α + β

No, we are not about to embark on a lesson in quantum mechanics. Alpha/Beta talk is the latest rage on Wall Street. Let's start with Beta which is basically supposed to symbolize risk - systematic risk to be exact. Beta is used to measure a stock's volatility relative to the overall market. So, for example, a stock with a Beta of 1 moves up and down with the market and therefore encompasses the same amount of systematic risk. Of course, modern financial theory, albeit incorrectly, equates volatility with risk. So the higher the Beta for a stock the riskier it is supposed to be. There isn't much you can do about this kind of risk. The simplest way out is to buy an index fund and do away with the risk altogether.

There is also a non-systematic component to risk which is specific to the business you are investing in. Outperforming the market will depend on how well you mitigate this kind of risk. You certainly can't diversify it away by holding 150 stocks in your portfolio as many mutual fund mangers on Wall Street tend to do. As we have discussed before, the way to go is to build a concentrated portfolio which contains businesses you really understand and bought after a lot of thought and due diligence.

Apparently, there is another way to accomplish this and it involves Alpha. Wall Street firms' ability to conjure up portfolio "strategies" which puts more fees in their pockets is once again on display here. A recent Wall Street Journal article explained how "Portable Alpha" works. The most recent issue of Institutional Investor also had an insert which devoted a section to "Alpha Beta Separation" strategies. What is all the hoopla about? Here is how it's supposed to work. Clients are advised to get exposure to their benchmark index (Beta) through the use of derivatives, freeing up cash to allocate to Portable Alpha - money managers using hedge fund type strategies to boost returns above and beyond the Beta portion of the equation. You got it. The whole pie in the sky pitch assumes that these money managers will consistently beat the market. Well, that just doesn't happen (see Dreman's book for more details). Oh, and I forgot to mention that proponents of Portable Alpha charge hedge fund type fees to boot. It doesn't get any better than that. The Journal noted that "critics say portable alpha is nothing but Wall Street hocus-pocus that lets money managers rack up higher fees." They took the words right out of mouth.

The Weather Channel

A recent Wall Street Journal article highlighted the fact that demand for catastrophic reinsurance products is outstripping supply. Meanwhile, hedge funds and private-equity firms are filling the gap by providing coverage in certain cases. But don’t forget the king of reinsurance, Warren Buffett. Indeed, Berkshire Hathaway is making a big bet on mega-cat reinsurance even as others flee. And here is yet another classic quote from Mr. Buffett on the subject: "If you like to watch football, you probably enjoy the game a little more if you have a bet on it. I like to watch the Weather Channel." Gotta love it!

Blue Gold

Over the past couple of years, sporadic articles have appeared in BusinessWeek and the Wall Street Journal about water. The sector certainly seems to be under the radar and yet water related indices such as the Bloomberg World Water Index of 11 utilities has returned 35% annually since 2003, far outpacing the S&P 500 and even various oil and gas indices.

A little bit of digging unearths a plethora of information about gloomy forecasts of a water shortage over the next couple of decades as well as neglected water infrastructure in various countries. From the United Nations to the OECD to the Environmental Protection Agency, there is no shortage of opinion on global water issues.

Big money is certainly getting onboard and has been gearing up to take advantage of the opportunities. The Gabelli Fund recently organized its first Water Infrastructure Conference and is one of the largest shareholders of Watts Water Technologies (NYSE: WTS). Then there is General Electric (NYSE: GE) which has water purification and treatment businesses and expects the opportunity to grow significantly going forward.

We have had the water sector on our radar for some time. Various stocks have pulled back from recent highs and appear to be trading at reasonable valuations. ITT Industries (NYSE: ITT) and Pentair (NYSE: PNR) are a couple of examples. There is also the PowerShares Water Resources ETF (AMEX: PHO) if you don’t want to pick and choose.

We finally pulled the trigger on a mini-conglomerate which recently decided to spin off it water infrastructure business through an IPO. Walter Industries (NYSE: WLT) which has also been the target of various activist hedge funds has been on a wild ride recently.

We first took a position at around $65 and then again at $44 during the recent market decline. The remaining shares of Mueller Water Products (NYSE: MWA) should be distributed to Walter shareholders in short order. Walter currently owns about 75% of the Mueller. A bunch of Wall Street firms initiated coverage of Mueller couple of days ago. Let’s take $20 as a price target. At that price, Walter’s stake in Mueller accounts for $38 of its stock price which is trading at about $55. In other words, you are getting Walter’s natural resources (coal and gas), homebuilding and financing businesses for about $17 a share. Let’s say the homebuilding and financing businesses are worth about a couple of dollars. This leaves $15 for the natural resource business. Assuming a coal segment comparable P/E of 14, this part of the business would only have to earn $0.93 to justify this price. This is way too conservative even if coal and gas prices decline significantly. Plus, the company has locked in the price for its coal through next year at above $100 per metric ton. And I expect demand for Walter’s high quality metallurgical coal used by the steel industry to be sustained for some time.

I think Walter Industries is worth at least $75. So get in on the Blue Gold rush by buying Walter shares and waiting for the full spin-off of Mueller.