Christopher Dall's  Instablog

Christopher Dall
Send Message
Associate Client Advisor (Investment Officer) with PNC's Institutional Investment Group.
  • A Lesson In Restraint 0 comments
    Apr 12, 2014 3:20 PM | about stocks: BAC

    Investment Thesis:

    • The first thing we learned in 2014 was the meaning of being overweight, specifically equities.
    • Amidst the president's campaign to promote the formation of personal IRAs for every American, retirement planning has becoming a significant topic of discussion.
    • The short term result is that while everyone focused on the diversification of securities, exposures, and the rest, we failed to prepare for the diversification of shareholders.
    • Near-term volatility derivative of a more positive comovement between news and market-price has livened the path between point A and point B, and that can be worrisome to some.
    • It might serve to remember our investing roots: prudence, patience, and due diligence. If Mr. Market fails to provide a straight line today, we can always come back tomorrow.

    Opening Remarks:

    I believe too many investors psychologically assign their portfolio into a vacuum or microcosm of the security markets, in which, after purchasing the basket of securities for the portfolio, no external factors could influence the impermeable membrane of their universe. The end of 2007 illustrated exactly what happens when every market-matching (beta = 1) portfolio tried to sell-off at the same time: equity became increasingly worthless as collateral and the overnight liquidity markets came to a screeching halt. While I never thought I'd be saying this, my takeaway from that understanding is foremost that investment policy must encompass a specific strategic plan for asset allocation.

    In these opening remarks, my goal is to persuade you, the prudent reader and prospective investor, of the inferiority of "breaking news" investing in relation to strategic, hypothesis-driven stock-picking. Ray Dalio, a true hedge-fund pioneer of alpha-oriented portfolios, has historically proposed a core-satellite strategy. My subjective understanding is that a portfolio begins with 3-4 core holdings, based in large-caps or blue-chips with positive growth outlooks and share price stability. The remainder of the portfolio is then allocated evenly between "alpha-bets," thematically satellites, chosen through application of a dominance hypothesis anchored in both qualitative analysis AND a quantitative valuation or measure of intrinsic value. In conclusion, I will provide an example of a process by which Bank of America's (NYSE:BAC) common equity and/or warrants could be evaluated for inclusion within a core-satellite portfolio looking for long-term returns.

    My belief is that commonly-accepted screening methods, drawing again on the example of a beta-target portfolio, are created using a filter of the same limited toolkit of metrics by each and every portfolio manager with a background in the "relevant" modern portfolio theory - coined in the 1970's and abused since - the large cap, which the amateur "beta" investor thought was "distinctly" uncorrelated to price movements (mistakenly thought of synonymously with systematic risk, or beta) [distinctly correlated to] his or her small-cap, all of a sudden, has a correlation of .9, instead of, for example, the .65 correlation he believed he had.

    Contemporaneous to the correlation calculations failing to account for similarity in portfolio screening / the moves of other investors, you have a new generation of investors who think that you have to sell every time the price of the security drops in a given day, thus creating the potential for fire sales, which, in turn, catastrophically repress the tri-party-repo system into the ice-age. If investment banks and bank holding companies can't find overnight liquidity, the credit-creation process halts and National GDP/Economic growth becomes threatened.

    Warren Buffet is fond of pointing to the notion that "what the wise do in the beginning, the foolish fail in the end," creating an easy basis by which to find short-selling opportunities. I look for short-term volatility that arises when "irrational exuberance" or Alan Greenspan's "animal spirits" cause an over-adjustment upward: risk-reward on a near-term bet that the volume-weighted average price jumping 15% on news, which only boosted intrinsic share value by 5%, isn't sustainable, would seem the definition of arbitrage (risk-free) investing.

    Neglected small-caps, and even some mid-caps, don't have market makers (dealers) offering a statistical spread (bid-ask) above and below the last price that effectively provides short-term liquidity at a price, with the spread accounting for the liquidity premium the dealer is offering, which they [the dealers] receive in addition to guaranteed compensation from the companies or exchanges on whose behalf they act. I thus draw the conclusion that betting on a mean reversion, or a correction from an over-adjustment, has the return value of shorted price to intrinsic value, plus the additional, contingent return factor that neglect or lack of market-makers (security floors / tighter-banded circuit breakers) causes mean reversion to overshoot - on a graph it would look somewhat like a sinusoidal function with the y-axis indicating % deviation from intrinsic value and the x-axis denoting time, with a coefficient affecting inverse correlation between the value of x (as it approaches infinity) and the magnitude of the range (within any single period, i.e. 2 pi = one period in the function y = sin (NYSE:X) ) - as X approaches infinity, the continuing value of y will go smaller [in magnitude] distances above and below the Y-axis, resulting in asymptotic behavior around the x-axis, defined to be y=0 when the security is trading at intrinsic value.

    (click to enlarge)

    Source: Princeton University

    Short-term arbitrage thus becomes a game of how quickly you can recognize and compute intrinsic value - I struggle to think of a single vocabulary term that has helped my security screening process more than the neglected-firm effect, which posits that while most securities are actively followed, allowing for news and announcements to efficiently be priced into the market, there are some companies for which analyst adoption rates have failed to match the pace of innovation or success in the ever-expanding global capital markets. I would argue that the effect either confirms or perpetuates the Grossman-Stiglitz paradox, summarized in the slide below. From this, I would conclude that investors have subconsciously associated or rather believe that there is a positive correlation between volatility, or risk, and return: and when you remember the other important synonym for volatility, that pervasive term "beta," the thoughtful investor could conclude that passive portfolios, with some obvious exceptions, became an autonomous system of incremental rebalancing efforts in order to achieve statistical optimization today with respect to yesterday's scenario. Taking once more from this very helpful Princeton lecture, I'll let the following slide drive in my point:

    (click to enlarge)

    Source: Princeton University

    If I were looking to outperform the market, other managers, or any of the traditional benchmarks that might be set, my first criterion wouldn't involve value, growth, trading multiples, or any of those other meaningless measures of relative non-sense. Price is what you paid, value is what you "think you got." Tangible vs. intangible, easily distinguishable in hindsight yet seemingly impossible to accurately associate in the present, the difference in these terms and semantics-based arguments that typically follow are only useful in that they recognize the meaningless nature of those screens. My hypothesis is that harmony must exist for a system of equations to function for its intended purpose: if the underlying basis, price and value, are consistently at odds, any system of equations that builds on their [price and value] relationship must be flawed in premise. Translating theory into application, my conclusion is that a prudent investor could feasibly find underpriced securities by screening for neglect: personally, I look for companies I haven't heard of, or heard from recently, on the premise that a successful company, in the absence of any news, might become underpriced.

    (click to enlarge)

    Source: Princeton University

    The last point I must make is that price is what you paid, value is what you believe you took away. The reason for my discussion of short-selling and market mispricing is surprisingly simple: if you, the investor, find price that exceeds value, why would you want that security in your portfolio? Conversely, again by your own due-diligence driven dominance-hypothesis, if you find value that exceeds price, wouldn't you want that security in your portfolio? Whether you, the prudent investor, are looking for a core holding, satellite, or even something else altogether, my hope is that the following discussion of Bank of America will provide an alternative strategy to "blind diversification."

    Bank of America

    Industry: Banking

    Sector: Financials

    Market Cap: 183,568.51

    52-week Range: $11.23 - 18.03

    Next Earnings Release - 4/16/2014

    Business Description: "Bank of America Corporation accepts deposits and offers banking, investing, asset management, and other financial and risk-management products and services. The Company has a mortgage lending subsidiary, and an investment banking and securities brokerage subsidiary." (Source: Bloomberg)

    Contingent Drivers of Upside (premium):

    • Credit downgrade lets them sell structured notes at a higher coupon again, this was previously dragging on sales
    • Merrill Lynch related regulatory sanctions have been taken care of, providing the opportunity for management to utilize the early merger toward producing the intended synergies.
    • Sandbagging the stress test (finishing poorly and needing a capital distribution plan resubmission) suggests management's firm control of earnings, balance sheet, and money/credit creation.
    • Rising interest rates have historically been a leading indicator of an expansionary period for the financial sector, with large-caps better suited than small-caps to handle increasing regulatory expenses while simultaneously benefitting from scale and perspective .

    Contingent Drivers of Downside (discount):

    • Broad exposure to the US economy, with the risk of cyclical downturns playing out in the financial industry first - additionally, the Fed's continuing pace of tapering amidst mixed signs pointing to economic stagnation reflects the troubles affecting fixed-income buyers.
    • Private-equity's pursuit of fire-sale repo-ed assets (from NPL's, foreclosures, etc.) has driven up real estate prices (i.e. Blackrock's bids at auction serve as a price floor, reducing affordability for homeowners/the # of homeowners applying for mortgages - this is being reflected in the loan originations down Y-o-Y.
    • Fannie/Freddie wind-down has the potential to increase the cost of mortgages to lenders as risks are transferred off their balance sheets and into the market - seen in CDS spreads and aggregate corporate and consumer defaults rates.

    Price Target (12/31/14): $24

    Dominance Hypothesis [reason to keep]: A few weeks ago, analysts were complaining that BAC had "too clean a balance sheet" and was too-creditworthy, not to mention the ever-present strength and strengthening of their earnings. Then came Friday, and the bank comes in 28th out of the 29 banks which finished (RIP #30) the stress tests; the following Monday, they receive a rating downgrade. I believe the downgrade serves as an opportunity to purchase more of the security, as a downgrade increases the expected return (b/c of an increase in credit risk), thus reducing the share price, ceteris paribus, in the short run. Remembering that a credit rating downgrade is an intangible with regard to BAC's actual operations, long-term per-share goals have remained the same, while the [potential] return from "today's" price point to target value has increased. There have been a couple of good articles touting the TARP-related warrants for 2018 and 2019, with dividends reducing cost basis allowing the investor to inversely leverage the potential for enormous capital gains upon a much smaller initial investment: the only caveat being that the broad end of your yield curve (i.e. duration) will see its peak 4-5 years from now, and most investors these days can't wait that long.

    Historical Price Chart: (click to enlarge)

    Neglected Firm Effect? Bank of America? What?

    If I haven't convinced you yet of the irrationality behind purported "fundamental" and "technical" investing techniques, in isolation, then it might be useful to point out that my suggested "buy" or value point slightly resembles the "teacup" technical event commonly used to support a hypothesis of technical strength. In my opinion, this fundamentally supports leveraging the "neglected-firm effect" toward identifying securities which might provide market outperformance in the medium to long term.

    So how does this lead us to Bank of America , one of the most commonly discussed SIFIs (systematically-important financial institutions) in recent history? The answer, I believe, is through their warrants. Warrants give you the opportunity to buy very long-dated calls on Bank of America, in this case specifically ones that's have strike prices contingent upon the level of dividend declared, in which dividends above scheduled thresholds reduce the price the warrant-holder will have to pay for shares in the future (2018 and 2019 expiration).

    The Series A warrants provide a moderate amount of inversely leveraged exposure to BAC's common equity with a lower dividend threshold, lower strike, but higher market value (premium you pay above the strike), while the Series B warrants (~$32 strike, trading $.92 a warrant) provide an opportunity for Roth IRA to leverage its maximum yearly allocation ($5,500, or $6,500 if you're above the age of 50) into maximizing the growth potential of Bank of America. I leave my description here of the two warrant series purposefully vague: my intention is that if the logic presented makes sense to the reader, my investment thesis will provide a workable framework against which due diligence may begin.

    Investment Thesis:

    Level of Conviction

    Suggested Exposure









    Rising interest rates allow more room for spread to be realized while additionally providing room for insurance or a margin of safety to be built in to transactions/lending.

    Mortgage originations down significantly Y-o-Y, indicative of private equity's increasing stake in the single-family home residential industry.

    Clean balance sheet and strong asset base - increased regulatory-related expense pressure on small and mid-size banks could benefit BAC.

    What else will regulators take away? RIP commodities, swaps, proprietary trading, self-governance, etc.

    Integral pillar of American economy, and thus stands to benefit from US growth and stability. Increasing emphasis on credit creation typically serves as a leading indicator of financial sector strength (with regard to their equity securities), and could thus lead to a record year for BAC.

    Abnormal Convexity Event - Unwinding of Fed's intervention into market interest rates has the potential for volatility and provides an otherwise unlikely opportunity for the market, and all associable securities, to deviate from historic trends. Whether or not this disrupts strategic planning/capital distribution plans depends largely on management's ability to recognize the event.

    Closing Remarks:

    Personally, I added the Series A to my financials watchlist, ostensibly to consider for my non-retirement account, and threw a small allocation toward the Series B in my Roth IRA. My thoughts were that betting Bank of America Merrill Lynch could have common equity worth $33 ($32 + the $.9-$1 the warrants are going for) by 2018-2019, after watching a company like Twitter IPO at $26 and open at $46, in the same morning, seems like a pretty safe bet.

    Regardless of which security you favor, or even if all three seem anathema to the predilections of your individual investment strategy, my point, and associated, purposeful neglect toward warrant-specific valuation metrics or return frontiers, is to engage potential investor in the search for something you could hold for five years. Warren Buffett advises each manager within the Berkshire Hathoway tree of corporations that they should act is if they wouldn't conceivably sell the company for a minimum of one-hundred years. Go ahead and take a moment to look at your portfolio, and ask yourself, "would I hold any of these, no "buy-the-dip," no avoiding a cyclical-recession, etc., for the next five years? Ten years? Fifty?

    The conclusion I draw from this is that the longer your investment horizon, or the longer the duration (point in which your investment breaks even, and all future cash flows are thus profit) you are looking to be exposed to and compensated for (i.e. you won't have liquidity for duration without selling for a loss), the harder it becomes to identify equity securities tied to corporations with sustainable product lines. While ten years from now we can all expect to still need insurance (even if there is a paradigm shift toward usage-based insurance that might "revolutionize" the industry), does anyone expect to see Bitcoins then? If the principle line of business for a corporation involves some kind of spread, or risk-pool calculated into a spread-based return requirement, then they might serve as an opportunity for due-diligence and tactical position entry to result in abnormally-positive return; however, if their principle line of business involves some widget that can, or will need to be replaced by an upgrade, better version, or the catch-all disruptive technology, then you might want to double check your work before adding them to your long-term holds.

    The lesson in restraint thus becomes apparent and available: while plenty of articles and arguments exist for Bank of America's downside, upside, trading discount, trading premium, etc., I encourage the reader to consider, on a personal level, where they believe the intrinsic value to be, on a per share basis, over the five years. If you believe the value created over a more significant duration will be greater than the price today, I encourage you to consider the security for your portfolio; conversely, should you determine the opposite, I would encourage you to not settle. The diversity of companies and securities available to investors in today's markets provides ample opportunity for large, abnormal returns: sometimes you just have to keep looking.

    Disclosure: I am long BAC.

    Additional disclosure: Indirect exposure through BAC.WS.B (Bank of America Warrant Series B).

    Stocks: BAC
Back To Christopher Dall's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers


More »

Latest Comments

Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.