There’s an interesting article in the Wall Street Journal highlighting that banks are increasingly the first source of funds for takeovers – providing more funds that the high yield bond market. Kinder Morgan’s recent acquisition of El Paso is cited as an example, but there’s increasing evidence that banks are increasing their risk appetite. The Fed’s confiscatory interest rate policies are steadily squeezing people out of riskless assets where there’s no return to be made. In our Fixed Income strategy we continue to own senior loan closed end funds such as Blackrock Defined opportunity Fund (BHL) and ING Prime Rate Trust (PPR). The prices on this sector had dropped more than 20% over the past six months, through lower NAVs and prices shifting from a premium to a discount.

Hedge funds are nervously waiting – not for the publication of my book, The Hedge Fund Mirage, but instead to see how big redemptions are going in to the end of the year. The WSJ has an article noting poor performance by some very large funds (Paulson, Maverick and Kingdon amongst others). Hedge fund investors are apparently maintaining their strategy of momentum investing even though it has served them so poorly over the years. Adding to winners and redeeming from losers. There aren’t many hedge fund investors who seek out under-performing managers.

We invested in Transocean (RIG) on Friday in our Deep Value Equity strategy. We had previously owned the largest owner of offshore oil rigs last year following the Gulf of Mexico oil spill when its stock traded down substantially on fears of enormous legal liability. Such fears were unfounded and the stock recovered. We exited although well before its high. In recent months concerns of economic slowdown as well as BP’s lawsuit have depressed the stock price which is now trading more than 30% below the market value of its rigs (according to research from JPMorgan). There’s considerable room for error around such estimates, but this provides a greater margin of safety than on other names in its peer group. In addition with consensus estimates for $5.26 per share in earnings next year it appears attractively priced. BP’s lawsuit will no doubt continue to be a cloud over them for some time, but with $17BN in market cap and $25BN in enterprise value they’re big enough to handle even a $1BN legal settlement. It also pays a $3.16 dividend which gives it a yield of almost 6%.

We continue to own Gannett Co (GCI). It has been an unrewarding experience so far. It’s true they’re in the hated newspaper business which continues to shrink every quarter, but they also own broadcasting and digital franchises which look much more attractive. The problem is their publishing division is their biggest, notably the newspaper USA Today. But they are consistently profitable and trade at less than 6X earnings which are expected to grow modestly next year (helped by election-related TV advertising and continued double-digit growth in their online businesses). We’d like to see them buy back more stock but cashflow from operations regularly exceeds $700 million per year (compared with their market cap of 2.7BN), and with minimal capex needs they’ve been paying down debt. Perhaps the improved lending climate noted above will induce a private equity buyer to acquire what we think is a very cheap company.

Disvlosure: Author is Long BHL, PPR, RIG, GCI

Through the ongoing and mind-numbing complexity of the European sovereign debt crisis, the bureaucrats in Brussels can be relied upon to introduce some absurdity into their deliberations. The latest is a report in the FT that under certain circumstances  the EU will suspend the ability of rating agencies to evaluate sovereign credits. Now it’s true that markets are generally too reliant on credit ratings issued by S&P, Moody’s and Fitch. The basic business model of charging the issuer for the rating is fraught with conflict, as catastrophically revealed during the sub-prime crisis. However, alternative models are hard to identify – increased competition among rating agencies would likely cause a “race to the bottom” in which issuers would flock to those with the most forgiving standards. And charging investors, the actual users of the ratings, is regarded by many as unworkable.

But the downgrade of U.S. debt that occurred in the Summer highlighted the absurdity of the rating agencies evaluating sovereign debt. Unlike a corporate issuer where a detailed financial analysis encompasses most of the necessary work, sovereign credit analysis incorporates a political judgment as well. The U.S. downgrade in the Summer illustrates the rating agencies straying beyond their expertise. U.S. creditworthiness is based to a large degree on a willingness to repay debt, and an opinion on which is as much political as it is financial. The rating agencies have no more insight on the politics than many other informed observers, and as such their opinions ought to be irrelevant except for the fact that so much bond investing is rules-based driven by the ratings that these agencies issue. Many bond investors are required to hold issues with minimum ratings from the three Nationally Recognized Statistical Rating Organizations (NRSROs), otherwise known as S&P, Moody’s and Fitch.  But really, since sovereign issuers have the ability to tax, their credit ratings are by nature not simply financial. The ratings frankly shouldn’t carry any more weight than other sell-side research on bonds.

As sensible as it might seem to ditch the legal support for NRSRO-issued sovereign credit ratings, the EU bureaucrats in Brussels have revealed their own muddled thinking in the latest proposal. No doubt France’s impending loss of its AAA rating, a possibility the French regard with horror but which financial markets have already moved past, is the catalyst. The FT reports that under proposed EU regulations ratings will be suspended during times of financial stress. So good ratings are fine, but bad ones are not. And presumably the EU’s credit experts will anticipate trouble by suspending ratings prior to a downgrade, therefore providing an eloquent and informed signal to investors that perhaps those bonds are not quite as safe as previously thought.

In the U.S. we can be grateful that we don’t subsidize such entertaining idiocy with our tax dollars. It must be more frustrating for those sitting in Europe.

The FT has a very good summary of the current state of play in the European debt crisis. Yet another weekend summit critical to the survival of the Euro is upon us. Once again, bottom-up analysis of investments is held hostage to the macro issues at play.

The EU is designed to seek consensus and is antithetical to the type of strong leadership now required. Since no single leader will be held responsible if the whole edifice crashes down, all the political calculations are based on domestic politics. It’s democratic, but ill-suited to the problems they’re facing.

The FT article highlights some important points regarding the European Financial Stability Facility (EFSF). Although €440 billion sounds like enough money, particularly if used as a first loss guarantee (theoretically increasing its firepower by 4-5 times) that’s not what’s really available. Prior bailouts of Greece, Portugal and Ireland have reduced this to  €250BN – and unsurprisingly these countries have withdrawn their pledges to the EFSF. In addition,  €230BN comes from Spain and Italy, and since Spain is quite possibly one of the future recipients of bailout funds the ultimate available funds shrink further.

For many months it’s been clear that German taxpayers would be writing a check – either to Greece or to their bondholders. But even that is looking less clear without sufficient bailout funds available. So it appears that the IMF will ultimately ride to the rescue. They’ve apparently already been asked, but the U.S. and U.K. both opposed such a move. One can only imagine the outcry in Congress at such a move. So making such support politically acceptable will no doubt require another round of robust risk reduction, since only when voters are poorer will they accept the need for U.S. money to bail out Europe.

But of course the U.S. is a net debtor as well. Things will work out – they invariably do when there’s no alternative. But the stage is set for macro issues to overwhelm everything else.

2002 seems like a long time ago, but that’s the last time hedge funds outperformed a simple blend of 60% stocks and 40% bonds. Through 2000-02 during the dot-com collapse hedge funds added value, but since then as assets have flowed in the weight of all that money has steadily dragged down returns. Following a torrid performance in September, the HFRI Fund Weighted Index (HFRX) is down 5% for the year, compared with 3% for a simple 60/40 blend. No doubt much of the selling in September was caused by the over-leveraged becoming less so with urgency – the frantic buying of October looks like its mirror image. It’s looking increasingly as if this will be the 9th straight year in which old-fashioned investing without the use of absolute return vehicles has outperformed the more modern variety.

Part of the problem lies in how some of the biggest funds have done. To take John Paulson as an example: he began the year with $38 billion in assets under management (AUM), around 2% of the entire industry. If he’s down around 40% on average across all his funds, that represents almost a 1% performance hit to the beleagured community of hedge fund investors. Given what appears to be modest return expectations among institutions of only 6-7%, that’s a chunk of performance to be made up by the rest of the industry since Paulson has on his own knocked almost 1% off aggregate 2011 returns.

Barron’s over this past weekend included an article warning that dividend paying stocks were getting expensive. Author Michael Santoli cited recent work from Vadim Zlotnikov at Bernstein Research comparing price/book valuations on low beta and high beta stocks. On this basis low beta stocks are at the 99th percentile of valuation (i.e. expensive) over the past 50 years, whereas high beta stocks are at the 6th percentile. Low beta stocks don’t have to be the same as high dividend yield stocks, although there tends to be a good deal of overlap. The kind of business that can pay a reliable dividend that grows predictably tends also to have less volatile earnings, so it makes sense for the two categories to overlap. Pro-cyclical businesses with high earnings volatility pay low (or no) dividends, conserving cash for less certain times.

Companies that we include in our Hedged Dividend Capture Strategy include boringly predictable names like Chubb Corporation (CB),Kraft (KFT),  Procter and Gamble (PG) and AT&T (T). Annual dividend increases of  6% or more are not uncommon among names like these over many years, and they all offer dividend yields that are competitive with high grade bonds (and much more attractive than treasuries). As the future increasingly looks as if it will not provide a fair return to traditional investors in fixed income, investors have been finding other sources of income and dividend paying stocks have been a beneficiary. BernsteinResearch invariably produces high quality work that is supported with reams of data. The increasing price/book multiple paid by investors for such names could indicate that they’re becoming relatively expensive, although the wide equity risk premium suggests that stocks are not that expensive compared with bonds using 40 years of data. If you go back a really long way however, Vadim Zlotnikov notes that over 140 years it’s not quite so compelling.

But the performance of dividend paying stocks has coincided with falling interest rates, and bond yields are similarly at or close to their 99th percentile of overvaluation by any measure this side of World War II. Such names can be owned as a long-only portfolio or with a market hedge so as to be beta neutral, but the possibility of getting yield with an “equity kicker” appears increasingly compelling.

I spent a most enjoyable day in Columbus, OH at the invitation of the local CFA Society. I should extend my thanks to Tim Steitz, Senior Investment Officer – Equities at the School Employees Retirement System of Ohio for organizing such a well attended event, and also Travis Upton, current President of the CFA Society of Columbus and Director of Portfolio Management at The Joseph Group. I talked about my upcoming book, The Hedge Fund Mirage, and hopefully offered some insights to investors growing their hedge fund portfolios. I also had several interesting discussions with investors about the alternatives to fixed income given government manipulated bond markets and the Tyranny of Low Rates.

I am finding that many investors are most interested in discussing less conventional strategies to generate income given the poor return outlook in bonds. Master Limited Partnerships (MLPs) and our Hedged Dividend Capture Strategy were both of interest to a number of people.

There can be little doubt that the European sovereign debt crisis has finally drawn the full attention of Europe’s leaders. After following events from a more than discrete distance, it is starting to look as if a consensus is evolving around three principles:

1) Greater write-down of Greek debt

2) More realistic stress tests of Europe’s banks with a view to requiring them to reach 9-10% equity capital to risk-weighted assets over a fairly short period of time

3) Using the EFSF as a guarantor of first loss on sovereign debt, in effect increasing its firepower to €2 trillion or more.

The European Banking Authority’s (EBA) last stress tests identified only €2.5 billion in capital shortfall for the entire region, a ludicrously low figure that lost them great credibility. Mike Cembalest, JPMorgan’s Private Bank CIO, memorably commented that the number was so low he thought the results were being released by country alphabetically starting with Andorra. At the same time the IMF’s estimate of the needed additional capital was €100-200 billion.

However, there is a problem with forcing banks to raise additional capital. They may instead decide to shrink their balance sheets instead, a prospect noted in the FT today. Issuing equity at 0.5 X book value is scarcely an attractive proposition and selling assets must be a realistic alternative. But that could well lead to a sharp slowdown in lending, further hampering the EU region’s efforts to avoid (or emerge from) recession.

George Soros floats an interesting suggestion that governments should first unconditionally guarantee their banks to stabilize them, following up with recapitalization later when their share prices have presumably recovered.

While it’s positive that constructive solutions are now receiving consideration, holders of risky assets can still benefit from being short the Euro. The € continues to be the focal point of the global slowdown. We are long ProShares UltraShort Euro (EUO) as a hedge against other types of long equity risk in our hedge fund. The risk of a complete disaster is receding, but the solutions don’t look to be positive for European growth.

Disclosure: Author is long EUO

My upcoming book The Hedge Fund Mirage explains how investors have not done nearly as well as the hedge fund managers to whom they have entrusted their capital. However, a handful of managers have genuinely created enormous wealth for their clients as well as themselves. Rick Sopher from  Edmond de Rothschild Group did some research on this topic on which the FT reported last year. Among the genuinely value added managers was John Paulson, whose rare insight into the sub-prime bubble netted his clients and himself many billions. John Paulson was credited in the article with generating $33BN for investors.

So it is with genuine sorrow that I have observed reports of John Paulson’s very tough year, culminating with warnings that as much as 25% of his assets may depart by year-end. In my book I had noted Paulson’s strongly profitable performance by way of illustrating that there are some very talented managers who have truly added value to their clients. Regrettably, John Paulson is slipping from this pedestal.

Ultra low interest rates may be the Fed’s best bet at preventing the economy from sliding into another recession, but for savers they represent a stealthy attack on the real value of savings. Money market funds barely pay anything at all, and even ten year high grade corporate bonds only yield 4%. After taxes that leaves very little real yield (i.e. after inflation) and no compensation for the risk of rising rates or any increase in default risk. In fact it would only take a 0.5% increase in long term rates to cause a sufficient capital loss in ten year bonds to wipe out a year’s worth of income. The fact that the Fed combined their announcement of Operation “Twist”, (buying long term bonds and selling shorter maturities) with an expression of concern over the U.S. economy was enough to trigger another round of risk aversion and a flight into the very bonds the Fed is trying to make unattractive.

The tyranny of low rates is the regime facing fixed income investors everywhere. High grade bonds have returned around 6% per annum over the past decade and have done that much just through the first nine months of 2011. But with yields at 4%, it’s pretty clear that the only way to repeat past performance is for yields to drop even further than they are now. A 1% drop in bond yields would cause around a 9% jump in prices, but the economic environment required to drive yields so low is unlikely to be friendly to many types of corporate risk.

There are alternatives. Investors should seriously consider reducing their conventional fixed income allocations. In any event, most balanced accounts will be below target on equities and above target on bonds following the sharp sell of in global stocks during the 3rd quarter. Rebalancing is generating bond sellers and stock buyers. But while this may push long term rates up a bit, the Fed is unlikely to contemplate raising short term rates until at least 2013.

As a substitute for bonds, we have three suggestions. Master Limited Partnerships (MLPs) pay distributions of around 6% and are likely to grow those distributions at 4-5%  over the next year. It’s enlightening to read through the public filings. One of our holdings in Magellan Midstream Partners (MMP). The tariff increases on pipelines  that cross state lines are controlled by the Federal Energy Regulatory Commission (FERC) and annual rate hikes are linked to the PPI-FG (Produce Price Index for Finished Goods). Regular price increases linked to inflation are part of the reason MLPs can grow their distributions so steadily. MMP for example hiked prices on its pipeline network that runs down the center of the U.S. from Minnesota to Texas by 6.9% in July. MMP also provides an interesting way to benefit from the growing use of domestic natural gas in the U.S. since they continue to expand in areas rich with shale gas.

Barrons regularly writes about MLPs – a recent article highlighted the attraction of the sector.

Another place of refuge from low interest rates is a combination of cash and stocks. It needn’t be as reckless as it sounds. The math can be quite compelling. Using ten year treasury notes which currently yield around 2% as an example: a taxable investor’s $100 investment would grow to $113 after ten years. The same $100 could be allocated 80/20 between riskless three month treasury bills and large cap stocks. Putting only $20 into  2% dividend yielding stocks combined with a very modest 4% growth in dividends would also result in $113 of value in  ten years. But this includes some very cautious assumptions – dividends ougfht to grow faster than 4%. They’ve grown at 5% over the past 50 years and companies are paying out a smaller share of their profits than in the past because it’s more tax efficient to buy back stock or reinvest back in their businesses.  And the $80 in treasury bills in this example may not pay any interest today but holding cash preserves flexibility to invest later when the future appears clearer or interest rates are higher. We’ve been discussing this strategy with clients. In effect the unusually high equity risk premium, the difference between the earnings yield on stocks and the interest rate on treasury securities, is making this possible as investors afraid of a repeat of 2008 seek safety in bonds.

Finally, it can be attractive to own a diversified portfolio of dividend paying stocks hedged with a short position in the S&P500. Stable earnings typically allow steady dividends, and such companies often have less volatility in their businesses and their stock prices than the market as a whole. $100 invested in dividend paying stocks can be made market neutral with around a $50 short position in an ETF such as SPY, hedging against short term price fluctuations but still allowing the investor to earn dividends and participate in dividend growth.

The Fed is making fixed income an unattractive hiding place. Prudent alternatives exist that offer the prospect of higher income with acceptable levels of risk.

The New York Times reported yesterday that regulators around the world are examining High Frequency Trading (HFT) with a view to curbing its influence over short term market moves. The use of computer algorithms to execute short term trading strategies has resulted in physical proximity to stock exchanges being valuable so as to reduce latency in the transmission of orders. In other words, reducing the time that electronic pulses take to reach their destination can have a meaningful impact on results.

There is an assumption among stock market regulators generally that increased volume is a good thing. Higher volume causes increased liquidity and, so the argument goes, lowers the cost of transacting for everybody. It’s generally not an unreasonable view, and the corollary is that the cheaper is it so trade, the better off are both the savers who put money in the market and the companies who acquire those savings through equity issuance. In fact, for all the focus on short term swings in the market it’s as well to remember that its ultimate purpose is to channel capital from savers to where it can be usefully invested in productive ways. That is the point, after all, of a stock market and at its most fundamental every related activity ought to be geared to promoting that outcome.

Regulators don’t currently expose every new trading strategy or activity to that litmus test. Perhaps that’s as well. But HFT does seem to be about as far away from channeling savings to useful places as it’s possible to be. The New York Times article mentioned above goes on to note how firms routinely post thousands of orders at a time, only to cancel many of them a split second later. Firms have been fined for trying to manipulate the market through the sudden appearance and disappearance of large orders. HFT was blamed by some  for the “flash crash” on May 6, 2010.

So ask yourself if the world would miss High Frequency Trading if it just disappeared from the landscape. Who would care, other than the traders themselves and (presumably) the providers of the trading capital they use. Would stock market returns be lower? Would the cost of raising equity capital be higher? It’s doubtful.