Where to Learn More About Investing

I wanted to provide some more sites that do a good job of teaching people about investing.  Below is the link for Howard Marks memo's.  They are a wealth of information and go all the way back to 1990.  So, there is plenty of reading material. 

http://www.oaktreecapital.com/memo.aspx

If you would rather have a video format than Consuelo Mack WealthTrack may be more enjoyable.  She quite frequently talks to some very good investment professionals.  Her link is below.

http://wealthtrack.com/

Finally GMO has a wealth of material, but you do have to sign up first.  Don't worry signing up is free.  They can be found at:

http://www.gmo.com/America/

Seeking Alpha Article on Redwood Trust

Below is a link to my article about Redwood Trust on Seeking Alpha. If you have been following this blog, however, most of this is covered in Redwood Trust Part I & II. 

http://seekingalpha.com/article/1578802-redwood-trust-competitive-advantages-growth-prospects-and-risks?source=email_rt_article_title

What to Read - Links

The first link is to a blog post by David Merkel.  I was going to do my own post on market cycles, but since Mr. Merkel already did a good concise one I will just share the link instead.

http://alephblog.com/2013/07/20/the-rules-part-xlv/


This second article is by Morningstar and provides more ammunition for my Contrarian Manager strategy which I posted about earlier.
http://news.morningstar.com/articlenet/article.aspx?id=603031


This last post is also about contrarian investing and where to look for potential ideas.
http://goinfront.com/blog/article/the_everyone_hates_it_portfolio


Enjoy

Beware of Bonds

Beware of Bonds

As some people have started to realize over the last couple months, bonds can be dangerous for your investment health.  Even so called “safe” bonds can be dangerous and even more dangerous than “risky” bonds at times.  There is no such thing as a “risk-free” bond.  While a bond may have low credit risk (i.e. low chance of bankruptcy) it still will suffer from interest rate risk, inflation risk, and/or opportunity risk.  The lower interest rates go the lower the future return and the more dangerous a bond becomes. 

Let’s start with inflation risk.  If you purchase a 10-year U.S. Treasury Bond, for example, with a yield of 5% and the current inflation rate is 3% then you are still earning a “real” (inflation-adjusted) return of 2% (5% -3% = 2%).  However, if interest rates are 2% and inflation is 3% then you have a negative real return of 1% (2% - 3% = -1%).  By investing in the 2% bond you are losing purchasing power.  

Interest rate risk also increases with low interest rates.  In this example let’s assume you own a bond with a yield of 5% and duration of 5.  Duration is simply a measure of the interest rate sensitivity of a bond.   So, in this example, let’s assume that over the next year interest rates increase by 1%, then your bond with a duration of 5 will DECREASE in price by 5%.  You gain 5% in interest over the year, but the price of the bond has dropped 5%, so you have broken even (+5% -5% = 0).  With a bond yielding 2% with duration of 5 assuming the same scenario with interest rates increasing by 1% over the next year then you will lose 3%  as the price of your bond drops 5% while the interest you earn is only 2% (+2% - 5% = -3%).  This ignores another factor.  If you have two bonds with the same maturity and different coupons then the duration for the bonds will be different as the lower coupon bond will have a greater duration.  Assuming both bonds have the same maturity date then the 5% bond may have a duration of 5, while the 2% bond may have a duration of 7.  As interest rates increase by 1% the 2% bond decreases in value 7% while the 5% bond’s price only drops 5%.  This also works in reverse, so if rates decrease the price of the higher duration bond increases by more. 

Over the last couple months rates have increased dramatically causing significant losses for those holding intermediate-to-long duration bonds.  I’ve been shorting (betting the price will drop) the 20+ year treasury bond ETF for a little while now and increased my exposure as interest rates decreased earlier this year.  Since then interest rates have increased significantly causing the price to drop.  This means if I wanted to cover my short (close my position) I will make an okay profit.  However, over the next several years I expect interest rates to continue to increase and bond prices to decrease more, therefore hopefully creating a larger profit for myself.  This position has its risk though, so I would not recommend it unless you understand the risks.  If you want a better explanation of the pros and cons of this position let me know.

Finally, if you invest in 3 month U.S. Treasury bills you could argue that you have limited to zero interest rate and credit risk.  However, in this environment of near 0% yields on these assets they not only suffer from inflation risk, but also opportunity risk.  If you haven’t been paying attention stock prices have been going up, so if you’ve been invested in short-term assets like money market you have missed out on some large gains.  This is the opportunity risk that you obtain when you purchase lower risk/lower return assets. 

 
There are other risks to certain bonds or for foreign investors, for example, currency risk.  But for U.S. investors investing in dollar-denominated assets this is not a concern.   Hopefully, I’ve shown that even “low risk” bonds can actually be quite risky and that the lower the yield the higher the risk.

Redwood Trust Part 3

I forgot to explain my history with Redwood Trust (RWT), so I figured I better explain my interest and how I think about adding to positions. 

I initiated a position in RWT in August 2010 and continued to buy RWT through August 2012 since its stock price continued to drop from my initial purchase and because the business continued to see fundamental improvements.  It ended up becoming my largest position.  As the price spiked in the second half of 2012 and first part of 2013 my allocation to RWT really increased and the future expected returns decreased.  This led me to sell 70% of my shares in RWT, although it is still my fifth largest position.  Typically I would prefer to buy and hold businesses, but since Mr. Market keeps providing opportunities to buy low and sell high, you might as well take advantage of it.  With the price dropping significantly recently it is back on my radar again.  If the price continues to drop I will look at adding back some of the position I sold.   I've actually already sold some out of the money puts at a strike price I think is attractive (plus I wanted to earn some interest on my cash hoard), but will likely buy some shares close to that strike price as well just to make sure I increase my allocation to RWT.  It's possible the price could drop below my strike but then increase above the strike before it gets exercised which is why I would buy some shares as well.  If you can't tell I'm really hoping the stock price goes down so I can buy more.  If it doesn't go down I will earn an OK interest rate on the money I have locked up with my short put position.  I've been increasing my cash holdings as more stock holdings keep hitting my trim targets and with money market yielding 0% shorting put options on businesses I like, at prices I would buy them at, seems to make sense.

If you have any questions please feel free to give a comment and I will try to get back to you shortly.

Redwood Trust Part II - Pro's/Cons

Investment Thesis
Since Redwood Trust (RWT) is an internally managed REIT with an operating business it has put in place an incentive compensation plan that more closely aligns management with shareholders.  Many REITs that hold real estate securities are externally managed pools that charge an AUM fee which incentives them to grow the size of the pool, not necessarily generate strong returns.  However, RWT exec’s are incentivized based on ROE.  Another difference with RWT is that they have an operational business that generates fees along with their pool of investments which is different from many real estate securities based REITS that only own securities. 

The business model they have created and continue to develop appears to have a significant amount of flexibility.  They can purchase jumbo residential loans on a flow basis or purchase an entire pool then decide to securitize the portfolio or sell it in a bulk transaction.  They can keep the lower rated tranches or sell them to other investors.  Having their own platform also makes them less reliant upon third parties for investments.  Their residential platform will soon be able to securitize conforming agency loans that will generate MSR’s which again they can keep or sell to someone else.  Their commercial business can purchase senior or mezzanine commercial debt and will generally sell the senior loans in order to generate fees.  Commercial borrowers can go to RWT as a “one stop shop” for their commercial lending needs.  Finally, RWT can purchase assets from 3^rd parties and can decide on the amount of leverage, if any, they want to use on different types of assets. 

Redwood Trust has a reputation for strong credit underwriting as not a single loan they have securitized has went into default since they restarted their securitization platform in 2010.  Securitizations prior to the financial crisis have also had a lower default rate than peers.  RWT also has historically been good capital allocator.  On August 4, 1995, Redwood IPO’ed with an opening price of $13.84/share and as of 06/28/13 the stock price was only $17.00, but the firm had paid out cumulative dividends of $52.20/share since inception.   These cash flows have generated an IRR of about 19%/year since its IPO.  Over the upcoming years it is likely that RWT will substantially increase its dividend payment and provide strong returns to shareholders.

RWT has tried to build a competitive advantage through its credit underwriting, relationships it has built, stance on reps and warranties, its ability to meet a variety of needs and the fact that it is not an originator; therefore it is not a competitor to banks that originate residential loans.  Not being part of a bank is significant as many banks do not like to work with other banks due to competitive reasons.

Coming out of the financial crisis RWT’s balance sheet had become relatively conservative.  However, this is changing as they have been able to purchase mezzanine debt as well as first/second loss tranche securities from their securitization platform.  Securitization volume for RWT is accelerating which will create more subordinated tranches for internal investment.  In 2010 they had 1 securitization, in 2011 they had 2, in 2012 they completed 6 securitizations, and in the first half of 2013 RWT had completed 8 securitizations.   RWT recently increased their 2013 securitization goal from $7 billion to $8 billion.   The increased volume will create more investments as well as fee income and should eventually increase the yield on the investment portfolio.  The company continues to expand its securitization platforms and believes the fee income will become a larger part of Redwoods returns.  Redwood may potentially benefit from the government’s role in shrinking the GSE’s as proposed legislation is currently being discussed.  The GSE’s have maintained a 90% market share since the financial crisis, so private companies, such as Redwood, could benefit greatly if/when they do shrink.  Also, Freddie Mac is already building out a risk sharing platform that would sell first loss securities to private investors and Fannie Mae is expected to do the same.  This not only could create more securities for Redwood to purchase, but could increase the supply of subordinated debt securities therefore helping to maintain or increase pricing of subordinated tranches in general.

The financial crisis has tightened credit standards which bodes well for RWT’s subordinated tranche investments which have benefitted from the conservative underwriting.  Up to this point RWT has experienced zero defaults from its securitization platform since restarting it in 2010.  Historically, RWT has experienced lower default rates than peers as it tends to be a more conservative credit underwriter.  With the housing market continuing to strengthen it is likely that foreclosures and default rates on its new securitizations could be relatively low, therefore, increasing the potential returns on its first loss tranches.

Risks/Concerns

There is a lot of competition entering Redwood’s markets.  Both large and small firms are looking to securitize real estate assets and certain firms, like JP Morgan, bring significant financial size and strength.  There is also significant capital looking to invest in riskier real estate securities, which means that RWT could have to pay more to obtain some assets. 

There have been significant losses of key personnel over the last several years.  There Chairman, who also was one of their co-founders and previously was CEO, left the company in 2012.  The other co-founder retired in 2007 and is now Vice Chairman of the Board.  In June 2013 the Managing Director of their commercial business resigned and in March 2012 the then CFO resigned.  The co-founders did have transition periods before they left, but the CFO and managing director were more of a surprise. 

 Rising interest rates could hurt the balance sheet as loans get extended and increased rates lower the value of current assets.  Also, widening credit spreads could decrease the value of assets on the balance sheet. Prepayment rates decrease with increasing interest rates which lengthens the time frame that RWT must wait to receive full par payment on its first/second loss tranches; therefore reducing returns.  Rising interest rates could also slow down securitization volumes if housing affordability drops and assets held on the balance sheet, waiting to be securitized, could create losses if not properly hedged. If housing has another downturn they could see losses on their new investments.  However, if rates rise they should be able to invest in higher yielding assets that will generate higher interest income over the long-term.  Also, some of the real estate securities they own are adjustable rate or hybrids that adjust to interest rates.  They have also fixed their floating rate debt, so if interest rates rise the derivative liability shrinks becoming a benefit to book value.  RWT owns a small amount of IO’s and MSR’s that would benefit from increasing interest rates.  Decreasing interest rates could lower future interest income on future investments and could increase the derivative liability.