global growth, high unemployment, etc. are issues which could come back all at once or slowly. Another is ETFs, which account for a greater portion of stock trading. When those ETFs have to buy or sell, they do not buy the least overvalued and sell the most overvalued, they buy/sell everything proportionally.
Bottom line: Macro factors are dominating the headlines and investors’ mindsets. When politicians get things organized and the general disorder returns to some normalcy, investors who are careful about their investments will prosper.
Always Asking, Never Assuming™
Christopher Holtby
Tags:bonds, commodities, correlation, dallas, fee-only, financial planning, investment management, north texas, real estate, sharpe ratio, standard deviation, stocks, wealth management
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Wednesday, July 21st, 2010
In an era of low interest rates, investors (retail and institutional), are searching for reliable higher-yielding investments compared to U.S. Treasury or investment grade corporate/municipal bonds. An investment called a Non-Traded REIT (“NTR”) has been popular with retail investors for at least a decade. NTRs have the following characteristics: 1) embedded upfront fees of 12-15% paid to brokers and sponsors (source: Green Street Advisors); 2) the NTR sponsor “owns fee-collecting external advisor”; 3) NTRs often acquire the advisor, “annuitizing the value of a stream that was supposed to have a finite life”; and 4) have little liquidity. The sales pitch to retail investors (institutional investors would NEVER invest in these deals because of the one-sided reward ratio) is the high yield (typically 200 – 300 basis points over comparable public REITs) and the fact that the NTR does not have price volatility.
NTRs have a very high internal sales load and a conflict of interest in the structure itself. The yield payout does not have to come from net revenues of the properties; it can come from various other sources (see Importance of reading fine print of a prospectus). Additionally, the advisor does not have to re-value the Net Asset Value of the NTR until some pre-determined time after the NTR shares have all been issued (could be a few years). Investors pay a premium (high sales load, annuitizing of fees, indiscriminate/”rushed” investments into real estate investments ) for the illiquidity of the NTR, whereas all finance books teach investors to demand a discount for such situations. NTRs can appear to be desirable to investors because of the merits of owning real estate properties (e.g. hotels, apartments, offices, retail complexes etc.) with a high yield and a “stable” value. To an investor not knowing the right questions to ask, the investment looks reasonable.
Bottom line: No investment is perfect. Before investing in any opportunity, the investor should understand how the internal structures operate and where the conflicts of interest exist. A Non-Traded REIT isn’t any different.
Always Asking, Never Assuming™
Christopher Holtby
Tags:dallas, fee-only, internalization, liquidity, non-traded REITs, wealth management
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Monday, July 19th, 2010
Here is a qoute (found in the Risk Factors section) from a 475 page prospectus, of a very recent REIT offering from XXX XXXXX Multifamily REIT I, Inc.: “Until the proceeds from this offering are invested and generating operating cash flow sufficient to make distributions to our stockholders, some or all of our distributions will be paid from other sources, such as from the proceeds of this or other offerings, cash advances to us by our advisor, cash resulting from a deferral of asset management fees, and borrowings in anticipation of future operating cash flow.”
An investment, theoritically, should pay investor’s based on net revenues from the investment and not based on money paid in or on ”engineered” cash-flows.
Bottom line: Why would an investor be in a rush to recieve payments from an investment if they are not stemming from net revenues?
Always Asking, Never Assuming™
Christopher Holtby
Tags:dallas, fee-only, net revenue, non-traded REITs, prospectus, risk verus return, wealth management
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Thursday, June 24th, 2010
Yesterday, I attended a real estate roundtable sponsored by the law firm of Andrews Kruth, LLP. The purpose of the roundtable was to bring together a leading lawyer, investment manager, broker and special servicer (they deal with problems), who focus exclusively on commercial real estate (“CRE”), to discuss the current state of the U.S. CRE market. The highlights:
a) Special servicers and master servicers are communicating almost daily, compared to monthly 18 – 24 months ago. These fiduciaries are loath for distressed investors to “steal” deals. Most special servicers have a dual track focus for problem loans: modification and foreclosure. Problem loans so far in 2010 are equal to the total problems for all of 2009. In 1Q10, the industry saw an escalation of problem loans, whereas in 2Q10, the number of problem loans have moderated.
b) Institutional investors expected an RTC Part II scenario to occur in 2009. This has not happened. Investors sought deals offered at 2x with a 20 IRR (sometimes written into the partnership agreements). The marketplace has accepted that certain distressed properties will offer less robust returns. There are examples, though, of properties offered at 20+ IRR, but the risks are large (e.g. Class A building, new, no tenants, in a city with 20% office vacancy rates). Investors have been looking for either ”trophies or train wrecks.” Properties stuck in the middle have had a hard time garnering attention. For example, foreign institutional investors only want core properties in core locations (Dallas is not a core location, but Northpark Mall would be considered a core property for US institutional investors). Investors are creating property portfolios that have the proper balance of cash flow and residual yield. The U.S. is seen, again, as a real estate “haven” on a relative basis, compared to Asia and Europe (source: AFIRE).
c) There is a great debate about CMBS 2.0. If my notes are correct, there are $1 trillion of conduit (CMBS) and bank loans that will require refinancing over the next 8-9 years . The industry disagrees about whether a new $1 trillion is needed, or whether the $1 trillion exists already (with the current conduit and bank loans) but requires a new level of re-fi and haircut structures. During the RTC period, we saw this de-leveraging process occur within 3 years. The marketplace believes that this time around, the de-leveraging will take longer and hopefully, less than 10 years. New CMBS deals have more transparency, proper underwriting and appropriate price/leverage levels (e.g. 3 deals done in 4Q09, with only 1 needing TALF assistance, but for only 20% of the structure). Conduit financing, done properly, can lower the cost of financing for all.
Bottom line: The U.S. commercial real estate market is slowly repairing itself with the assistance of the Federal Reserve (by holding rates near zero). The time frame and depth of the de-leveraging process for legacy conduit and bank loans will have consequences for the U.S. economy.
Always Asking, Never Assuming™
Christopher Holtby
Tags:AFIRE, commercial real estate, dallas, fee-only, financial planning, wealth management
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Wednesday, May 26th, 2010
There are three different types of U.S. Treasury bonds: interest bearing (e.g. coupons), interest paid at maturity (e.g. zeros), and inflation adjusted (e.g. TIPs).
As of 5/24/10, the US Generic Government 10 year TIP had a yield of 1.2748, the US Generic Government 10-year bond had a yield of 3.2287, and the US Generic Government 10-year Zero had a yield of 3.53 (source: Bloomberg). Zeros have a higher yield in order to compensate for the risk involved with being the most sensitive to interest rate changes. A zero does not receive annual interest payments, but is purchased at a discount to par. Today the bond market has priced in a 1.95% inflation rate over the next 10 years. Do you agree with that assumption? As of 3/10, the spread was 2.26%. As of 11/09, the spread was 2.12%. From late 2008 to early 2009, the spread was zero to slightly negative, implying no inflation. Throughout 2009 the spread has widened but has remained within a band of approximate 0.40%.
Over the last 3-6 weeks, the bond market decided that zeros were a better investment. Actually, bond traders decided that zeros, based on duration, convexity, correlation and spread differentials were a better trade than coupon or TIP bonds. Recently, the media has reported that zeros are outperforming other Treasury bonds, and the sheep of the sea are now rushing to buy zeros. Traders will ride the wave until the next arbitrage opportunity comes along.
Which type of U.S. Treasury bonds to own depends completely on the investor’s need. If you need to fund a liability 10 years from now that requires only 3.53% a year to fund, then buying a US Treasury zero could be the right answer. If the investor needs more interest or needs income etc., than a US Treasury zero does not fulfill the need. Whenever an investor buys an individual bond, a bond ETF, or a bond mutual fund, it is important to know how the historical spreads compare to other bonds.
Bottom line: Wall Street bond traders make a lot more money than stock traders. Try to trim down their bonuses.
Always Asking, Never Assuming™
Christopher Holtby
Tags:convexity, dallas, deflation, duration, fee-only, financial advisor, financial planning, inflation, investment management, tips, wealth management, zeros
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Friday, May 21st, 2010
The world of commodity investing is rife with rumours of Chinese involvement. The blog posting, Internal disagreement with Beijing, describes the ability of China to produce more than it consumes (e.g. steel, cement, fertilizer, soybeans etc.). At the same time, China has imported basic metals to such an extent that those commodities have been on a strong upswing. Investors have been “leaning” on the China story as a reason to invest more in commodities. Another reason to invest in commodities is their non-correlation to stock markets. There comes a point when the financial markets investing in the the commodity markets are out-of-balance. Currently the financial future markets are “almost 12 times the size” of the physical markets compared to 2 times 15 years ago (source: Absolute Return Ptrs). Today, there is a “herd” mentality for commodity investing.
Investors are myopically focused on finding some investment that can help diversify away certain types of risks: deflation, inflation, and sovereign default. These are the most popular high level worries of the day. Diversification is meant to mitigage risks, not eliminate them. When looking for new solutions, investors need to consider all aspects of the solution such as: Who are the participants in the investment? Who are the natural buyers/sellers? Why do such natural buyers/sellers change their mind? How much leverage is in these markets? Have there been new financial products introduced into these markets? What have been the reasons for ups and downs in the past?, and so on. For the current investing public, commodities are a new tool, requiring greater initial due diligence in order to understand the characteristics/personalities of these markets.
The sponsors of Exchange Traded Products (e.g. Exchange Traded Funds, Exchanged Traded Notes) have introduced an avalanche of new products. These products allow investors to gain exposure to commodities. A strong majority of these products have exposure to the futures markets. Futures markets represent the spot price and forward curve prices of commodities (interest rates, currencies and various commodities). Depending on the price relationship between spot and forward prices, an ETF investing in commodity futures will not always have the same return as the underlying spot price returns of the commodity (e.g. oil). When investing in the spot price of certain commodities, investors must accept physical delivery, whereas investing in the futures market does not involve this requirement.
Bottom line: Sometimes commodities are a good investment, sometimes they are not. The why, when and where questions require investors to consider economic, political and financial back-office operational issues. As a miner told me when I worked for Barrick Gold Corporation one summer, “Don’t play another man’s poker game.”
Always Asking, Never Assuming™
Christopher Holtby
Tags:backwardation, commodities, contango, dallas, ETF, fee-only, financial advisor, financial planning, investment management, roll yield, wealth management
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Wednesday, May 5th, 2010
Over the last 18 months, mortgage bonds on the Federal Reserve’s balance sheet have ballooned to over $1.25 trillion (source: WSJ). Those assets were purchased to create stability in the mortgage bond market after Fannie Mae and Freddie Mac entered conservatorship in August 2008. In the absence of the Federal Reserve purchases, mortgage bond spreads and yields would have remained high, effectively strangling any opportunity for individuals to re-finance or purchase homes.
The Fed’s heavy allocation to mortgage bonds means it has the same risk as any Wall Street mortgage bond trader. When holding callable bonds, a bond trader’s risks are: duration risk (i.e. change in price for a change in yield), financing costs, and the impact of changes in the slope and curvature of the Treasury yield curve. She is also focused on the implied volatility of options on interest rate swaps. This allows traders to control most of their risks. The Fed is short interest rate volatility, which means if it raises interest rates to control the money multiplier (currently held as excess reserves at the Federal Reserve by commercial banks), it will cause losses on its mortgage bond portfolio. The Fed’s portfolio also has negative convexity (caused by callable bonds) which is doubly not good. Mortgage bond traders use a computation called Option Adjusted Duration to calculate price risk per basis point increases (mm/bp) and the numbers are mind-numbing in terms of potential losses as interest rates rise.
Does the Fed allow for losses on its mortgage bond holdings or raise short-term rates to slow the economy? There are economic, reputation and political risks with each alternative. Currently the implied volatility of interest rate options are low, meaning the market is not predicting a large entrant into this market or a potentially disruptive event. Congress, Treasury and the Fed thought it was risky when Fannie and Freddie tried to control their interest rate using hedging and asset/liability matching. The answer lies somewhere in the middle, but the process will be disruptive.
Bottom line: This Catch-22 dilemma for the Fed is well known. Setting aside the industry jargon, it means investing in bonds will be a bit more tricky in the future.
Always Asking, Never Assuming™
Christopher Holtby
Tags:convexity, dallas, fee-only, financial advisor, financial planning, interest rate policy, investment management, mortgage bonds, short gamma, wealth management
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