Getting the Odds in Your Favor

Michael Mauboussin from Legg Mason Capital has a bullish column this morning in the Financial Times on stocks.

Mauboussin makes three points why he thinks U.S. stocks could be poised for significant gains in the next few months (I have posted the link to the piece below). My favorite part of the article, though, is how he starts his column.

Investing money is sometimes compared to gambling, even though professional investors hate to be considered in the same boat as a Las Vegas card player. However, there have been numerous examples of very successful investors that have also been very good gamblers.

Bill Gross from Pimco, for example, put himself through college by playing blackjack, and is now head of one of the largest and most succesful money management firms in the world. Warren Buffett is an avid bridge player. And Ed Thorp - who wrote the book on blackjack card counting called Beat the Dealer - was also a very successful hedge fund manager.

So when I read these introductory paragraphs from Maubossin today I thought it was a pretty good way to think about investing:

Puggy Pearson, a colourful gambler who won the World Series of Poker in 1973 and dropped out of school before the age of 12, was once asked about the key to his success. “Ain’t only three things,” he crooned. “Knowin’ the 60-40 end of a proposition, money management, and knowin’ yourself.” With a flourish, he added, “Any donkey knows that.”

... Pearson’s point is that an investor should always seek to have an edge, where the expectations implied by the price fail to reflect the fundamental value. Betting on horses provides a simple but accurate metaphor, where the odds on the tote board encapsulate expectations and the likely performance of the horse captures fundamentals. You don’t make money knowing which horse will win or lose; you make money determining which horse has odds that are mispriced.

FT.com / Markets / Insight - Flutter on equities could prove a winner

Put another way, success in money management can be boiled down to three factors: money management; emotional discipline; and looking for situations where the odds are in your favor.

Now to put these ideas to work!

It's That Time of Year: Municipal Bonds Yield More than Treasurys

In the last few years one of the more predictable patterns in the municipal bond market occurs at year-end.

Normally, of course, municipal bonds yield less than comparable maturity Treasury bonds because of their tax-free nature. However, several times over the past few years we have seen situations where as we approach the end of the year that AAA-rated municipals are yield more than comparable Treasury, setting up a nice buying opportunity.

Here's why: this phenomena occurs because, for whatever reason, municipalities wait until year-end to issue a large amount of debt. However, this is also the same time of year when some of the largest buyers of municipal bonds - namely, insurance companies and banks - begin to reduce their investment activity in preparation for year-end. This imbalance - lots of supply, less demand - causes municipal yields to rise.

After year-end, going into the first quarter, supply pressures are lessened, and municipals revert back to their normal relationship relative to Treasurys, i.e., yielding less. Hence the opportunity.

This year the situation has been exacerbated by the possible expiration of the Build America Bond (BAB) program. BAB's were introduced a couple of years ago by the Obama administration as a wait to spur infrastructure spending as well as creating jobs. The interest paid on BAB is subsidized by the federal government (usually the feds pay 35% of the interest tab), making it attractive for municipal governments.

However, at this writing, it is not clear whether this program will be extended into 2011, so there has been a rush by municipalities to issues BAB's. When you throw on the usual year-end spate of new municipal issuance, municipal yields now yield more than Treasurys.

Now I can hear some of my readers say: Not so fast. Municipal credit concerns are growing, and a number of analysts are warning of municipal defaults (which historically have been quite low, by the way).

I don't disagree: I too expect that we will see weaker municipal credits have a difficult time, and possibly try to default. However, unless you are forecasting financial Armageddon, I have a hard time seeing any state defaulting. Moreover, "essential service" bonds like those connected with water and sewer projects are also unlikely to default. Yet even these credits are offering attractive relative yields these days, which to me is a chance to add return to portfolios without adding much risk.

I have attached a link to a Bloomberg story discussing the current market situation.


Munis Yield More Than Treasuries as State Funds Wane (Update4) - Bloomberg.com

The Markets Give QE2 the Bronx Cheer

Ever since the Fed announced its second round of quantitative easing (aka QE2) it has been subjected to pretty severe criticism from a number of sources.

Politicians, of course, will use any excuse to rail against the central bank (all the while hoping that they succeed) but numerous economists and academics have also come out against the plan.

I don't know whether QE2 will work, but I would agree that that the recent sell-offs in the stock and bond markets have been directly related to the negative chorus. Here's a short piece from today's Wall Street Journal:

Criticism of the Federal Reserve's latest bond-buying program, both from insiders and from U.S. politicians, is muting the plan's potential benefits for the economy.

Amid widely publicized skepticism about the efficacy and wisdom of the bond buying, investors and traders are questioning whether the Fed would be able to expand its bond purchases beyond $600 billion—even if inflation continues falling and unemployment remains high. Those doubts have contributed to an increase in yields on U.S. Treasury bonds since the Fed announced the program on Nov. 3, they say.

Criticism Hinders Fed's Easing Plan - WSJ.com

I continue to believe the sell-off has presented an opportunity for bond investors to extend maturities and add yield to portfolios.

Regardless of whether the Fed's initiative is effective or not, I think it is almost a certainty that short term interest rates will remain near 0% for most of 2011, at the very least, which puts an anchor on the overall bond market.

I also think that municipal bond investors should view the recent weakness in the muni market as an opportunity as well.

The muni market has been overwhelmed by a huge wave of new issues (both traditional muni issues as well as Build America Bonds) at a time when muni demand has slackened. Whenever you see AAA-rated muni bond yields higher than Treasurys, in my opinion, this is the time to buy, not sell, regardless of whatever concerns you might have on muni credit worthiness.

Thoughts on Copper and other Commodities

I went to go see Pete Ward, metals and mining analyst at Barclays, yesterday.

Pete, in my opinion, is one of the best analysts in this space. He has been following the group for probably 15 years or so, and has made some terrific calls on his stocks during that time.

Interestingly, before he went to Wall Street, he was a gold buyer for a jewelry company for 10 years, so he has been involved in the industry from a couple of different perspectives.

Pete has been bullish on copper for some time, and remains a "raging bull". The reason, says Pete, is simple demand/supply.

The demand for copper remains robust worldwide. Thirty years ago this demand might have come largely from the telecom companies for use in copper wires, but this has essentially ended (nearly all fiber laid today is fiber optic). Instead, copper is used in areas that require efficient uses of conducting electricity, which means automobile production (especially the new electric cars); housing; and electric grids.

This last part was particularly interesting to me. In the United States, our electricity is largely produced the way it was back when Thomas Edison discovered electricity. Fuel is shipped to a power plant, which then produces the electricity that is then distributed to local customers. The relatively flat topography of the U.S. makes this possible.

However, in the rest of the world, the distribution of electricity is done mostly through copper wires. In China, for example, Pete discussed how the simple vastness of the countryside - coupled with a very rocky terrain - makes transportation of fuel over long distances impractical. Instead, the Chinese will string copper wiring over mountainous terrain to get the electricity to where it is needed.

Thus, this means that Chinese demand for copper will only grow over time. Copper remains the best conductor of electricity - there is no better alternative on the horizon.

Problem is, copper mining is still an incredibly labor and capital intensive business. Opening a new copper mine almost anywhere in the world takes at least 7 to 10 years, assuming there is sufficient copper veins to warrant exploration. And since there are no new mines being opening, this means essentially no new supply.

The newest copper mines are being opened in fairly nasty places, like the Congo and Mongolia. Pete went to the Congo last year, and described an incredibly dangerous environment (he does not plan on returning any time soon, by the way).

The best way to play copper, according to Pete, is Freeport-McMoRan Copper & Gold (ticker FCX). The stock has had a terrific move over the last year, but Pete says there is still a good deal of upside to come. The fact that there are a lot of skeptics on copper is actually good news, said Pete, and I agree: big moves in stocks rarely occur when there is already widespread bullish consensus.

Moving on to the other commodities: Pete still likes the coal stocks, feeling that the market does not appreciate the continuing demand for the fuel despite the environmental concerns.

Interestingly, Pete does not like gold or gold stocks. As a former buyer of gold, Pete finds the current widespread bullish sentiment on gold puzzling. Unlike other commodities, gold is only used in the making of jewelry, and this is not sufficient reason for the recent rise in the price of gold. Moreover, Pete notes that Chinese women often prefer silver jewelry rather than gold, since it matches better against the color of their skin.

Finally, Pete is also not a fan of aluminum. Too much supply (again from China) and not sufficient demand makes Pete a little wary of names like Alcoa.

Viewers pull plug on US cable television

This was an unexpected story that I ran across this morning in the Financial Times.

Cable television - which only a few years ago was being touted as a "growth story" and Comcast CEO Brian Roberts was the talk of the financial world - suffered its largest decline in 30 years in the third quarter. What seems to be happening is either younger viewers are watching TV on their computers, or economic stress is causing subscribers to stop their cable service.

For whatever reason, this could be a major transformation in the entertainment world.

Here's an excerpt from the FT's story:

The number of people subscribing to US cable television has suffered its largest decline in 30 years as younger, tech-savvy viewers lead an exodus to web-based operations, such as Hulu and Netflix.

The total number of subscribers to TV services provided by cable, satellite and telco operators fell by 119,000 in the third quarter, compared with a gain of 346,000 in the third quarter of 2009, according to SNL Kagan, a research company.

Although TV services offered by telecoms and satellite providers added subscribers over the period, cable operators were hit hard, with subscriber numbers falling by 741,000


FT.com / Media - Viewers pull plug on US cable television

This is not to trash Comcast or any other cable company (although, truth be told, I can't tell you the number of times that I have cursed Comcast's internet service, which always seems to crash when I need to get on the web) but rather to point out what former General Electric CEO Jack Welch described as "the law of unintended consequences".

It is obvious to everyone that the internet has transformed most aspects of our everyday life - this was anticipated for many years. However, what most seemed to get wrong is who the ultimate winners and losers in the internet world would be.

Telcos and cable companies are suffering greatly. I would argue, for example, that AT&T and Verizon are heading towards the same fate as GM and Ford were years ago. That is, they suffer from huge infrastructure costs, large legacy pension and health care burdens, and declining revenues from the only profitable parts of their business (landline phone service). To me, both cable and telco are unattractive investments.

What about media?

Good Read from Buffett: Pretty Good for Government Work - NYTimes.com

(I apologize for the late posting of today's note. I have been doing battle with my employer's security software, which suddenly seems to find that Random Glenings - a must-read part of the financial scene for more than a year - has suddenly become a security risk. C'est la guerre).

It is very fashionable in my business to trash the government. Most analyst meetings I attend, and internal investment committee meetings, often diverge into complaints about the government, and government policy. And while I agree that sometimes government policies can be frustrating and irritating, I think sometimes we all benefit from decisions made in Washington, even though we don't like to admit it.

This morning's New York Times carries an op-ed piece from Warren Buffett which I thought was worth reading. He points out that the brave and decisive actions taken by our government a couple of years ago staved off what would have been a financial disaster brought on largely by Wall Street (the Street now, of course, has conveniently forgotten this).

Here's an excerpt:

In the darkest of days, Ben Bernanke, Hank Paulson, Tim Geithner and Sheila Bair grasped the gravity of the situation and acted with courage and dispatch. And though I never voted for George W. Bush, I give him great credit for leading, even as Congress postured and squabbled.

You have been criticized, Uncle Sam, for some of the earlier decisions that got us in this mess — most prominently, for not battling the rot building up in the housing market. But then few of your critics saw matters clearly either. In truth, almost all of the country became possessed by the idea that home prices could never fall significantly.

That was a mass delusion, reinforced by rapidly rising prices that discredited the few skeptics who warned of trouble. Delusions, whether about tulips or Internet stocks, produce bubbles. And when bubbles pop, they can generate waves of trouble that hit shores far from their origin. This bubble was a doozy and its pop was felt around the world.

So, again, Uncle Sam, thanks to you and your aides. Often you are wasteful, and sometimes you are bullying. On occasion, you are downright maddening. But in this extraordinary emergency, you came through — and the world would look far different now if you had not.

Pretty Good for Government Work - NYTimes.com

One irony of today: Buffett was criticized for not mentioning the Obama administration in this editorial, and so had to go on television to point out that such criticism was missing the point of his article (although he said it in more polite language).

Others have pointed out that Buffett - and Berkshire Hathaway - benefited from some of the loans and investments they made in 2008, and so today's editorial is a little hypocritical. To this I say: Buffett was very public that you should be buying stocks, but most were too fearful to do so. Buffett put his money where his mouth was, so to speak, and to me at least he has every right to make the points he did today.

Jeremy Grantham Talks Asset Allocation, the Fed and Where He’s Advising Clients to Invest « Portfolioist.com

I've written about Jeremy Grantham of GMO a number of times on Random Glenings, but when I ran across this article this afternoon on Grantham's latest thoughts I couldn't resist posting it.

The entire article - courtesy of the blog Portfolioist.com - is worth a read. Gratham remains bearish on stocks in the U.S. (with the exception of large cap names like Coca-Cola and Johnson & Johnson) but bullish on the emerging markets. This part is included in the article that can be found on the link below.

The most interesting part (to me, at least) was Grantham's comments on the importance of asset allocation in portfolio returns. Here's an excerpt from the piece:

About 11 minutes into the interview {which in in the link}, Grantham launches into an interesting defense of the importance of weighting your asset allocation correctly. It comes up while he’s discussing emerging markets and how they have returned 3.3 times the S&P 500 since he first recommended overweighting that asset class in 2000.

…That incredible discrepancy…says the main event in investing should be getting the big picture right. It’s nice to pick stocks, but how many good stocks do you have to pick in a whole portfolio to equal that incredible move between the biggest asset class in the world, US equities, and the third or fourth biggest asset class, emerging markets? It’s these movements between the big asset classes that make you money.

As I wrote this morning, the market in 2010 has been all about asset allocation, and not much about stock selection. While this may very change in 2011, most of my client meetings over the last few months have been all about asset allocation, and I suspect this will continue as we move into 2011.


Jeremy Grantham Talks Asset Allocation, the Fed and Where He’s Advising Clients to Invest « Portfolioist.com