Eight Notes on Insurance, Economics, and Value Investing

1. Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”  An interesting comment to be sure.  Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.  That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.  So who would be affected?  Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.  Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
2. Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”  Now, we weren’t talking about credit card debt, which they paid off in full every month.  They did have a home equity loan at 8.5% fixed.  My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.  Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.  My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.  Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
3. As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.  Shoe retailers and mortgage REITs have not done well of late.  Am I predicting no recession by buying the retailers?  No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.  I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
4. Does buying a mortgage REIT mean that I am betting on further FOMC loosening?  No.  The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.  While a FOMC loosening would probably help, I’m not counting on that.
5. My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
6. If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.  The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
7. Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.  There is only so much room for shorting, which is an artificial overlay on the system.  We aren’t at the limits of shorting yet, but we are getting closer to those limits.  It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).  It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
8. I’m thinking of doing a personal finance post on what insurance to buy.  Is that something that readers would like to read about?

Comments

[Dave therave]

I would be interested in what insurance to buy. Thanks for the always interesting posts!

[Tim McGeeney]

David:

Great point about shorting and the limitation of these various strategies. Also, to extend you point on Balanced Fund just take a look at how well these have done over a full market cycle (2000-2006). A few names: OAKBX, DODBX (closed), WASAX & MDLOX. They provide better transparency, have daily liquidity, lower volatility and similar returns to Hedge Fund of Funds - oh and at much cheaper levels!

[DaveJ]

I agree that mortgage insurance is in trouble. The stand alone mortgage insurers that you mention (MTG,RDN,PMI,TGIC) could fail. However AIG and ORI which are diversified will not. In fact they will gain market shares. AIG could dominate this business if they want to. The others will be credit downgraded at the least whereas AIG's United Guarantee has the full backing of AIGs balance sheet (if AIG doesn't want to let it fail).

In addition, piggyback loans are going the way of the crop and buggy since banks don't want to take on this risk. This gives MI a larger part of a declining market. The declining price environment will increase payouts but raise persistence which is good for MI companies.

This is just reason that I am long AIG. They also benefit from world growth, have a great reputation for underwriting and inovation. They can grow at 12-15% and pay dividends and buy back shares. In addition they benefit from a declining dollar since half their revenue is from oversees. They at P/E of 10 which is an all time low.