Four Ways to Keep Cool in a Nervous Market

The market is chock full of contradictions. It's a jungle out there and what's an investor to do?

1. Dump the idealism and embrace reality.
2. Hone your cash-flow analysis skills.
3. Avoid paying a premium for assets (think value).
4. Let fixed-income do some of the heavy lifting.

1. Forget about the good 'ol days, when home equity was an ATM machine in "drag" and cheap liquidity flooded into our simple lives (and wallets). Only to be promptly dispatched for more temporal needs. A sordid tale we can only explain in prose: 

Alan Greenspan once sat on a wall
Until banks and homeowners began to fall
Neither Ben Bernanke & Hank Paulson, nor Jamie Dimon's men
Could get the credit markets to work again   

...or 

Greenspan lowered rates when business stopped spending on cap-ex
Lenders and borrowers got frisky (and) had gratuitous sex
So the Fed and Treasury put a gun to JP Morgan's head
Help us out good buddy or we're all dead!  

Either way, this credit mess is a structural problem and caused by a catastrophic failure in risk management. It started with crummy lending standards (2001-2006) and will likely waft into commercial loans and credit card receivables going forward.

Here, systemic risk was amplified by liberal use of leverage and a generous interpretation of one's balance sheet (lenders and borrowers). More shoes will fall before the offal is cleaned up. You can put lipstick on a pig, but it's still a pig!

Other usual suspects weigh in too: high commodity prices, expensive military conflicts, rising unemployment, a potentially polarizing presidential election, etc., etc. Throw global inflation into the heap and you've got a party with no punchbowl.

2. A lion's share of my investing success is credited to keeping a watchful eye on changes in cash-flow and accrual accounting (as a measure of earnings quality). This has been true for both equities and fixed income holdings.

Cash-flow analysis is the first step in my investment screening process. Fundamental ratios such as ROE, ROI, P/E's, Price-to-Sales are important, but meaningless if the numbers are skewed by creative or aggressive accounting methods. The model we use is a variation of a method known as "dual cash-flow" analysis.

3. The difference between fair value and overpriced depends on the current price of a security relative to an investor's perception of its intrinsic value. Who's to say a rapidly growing company selling for 65 x earnings is any more expensive than one trading at 12 x earnings?

A growth stock may warrant a lofty multiple, but a lower P/E security might be cheap for a reason. How does an investor tell the difference?

Before looking at charts or technical indicators, we compare revenue metrics and capital productivity to our cash flow/accrual analysis. As every picture tells a story, this combination of data reveals much about how management minds the cookie jar.

Next, we compare the financial analysis to price of the security. This helps to determine whether or not the data we are seeing is reflected in the current market price:

• Are investors ignoring potential danger signals?
• Is the market discounting possible improving trends in cash-flow?

4. We are big fans of income producing investments because they help offset price volatility over time. In our portfolios, we have a variety of yield holdings including, traditional and trust preferred shares, corporate and municipal bonds, closed-end funds, CDs, etc.

Yet, fixed income securities have not been immune to market carnage either. Cash yields are horrific, and spreads between junk bonds and Treasuries are rather "tight". Credit quality is an issue too, and it doesn't help that the big "three" rating firms (S&P, Moody's and Fitch) have been so slow to make these distinctions.

However, from despair, opportunities do come. It's times like these when investors need to tune out the hubris and hunt for bargains in the yield bin. Here's a few areas we've been looking at:

Closed-end mutual funds*: We are seeing double digit discounts in net-asset-values across a variety of closed-end fund styles. Everything from "munis", emerging market debt, senior loans, to equity income (long/short strategies), are trading for 80 to 90 cents on the dollar!

Municipals: Current yields average 4.5%, which is equivalent to a 7% (or more) taxable yield for folks in high tax brackets. It works for average taxpayers too as 4.5% beats CD rates and credit quality remains AA or better.

Emerging Market Debt: Although the US dollar has firmed up a bit, prospects for a meaningful rally in the greenback appear dim. So, investors may want to look for funds invested in debt issuers of emerging market countries that are denominated in the local currency.

Senior Loans: Also known as loan participation funds, investors should seek out portfolios holding term loans and senior debt obligations secured by operating assets. In our opinion, this is one of the few attractive asset classes in the fixed income universe presently. Credit quality varies and most closed-end portfolios hold variable and/or fixed rate obligations from companies in a wide variety of industries. Yields are currently north of 6% and if the Fed raises rates, distributions will likely increase. First-lien loans also have "senior" liquidation preference in the event of default.

Equity Income: These are a newer breed of yield vehicles which employ index-option strategies to provide income and capital appreciation. Current distributions are averaging 9% or more.

Exchange-traded Debt Securities**: These resemble a preferred share dressed up as a bond. Distributions are considered interest and as a result not eligible for the 15% tax rate on dividends. However, exchange-traded debt can be bought and sold just like an equity and a company will usually cut or eliminate their common-stock dividend before deferring interest payments.

* More info on closed-end funds is at: http://www.etfconnect.com/

** More info on exchange-traded debt securities is at: http://www.quantumonline.com/

Comments

[Brian in Mo...:]

Thanks, Nice reality check actually.

2008 Aug 13 07:22 AM

[longtermstocks:]

Sound advice thanks

2008 Aug 13 09:33 AM

[bbzz24:]

Great article!
If you add macroeconomic cycle as additional screen to figure out who will fare better in the shaping environment, your results may even be better.

On munis: I am staying away from them as their cash inflows are significantly constrained by lower tax revenues and many have sizable unfunded employee benefits. They don't look fundamentally stronger than junk bonds in this deteriorating economic environment.

2008 Aug 13 10:01 AM

[MarkMedayski:]

Too much advise,thanks.
In declining market everything declines and in rising market even junk flies.Dow Jones around 9000 till December at best optimistic estimate,then next year 6000-7000 not sure how your indexing will perform then.

2008 Aug 13 10:17 AM