Irrational Stupidity

I chose the title of this article because I wanted to get the attention of the readers of Seeking Alpha. My intention is to compliment one individual, but also to point out that not only does the average citizen make horrible decisions, but supposed icons of finance such as Alan Greenspan, make these same mistakes. Unfortunately, these icons create problems that affect millions, if not billions of people.

Robert Shiller is the person I would like to compliment for his rational and reasoned approach to the world of economics as well as his reality based thinking. I remember his comments about the stock market in the late nineties and his thoughts about real estate in 2004-2005. Of course people thought he was a little crazy at the time, but now he appears brilliant. The reason he appears this way is simply that he acted in a reasonanable and rational manner. Now, please stay with me, I promise to get to the point.

I recently wrote an article concerning some "bulletproof investments." In that article, I mentioned that I had been involved in the fixed income area for 38 years. I made mention that fixed income types tend to be pessimistic, but I failed to mention that they also tend to be realistic. Over the past month I have seen what I term "irrational stupidity" overcome any sense of reasonable thinking. I would like to give you some examples and I want to throw in an idea to show you how irrational some of the "experts" can be.

A few days ago, I recommended three different fixed income ideas, all of which I believe are still bulletproof, but of course they have gone down in the panic selloff. The amazing part is that these recommendations are just as strong today and in one case stronger. Let me quickly outline my recommendations and show my reasonable thinking.

I recommended the following fixed income instruments. The first one was Gabelli Natural Resource and Income preferred (GGGNP.PK). The symbol is GGNPRA. I told the readers that these triple A preferred securities had a mandatory call, if the coverage of the common stock in this closed end fund went below 2 X the value of the preferred, these preferred would be called. I also mentioned that as of 6/30/08 the value of the common shares was 485 million dollars.

Well, I called Gabelli Friday and found out that the fund which is involved in energy and gold shares has declined to 220 million dollars. I also made sure that my reading of the prospectus was correct concerning the mandatory call. The company confirmed this fact and they may be forced to call these preferred if the market declines further. The facinating part is that these preferred are trading in the $17-$18 area and the call price is $25 dollars per share. Now, is it reasonable or irrational to think that a AAA rated security that has a current yield of 9.5% with a good chance of being called, a bad investment? I will let you be the judge, but let me get to the next example.

I recommended the NYSE debt instrument of Constellation Energy, Inc. (CEG) The symbol is CEGPRA .This company was taken over by Mid American Energy which is a subsidiary of Berkshire Hathaway (BRK.A), which of course is run by Warren Buffett. In effect, Mr. Buffett made a billion dollar down payment for this company last week. He must await the regulators approval, which is almost certain, yet Friday the common shares of this company were up on the day, and the corporate bond of the same company was down 7%. How is it possible that this debt instrument could decline when it has an 11.5% current yield and close to a 14% yield to call and I believe that they will be called in 2013? In addition this bond is much safer than the common shares? My conclusion, irrational stupidity. The story gets better, so stay with me.

I recommended a floating rate preferred issued by MetLife, Inc. (MET). The symbol is METPRA. My reasoning was straightforward. This preferred issue trades with the following formula. It floats 100 basis points above the 3 month libor with a minimum rate of 4% with no maximum ceiling. I recommended it at a price of $10 dollars per share, which at the time produced a current yield of 10%. This preferred was originally issued at $25 dollars per share and is callable in 2010. My reasoning was that MetLife is one of the oldest insurance in the U.S. It always has been run in a conservative manner and since it was de-mutualized, its performance on a financial basis has been outstanding. Of course like all insurance companies, it uses leverage, but many of you may not realize that insurance companies do not have to "mark to market" in most of their investment areas.

Here to me, is the astounding part. MetLife has billions in liquidity and it just sold 75 million shares in a secondary offering last week. Obviously, this adds to its liquidity and financial strength. Friday, one of the only stocks to go up in a significant manner (2.25%) was MetLife, yet this preferred went down 3.5%, when in fact the financial backing and security behind the issue was enhanced. Please contact Graham and Dodd in heaven and ask them how this is possible. This preferred could easily out perform the common shares over the next few years.

It now has a current yield of 11.6% and it is callable in 2010. It probably will not be called, but I think one of two things will happen. One, we get through the financial crisis and interest rates normalize. If that is the case, then it would be very possible that 3 month libor may be in the 5%-6% area. This would translate in a current yield of 15% to 17.5%. Assuming the world doesn't come to an end, this security would trade on a consevative basis in the $15-$20 dollar area (it traded at $26.00 dollars last year), but I would rather take a conservative view. Now, if this works out as I think it will, your total return will be the 11.6% current return at a minimum plus an additional 50% to 100% in appreciation.

Have I missed something? Am I suffering from irrational stupidity? I don't think so, but some of you may feel that Google (GOOG) is a better investment, and please feel free to buy all the shares you can.

Lastly, I would like to address and area where many of the Wall St. types are pounding the table about what a good value municipal bonds are today. To me it is a great example of simplistic thinking. I have heard over the past months that municipal bonds are a great value because their tax exempt yields are much higher than U.S treasury yields. An example would be that a 30 year AA municipal yields 5.3% when a U.S treasury yields 4.15%. The tax equivalent yield in the 28% tax bracket is 7.375%. Sounds great and many of the people on Wall St. will tell you that the default rate on municipal bonds has been historically low.

Well, first of all nobody in their right mind should compare municipal bonds with U.S treasuries. Aside from that observation, the default rate has increased over the years and there is a very simple reason why. In the early 1900's we did not have municipal bonds issued by sport stadiums, hospitals, ethanol plants and many other crazy financial projects, In addition, we did not have state governments running budget defecits, like the ones today. Many municipalities have pension obligations they will never be able to honor.

I could go on but suffice it to say, that if you are looking for another black hole to invest in, look no further. Hopefully I have provided some reasonable and rational thinking, but if you disagree, please feel free to blast away at me.

Disclosure: Author is long all stocks and debt mentioned.

Comments

[pickaroonwyo:]

Interesting article. I like to follow closed end funds. There are really some tremendous values, especially bond funds. I like PIM, GIM and FAX. Learn more at etfconnect.com

2008 Oct 12 08:42 AM

[hatarakiman:]

when you see the yield of the muni money market fund higher than the yield of the taxable money market fund, then you know how smart investors are...

2008 Oct 12 10:36 AM

[Bud Labitan:]

Benjamin Graham wrote about these market excesses many years ago and described a metaphor for these activities. He called it Mr. Market.
You may also enjoy the advancement in valuation ideas here: "The Four Filters Invention of Warren Buffett and Charlie Munger." It explains and honors the intellectual partnership of two brilliant men. The genius of Warren Buffett and Charlie Munger's four filters innovation was to "capture all the important stakeholders" in one "multi-variable" four step process. www.amazon.com/dp/0615...
Unwinding and unwinding of complex derivative contracts will occur. In time, market values will meet intrinsic values.

2008 Oct 12 04:50 PM

[andruomail:]

Interesting about the CEG-A -- yielding 11+% today. Some things to pause on: Buffet's company's merger proposal goes up for vote in summer 09, and long-term CEG shareholders aren't too excited about the low price. He did put $1 billion into preferred stock up front that from what I can tell is senior to CEG-A and convertible to senior notes @ 14%. You might end up with the preferred stock but no Buffett. There is however a competing slightly higher offer from the French, so somebody strong might end up with the company at any rate.

2008 Oct 12 09:07 PM

[andruomail:]

Interesting about the CEG-A -- yielding 11+% today. Some things to pause on: Buffet's company's merger proposal goes up for vote in summer 09, and long-term CEG shareholders aren't too excited about the low price. He did put $1 billion into preferred stock up front that from what I can tell is senior to CEG-A and convertible to senior notes @ 14%. You might end up with the preferred stock but no Buffett. There is however a competing slightly higher offer from the French, so somebody strong might end up with the company at any rate.

2008 Oct 12 09:07 PM

[BondGuy:]

Maybe you are worried that buying the bonds from, for example, the ninth largest economy in the world, California, backed by one of the wealthiest tax bases in the world, with a constitution that explicitly prohibits defaults on the state's bonds, to be an irrational investment. Most people would consider a state guaranteed taxable equivalent return of 9.5%, a number that is higher than the long run expected return on the S&P 500, to be a once-in-a-lifetime opportunity. You are certainly entitled to disagree with the once-in-a-lifetime opportunity argument, but if you think this is the most irrational bit of exuberance out there, I suggest you try getting out a little bit more. The fact is that the rate of default on high quality municipal bonds is 1/4th that of the highest rated corporate bonds put out by bellwethers like GE and Microsoft. I'd call that type of investment pretty rational.

2008 Oct 13 09:15 AM

[bond girl:]

I'd have to agree with Bond Guy. Touting the corporate debt of some brow beaten corporations and then saying how silly it is to buy cheap municipals seems somewhat contradictory. We all know that municipal debt is not Treasury debt, but here's a thought: in this environment, corporate debt is more risky than most basic municipal debt. Presumably, we all should look at the credit worthiness of a bond (corporate or municipal), and municipal bonds are trading like their pre-insured ratings. Corporates are trading like they could go under at any time, which they actually can.

2008 Oct 13 01:22 PM

[pone:]

Thanks for common sense and analysis.

On the CEG shares, wouldn't it make more sense to be in the CEG common and get exposed to further upside if we get a real offer to beat Buffett's offer above $26.50?

On the GGN shares, who are you talking to there? When I called them, they were extremely legalistic and did not want to answer any question concerning the preferred A shares. They said that their board was reviewing the preferred A shares and may do things to prevent the call that your article refers to. It definitely did not leave a great impression.

The Met life situation was caused by a market panic that the financial meltdown was spreading to insurers. If that ever worked its way to completion, I could see it getting very ugly.

2008 Oct 13 05:39 PM

[jackinwv:]

Can anyone tell me how I may find the CEGPRA and METPRA issues. I found the Gabelli at my Scottrade account but can't seem to find the other two anywhere under these symbols?

2008 Oct 13 10:47 PM

[andruomail:]

If default's against the CA constitution, is it impossible to do? even if it were, the state congress can probably get together and change that with a supermajority vote. (I'm not convinced this will happen, just reading the fine print.) And bond insurance from Ambac's not very reassuring. Maybe if you can find out they're insured by Berkshire (buffet again), if indeed he would reinsure CA bonds.

2008 Oct 14 02:26 AM

[31October:]

Bondguy,
Municiple bonds are not as stable as you think. Many depend on revenue from tolls, ticket fees, and sales tax. If people can no longer mortgage their house to buy beer and go to the game, then flexible-revenue munis are damaged.
As a fiscal analyst/accountant for a state government, I learned that legislators apparently make revenue assumptions while on meth. I called my city administrator and mayor; they blew me off -- Guess who is laying off cops now. I publicly called out the chair of my state's Senate finance committee to explain a $493 million overspend. He said it was a suprise. (I no longer work for the state.) These officials stared at us blankly when we told them what was going to happen and said, "We'll issue more bonds to cover it." NOBODY IN GOVERNMENT BELIEVES THAT THEY ARE SPENDING REAL MONEY, AND THEY WILL NEVER STOP INFLATING GROWTH PROJECTIONS.

Responsible government spending means nothing when elections are at risk. Therefore, the state constitution will hold back $10B of debt as well as a sheet of toilet paper would.

You demean the author. Remember, Great Britain once had the largest economy on Earth. It collapsed pretty quickly. It had more industry and less debt than California.

Are California bonds safe? I don't know; ask the investors in Orange County bonds.

I would place my faith in a profit-driven enterprise before government buffoons. Yes, I own MET.PR.A and MET.PR.B, and yes, there is a risk.

2008 Nov 19 10:27 PM