Whenever I look at an insurer these days, I take a look at what percentage of their investment portfolio is made up of munis. Fairfax did fine with them during the financial crisis, but at the time they bought only Berkshire-insured munis. I don’t know if I would trust any other bond insurer right now and unfortunately, it appears as if Berkshire has mostly exited the market.

When Ted Garrard took over as chief executive officer of Toronto’s Hospital for Sick Children Foundation last year, donations were down, investments had sagged and there was a public outcry over the $2.7-million paid to the former CEO.

Some wondered whether the foundation, one of the largest charities in Canada, would recover.

It looks now like those fears were misplaced.

According to recently released annual filings, donations have held steady at $88-million, costs are down 20 per cent and executive pay has been curtailed.

Even more stunning, the foundation’s investment portfolio generated a 41-per-cent return for the year ended March 31, 2010. That helped boost overall assets, which includes other holdings, to a record $670.2-million at year end.

So how did he do it?

Mr. Garrard credits much of the success to Prem Watsa, chairman and CEO of Fairfax (401.99-3.26-0.80%) Mr. Watsa is famed for contrarian market calls and he has been using that same approach as a volunteer at the foundation, where he has overseen investments for 15 years. “This comes naturally for me,” Mr. Watsa said in an interview.

Mr. Watsa said his investment strategy at the foundation has been fairly simple: Keep the asset mix relatively steady and look for value.

When he started at the foundation in 1995, 80 per cent of its then-$148.2-million portfolio was invested in equities. Mr. Watsa brought that percentage down slightly over the years and, in 2007, slashed it to 35 per cent, convinced the markets had peaked. Most of the remainder went into government bonds.

How Prem Watsa Turned SickKids’ Portfolio Around (Globe and Mail)

One of the things I really admire about Watsa’s approach to investing is the constant monitoring of overall market conditions and how it shapes his asset allocation break down and whether or not he hedges. I think it’s the right approach, some investors are so fixated on equities or bonds that they’ll stay in the asset even when their markets become frothy. Instead of remaining disciplined, they relax their investment standards and invest blindly. That doesn’t end well for their investors.

One day after requesting a bailout worth more than $100 billion, financially troubled Ireland plunged deeper into a political crisis that could complicate a rescue deal with the International Monetary Fund and European Union.

At the same time, concern mounted that attempts to prevent a broader regional debt crisis by shoring up near-bankrupt Ireland may not be enough to prevent the need for more bailouts in ailing Portugal, and perhaps even for the far larger economy of troubled Spain. Coupled with the worsening political turmoil in Ireland, those fears dashed hopes of a market rebound on Monday, rattling stock markets and causing the euro to lose ground against the dollar after initially posting a slight rise.

In Dublin, Prime Minister Brian Cowen, under fire for mishandling the crisis, said he would step down early next year. But he resisted calls to tender his resignation immediately, vowing late Monday to remain in office and push through an austerity budget next month that is considered essential to clinching the rescue deal.

The political crisis potentially poses a new complication in efforts to shore up Ireland. With banks buckling under the weight of a colossal real estate bust, the government is in tense negotiations with the IMF and E.U. over the bailout’s size and conditions. European leaders are pressuring Ireland to reach agreement quickly to bolster market confidence in other debt-wracked countries in the region, as well as to prevent the euro from destabilizing. Britain and Sweden pledged direct loans to Dublin on Monday.

Irish political turmoil complicates financial-system fix (Washington Post)

A friend of mine has been looking at what’s happening in Ireland and passed along the following idea:

I think the Irish crisis for now will play in a similar way to the US one. Liquidity figures globally is pretty strong and these politicians won’t let these banks go under.

I don’t recommend playing the banks. Their upside is going to be ripped to shreds as the Irish/Euro politicos won’t let the outsize profits captured by US banks to happen again in that area.

What people should pick up is companies whose deposits/counterparty/financial risks were tied to banks. So, it would be good to find leasing companies and big users of financial hedges to go long in the Irish space.

I think that this is a great idea in theory because in the US, a number of aircraft leasing companies fell tremendously as worries spread about the risk of their lines of credit vanishing if banks failed (but bounced back when financing fears proved overblown). The problem is I just can’t see a good way of implementing the idea. Yesterday, I paged through the listings on the Irish Stock Exchange, in hopes of finding a company in some kind of business that would be affected similarly. Unfortunately, I didn’t have much luck. I know that aircraft leasing is big in Ireland but it seems as if many of their top companies have been acquired — for example, Genesis Leasing was recently bought by AerCap back in March. Moreover, you need a company with liabilities specifically tied to Irish banks.

If you have any suggestions, feel free to shoot me an e-mail or leave a comment on the post. I think this will be a really interesting spot to watch for now.

Click to play

Grantham gives his thoughts on a wide range of topics from the Fed’s policies, US equities, emerging markets, commodities, and even farmland/timber.

In a recent article Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

Reports Of The Death Of Mean Reversion Are Premature (Behavioural Investing)

Anne-Louise Fogtmann has a good take down of what Montier said at the conference. Montier outlined his own views which I thought were interesting, particularly on cash:

Seven “immutable laws of investing” apply, Montier argued, as they have in the past:

-Always insist on a margin of safety.
-This time is never different.
-Be patient and wait for the fat pitch.
-Be contrarian.
-Risk is the permanent loss of capital, never a number.
-Be leery of leverage.
-Never invest in something you don’t understand.

With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” A few of his specific calls: Government bonds have no return potential; emerging markets look overvalued; and in a world where both bonds and equities could be too expensive, cash becomes a much more attractive investment, even when the yield is near zero. Not only is cash a better inflation hedge than bonds (it’s a zero duration asset), it can act as a store of value during periods of deflation.

GMO’s James Montier Says Rumors of the Death of Mean Reversion Are Greatly Exaggerated

The market’s had a pretty good run lately, making most equities more expensive for value investors. The dynamic between cash and equities is a really interesting one for us because we tend to hold portfolios that are more concentrated. Other investors might have the kind of allocations which allow them to replicate the movements of your typical indicies, but value guys tend to take a 5% to 10% position approach. This makes our allocation decision a bit more difficult. There’s a big difference between re-creating an index versus putting on 10% positions in full value/expensive stocks. This is why, for concentrated investors, it makes sense to shift to cash rather than equities. At the same time, there are pockets of value scattered throughout the market. While no one sector seems to offer compelling valuations, I have been spending most of my time analyzing select companies in industries ranging from energy to insurance.

Montier’s point about emerging markets being expensive is one that resonates with me. Take the case of Brazilian banks Bradesco (NYSE:BBD) and Itau (NYSE:ITUB). Both are priced richly at over 4x book value, but are generating high returns on equity (32% and 40%) implying an 8-10% return. If we dive deeper into the financials and analyst estimates, we can see that much of this is being driven on the prospect of loan growth. Brazil has a rapidly growing middle class and most people expect that financial services firms will be able to profit from that growth.

I agree that a developing middle class should be able to help the banks. In theory, as the banking sector in Brazil becomes more formalized, citizens should be depositing more money into banks and using them for payment transfers. That should lower the cost of funding for Brazilian banks. Plus, Bradesco and Itau are targeting for insurance income to make up 25% of their earnings in a few years. These are truly financial services supermarkets and I could see that part of the equation working out. But analysts are modeling loan growth at rates of 30% annually. I just don’t know if Brazil can sustain such growth levels. You could make the argument that much of the growth could be going to consumers, not commercial enterprises, but to me that kind of lending is much more difficult. At least when a bank loans to a business, the credit analysts can give a business a good scrubbing and have the business’ assets used as collateral. Consumer lending is an entirely different beast. They could try to increase the amount of mortgages on their books, but the problem there is consumer demand might not match up with supply, you might end up creating a mini-housing bubble.

To me, emerging markets at this point have a lot of things going for them. I do expect the BRIC countries to do well over the long term. But as a value investor I just don’t think you will get the margin of safety that you are looking for. Everything has to go right for them to warrant such high valuations. Buying right now is akin to being a trend follower or momentum investor. I have a list of great companies in BRIC countries that I usually check every other day. The way I figure it, given the way the global economy is going — any heightened level of volatility might trigger a pull back and make some of these companies a bargain. For now, you might be better off analyzing large caps with emerging market growth exposure. Those businesses still seem to be trading at attractive valuations.

After parsing through bank earnings one thing that sticks out is non-performing loans (NPL) remain high. Tracking NPLs and more particuarly NPL inflow rates will help you determine the amount of problematic loans coming into the pipeline. In any recovery you should see this number decline sequentially and from 4Q09-2Q10 that’s exactly what you’ve seen across most banks. But results from 3Q paint a different picture particularly in one region.

A closer look and you’ll find that Southeastern banks or banks with heavy exposure in the Southeast are starting to see the rate of inflows increase. On surface you may not be able to spot the NPL trends as a majority of these banks have disposed NPLs through sales or a transfer to held for sale which skew the inflow calculation.

Let’s take a look at some of the Southeastern banks that have reported 3Q results:

Regions Financial (NYSE:RF) which has $133 billion in assets and banks in the southeast saw NPL inflows of $1.4 billion compared to $900 million last quarter. The inflows were primarily due to income producing commercial real estate (CRE) and land/condo/single family loans. A quick glance shows at the end of 9/30/10, RF had $3.372 billion in NPLs, down from $3.473 billion last quarter. Taking the difference plus adding back charge-offs of $759 millions gives you $658 million in NPL inflows and implies a solid deceleration given last quarter’s NPL inflows of $900 million. But RF also transferred to held for sale $1 billion in troubled assets which they marked down $233 million skewing the inflow calculation. The actual inflow rate is closer to $1.4 billion when you consider the $658 million inflows + $1 billion in troubled assets – $233 million mark.

SunTrust (NYSE:STI) with $175 billion in assets saw NPL inflows increase to $296 million from $188 million in 2Q.

BB&T (NYSE:BBT) which has $157 billion in assets saw NPL inflows increase to $693 million from $505 million in 2Q excluding troubled asset sales which would make the inflows worse. 50% of BBT’s loan portfolio are comprised of commercial loans.

All three of the banks above saw NPL inflows decelerate from 4Q09-2Q10.

Synovus (NYSE:SNV) mainly a Georgia bank with $31 billion in assets saw NPL inflows increase to $422 million from $339 million after adjusting for the disposition of $172 million in trouble assets. This was the first increase in 5 quarters.

BancorpSouth (NYSE:BXS) with $13.6 billion in assets and banks around the Gulf had NPL inflows increase to $133 million compared to $115 million. BXS had no troubled asset sales.

Whitney Holding (NASDAQ:WTNY) a Louisiana bank with $11.5 billion assets saw NPL inflows improve but announced that it will sell $180 million in troubled loans and reclassify $100 million in additional NPLs to held for sale in 4Q10.

You are seeing inflows pick up in a few banks in the mid-west as well but it is not as widespread as it seems to be in the Southeast region. There could be a few reasons:

1. A slowdown relative to the rest of the US

2.Inflows continue to improve at the bigger banks(ex-C as numbers remain skewed due to their asset disposition strategy) most likely due to having a diversified footprint and loan portfolio. A good amount of improvement is also coming from card portfolios which most regionals tend to avoid. Typically regionals have higher concentrations of commercial, CRE, and mortgage loans which continue to struggle.

3. Banks are finally owning up to their losses.

I am not implying this is a trend and that we’ll see NPLs skyrocket but I do believe NPLs will remain relatively high and we’ll continue to ebb and flow from these levels for quite sometime. It’s a metric worth monitoring.

Here are his six recommendations:

1) Emphasize U.S. quality companies, which are still cheap in an overpriced world.

2) Moderately overweight emerging market equities.

3) Moderately underweight the balance of global equities.

4) Heavily underweight lower quality U.S. companies

5) Carry extra cash reserves for a volatile market with insecure fundamentals.

6) For the very long term (20 years) overweight resources, particularly if they have a sharp decline. (This is my personal view rather than that of GMO, which on this topic is agnostic.)

Grantham October

(Flickr:IzaD)

Recently, Ben Stein had a chance to interview Warren Buffett and got his thoughts on gold:

My first question, as I sit there on the couch in his office, is: “What about gold? Is this a classic bubble or what?”

“Look,” he says, with his usual confident laugh. “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

Okay, so gold is not a screaming buy to Buffett. What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?

“Equities,” Buffett answers without a moment’s hesitation.

Warren Buffett: Forget gold, buy stocks (Fortune)

My problem with gold is that I think an investment in it requires you to accurately gauge the anxieties and fears of the investors who are buying it. I don’t think I have any talent for doing that. I’ve read a bit on George Soros because his theory of reflexivity seems applicable to playing gold — and Soros has indeed said he intends to keep buying gold, but it’s not a concept I’ve mastered. Maybe mere mortals like us can’t master it. He goes into his theory of reflexivity in detail with his book The Alchemy of Finance which I’ve read. While I wouldn’t make an investment decision with his theory, I can see why it works for him.

But, I think the dollar is facing real problems. So finding investments that will protect your purchasing power makes sense.

A lot of people complain that gold is not a productive asset and that’s true. Owning gold is not like owning a business, it probably wont make you rich. I think that beyond supply and demand issues, an investment in gold is really an act of speculation. Gold investors tend to have these specific fears about the economy and see gold as this one commodity that keeps on rising. Inevitably, they must expect that when the time comes they’ll sell to another person at a higher price. That’s momentum investing and it’s a pretty tough game.

However, for some people buying might make sense. A friend, upon hearing what Buffett said that even though all the world’s gold would fill a cube 67 feet in each direction, with its high density it can easily be formed in coins. Plus, with its high value-to-weight ratio, gold can be easily moved. Now contrast that with owning an oil company. You can’t move an oil field and even if you own it, countries can come in and nationalize it or take away your permits. The same goes for farmland. I think it’s for these reasons that gold has remained a store value for so long, even if productively, it’s not very useful.

If you are ultra-wealthy and worth $100M, putting $1M-$5M in gold might make sense as some kind of disaster insurance. If things get really bad, you might be able to flee the country and use your gold holdings to start a new life. From an asset allocation stand point it might make sense. At the same time though, I wonder. If things got so bad that you needed to flee the US, maybe you would be better off investing in guns, ammo, survival training, and canned food.

So would I ever buy gold? Probably not. While I do think the US will face some difficulties such as an elevated level of inflation going forward, I have a hard time wrapping my head around the idea that we’ll be in such bad shape that fleeing the country will be the only option. I’ve seen investors such as Seth Klarman use gold as a disaster hedge without actually owning it. Instead, he used out of the money options which inexpensively gave him exposure to sharp movements in its price. I’m a fan of cheap insurance like that.

I respect the macro though and lately have devoted most of my time recently to finding special situations and event driven value investments. These tend to be more market neutral and have defined catalysts in place, making them easy to test. Right now, to me, that’s a much more appealing strategy than simply buying and holding.

I’ll try to have some quotes / notes up soon.