Article: James Montier on how CAPM is CRAP

Today's "Outside The Box" piece from John Mauldin's free InvestorsInsight newsletter debunks beta as a useful measure of risk. Beta measures a portfolio's volatility when compared to the market. The article illustrates why beta is a poor measure for risk by using multiple empirical studies. In my own investing, I use a stock's margin of safety as a measure of risk.

In recent months, I've been deciding whether or not I need to calculate a Sharpe Ratio for my portfolio. The Sharpe Ratio is a measure of outperformance normalized by the amount of risk taken and highly regarded by my quant friends. In the end, I decided that I did not want to spend the time to calculate this ratio. My main reason is similar to the reasoning against using beta. Specifically, risk should not be measured by the short-term variance of one's returns. At the same time, I have also decided to measure investing success by maintaining 12% IRR at year-end instead of comparing results with the S&P. Although I will still compare results to the S&P for illustrative reasons, I will not beat myself up if I don't match the S&P. Beating the S&P year-over-year is a game that mutual fund managers need to play to separate a fool from his money.

Blog Link - Nicholas Financial VIC Analysis

Randy from the Stock Notes blog is the one who wrote the most recent Nicholas Financial Value Investor's Club (VIC) recommendation. He has write-up posted it on his blog. Great write-up! I'll be buying more in the next week or so.

Reasoning about Two Sub-prime Lenders

Early this month, I invested in two sub-prime lenders, Nicholas Financial and CompuCredit Corp. Nicholas Financial purchases sub-prime auto loans at a discount and services them. Nicholas Financial makes most of its money buying loans at a discount from dealerships and charging high interest rates on those loans. CompuCredit provides credit and related services to the sub-prime borrower market, those without access to conventional forms of credit. The majority of its revenues comes from credit cards with high interest rates and from fee-based cards.

I have not gotten a chance to do full due diligence, but have read very convincing analyses of these two stocks. Nicholas Financial has been recommended at the Value Investors Club multiple times. VIC is a really great resource for those looking for value picks. The analyses by members are much better than what I can present to you. Guest access to the site has a 45 day lag, but the most recent write-up of NICK recently appeared on the guest access page. As for CompuCredit, Tom Brown from Second Curve Capital and Bankstocks.com recommended it a few months ago, calling it one of his best picks in the financial sector. I have only done some cursory DCF analyses but the margin of safety for both stocks appears to be greater than 35%.

Folks have been very wary of sub-prime lenders because of the fear of rising defaults from the overextended American consumer. This is especially true for sub-prime mortgage lenders who have extended exotic loans to finance the housing bubble. It's unclear how all this will play out, but all sub-prime lenders are being punished in advance of a potential rise in defaults. Is this rational? If I were a sub-prime mortgage lender, I would be worried. Many adjustable rate mortgages (ARMs) will be re-adjusted soon and many borrowers will realize that they cannot meet the minimum payments. This will cause a rise in the default rate, sending many more of the sub-prime lenders into bankruptcy.

Given the likelihood of further pain in the sub-prime mortgage lender industry, how will this affect NICK or CCRT? I argue that there will be minimal impact. These companies service a different segment of the credit-strapped consumer and have demonstrated conservative loan operations. CCRT's clientele does not even qualify for credit cards, so taking on mortgages would be out of the question for these people. There may be more overlap between people borrowing money to buy a car and people borrowing money to buy a house. However no auto loan financier in their right mind would take on a loan from someone whose monthly income could barely pay off an ARM monthly payment. For these reasons, CCRT and NICK should not be batched together with other sub-prime lenders. The only major risk I see is the risk of a recession. Defaults are likely to rise during a recession and these two stocks will go lower (along with the whole stock market). If there is a recession, it will be the time to load up on these two stocks. Both companies have been around for at least one credit cycle and know how to run a tight ship when the going gets rough.

From this reasoning exercise, I conclude that NICK and CCRT are lower risk than they appear and are in fact significantly undervalued at current depressed/stagnant prices.

Link: Chesapeake Energy Analysis

I like Chesapeake Energy as a contrarian play. Over the last year, natural gas prices have declined from last year's peak to about $6 per mcf due to mild winters and cool summers. Even if it gets much colder in the next few months, the current glut of NG supply may still keep prices depressed. Lower NG prices is a short-term risk to what I think is a long-term trend. The company's multi-year reserve acquisition binge has ended and management will now be devoting their efforts to drilling. I expect reserves to increase dramatically as unproven reserves are proven. This will further boost the present value of the company as presented in Eric Schleien's excellent post about the break up value of the company. Even though CHK has 2x more unproven reserves than proven reserves, the unproven reserves are valued at 1/2 the value of the proven reserves. In other words, proven reserves are 4x more valuable than unproven reserves according to this analysis. The analysis appears very conservative because historically 50% of unproven reserves are converted. Coupled with the potential for NG prices to increase, we have a very undervalued asset play.

I have a position in this stock and will be purchasing more under $28. For a second opinion, check out this post at Theo Wong's site. Note that McClendon did not actually make the $9 million dollar purchase; it was a stock grant.

Book Report: Pioneering Portfolio Management by David Swensen

I just finished reading Pioneering Portfolio Management: An Unconventional Approach to Institutional Investing by David F. Swensen, the Chief Investment Officer of the Yale endowment. Although not a value investing book per se, it sheds a lot of light on the whole investing process. He takes a very top-down approach to investing with a lot of data to back up claims. Although he may disagree with Warren Buffet in approach, he shares a similar view that investors in equities should either invest in fairly inefficient illiquid opportunities selling at a discount to intrinsic value or invest passively through index funds.

The following are a few interesting points that I noted from the book:
1) The more liquid an asset class or security category, the less opportunities there are for active management to generate alpha.
2) Mutual funds that concentrate in a limited number of stocks often outperform very diverse index-like mutual funds.
3) Consistent high returns from private equity firms depends primarily on the amount of value that the firm adds to the process. Buyout firms that have expertise in improving operations can be expected to do much better than firms that perform buyouts just to liquidate. A lot of buyout transactions underperform the S&P if one leverages the S&P's returns by the same amount as the buyout transactions.
4) Not much diversifying value from corporate and foreign bonds. Corporate bonds tend to have features that favor shareholders rather than bondholders, e.g. callability of bonds. Fixed income allocations should be concentrated in Treasury bills of different duration as they serve as a ballast during times of crisis or times of deflation.
5) The majority of the portfolio returns will come from marketable equities and alternative asset classes like private equity, long/short funds, merger-arbitrage funds, and real estate.
6) For those aspiring to be quants, Swensen emphasizes the necessity to pair qualitative assessments of investments on top of pure quantitative approaches. Many times backwards-looking analysis can be misleading and soft analysis is necessary when evaluating companies and funds run by real people and entities.
7) He likes to foster contrarian thinking in his investment committees. He doesn't expect immediate positive feedback from contrarian ideas. Small controlled experimental failures are often precursors for eventual success.

Like many of the other authors whom I read, Swensen believes in the importance of asset allocation, intelligent diversification, and the futility of market timing. Unlike typical value investors, he believes that value investors face likely failure unless they have a significant edge over other market participants. He also doubts most investors have the intestinal fortitude to hold onto out-of-favor companies in their darkest hours. In other words, he believes in value investing, but doesn't think that most investors can practice it with success.

In the last chapter of the book discussing the investment process, Swensen tells readers that the most important decision one can make is in deciding an investment policy, i.e. an asset allocation. Once that is set then one can worry about execution and fine-tune particular strategies. As it applies to me, my asset allocation decision is relatively simple. I recently entered my mid-twenties with approximately ten months worth of expenses in an emergency fund. I have a stable income and may be looking to buy some real estate if the California real estate market can start toppling =). The majority of my money is invested in equities. Currently I have 90% in equities, 5% in fixed income, and the remaining 5% in cash. Because the 5% cash is actually earmarked for stocks and options strategies, I am slightly off my target of 90% equities and 10% fixed income. I'll try to rectify this by the end of this year.

Overall, I highly recommend this book. In particular, chapters 4 to 8, 10 and 11 are especially relevant for the individual investor. I have to admit that this book wasn't as easy a read as say Jim Cramer's books, but there are definitely a lot more gems.

Results for 2006

Happy new year! I'm just recovering from food poisoning, so I will have to keep this post brief. As of the today, my personal investment portfolio IRR for 2006 is 14.75%, which trails the S&P's 16.11% for my particular inflows. I'm pretty satisfied with my performance this year despite my lagging the S&P. I generated a lot of excess alpha in my 401k by trading into MSFT stock. The investment return for my 401k portfolio this year is 21.1%.

Over the last two and a half years, I have been able to grow my personal portfolio at 12.14%. This is not great, but acceptable given some of the bumbles that I've made since starting to invest. Let's hope 2007 is the year my investment theses come to fruition. I wish everyone the best for the coming year.