Five things I learned this week: Feb 23rd 2013

I am a big fan of Ray Dalio, and the second interview on this page (on CNBC) is phenomenal. As you’d expect the commentary has a lot of focus on what he said about the economy, but not enough on how he thinks. I think the part where talks about why had a leveraged fixed income portfolio alongwith stocks is gold. He says that an average public company in the U.S. has 2x leverage (has as much debt as it does cash), and so a 2x leverage in a bond portfolio makes a lot of sense. Then there was the one comment about diversification which beats every thing I have ever read on asset allocation. He says that if you have a 50-50 break between stocks and bonds, you will still have 80% of your risk in the 50% part that is stocks, so that’s not diversification enough, and one has to pick the bonds (long-dated in this instance, which will balance the risk that you have in equities). In Prof. Gideon Saar’s class at Cornell, I learned very well about how diversification is important and mathematically proven, but this one comment makes it all come together for me.

It’s a little shameful that I hadn’t looked at this before, but the sequester would cut $90B of spend on an annual run rate while the Fed’s program is putting in $85B of liquidity a month. Of course, Fed’s asset buying program is a supply-side mechanism, and is trying to nudge the economy via capital market transactions and thus needs active participation by other players in the capital market to achieve its desired impact (6.5% of unemployment rate), which doesn’t happen either immediately or efficiently, but that does put the scale of the sequester (or, the Fed’s program, if you were inclined) in perspective.

After reading a bunch of different notes, it clicked for me why distressed debt can be one of the best diversifiers in the portfolio if you know what you’re doing, for the simple reason that the payout is not dependent on the resale value of the bond. In fact, the market could shut down and the distressed debt call still pay, because you keep collecting coupons, presumably at a coupon rate lower than the yield you bought it at. Investment grade debt also pays coupons but the returns are primarily driven by the resale value of the bonds.

This earnings season beat have been about 3-4%, BUT the estimates had come down the 6% before the season. Nothing sets you up like lowered expectations.

I was reading an interview with Barry Rosenstein of JANA Partners, which has a substantial portfolio of activist picks, and he talked about how the managers in today’s corporations have typically little ownership and when they do have ownership, they’re often compensated by stock options, leaving them to build their wealth via cash, which encourages empire building. I would be interested in what he thinks about RSUs, which many consider to be better at replicating ownership than options.

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