The Aleph Blog

Balancing Quality Against Valuation

A letter from a reader:

Hi David,

I am XXX, from India. I started reading your blog since few months. Few of the things i learnt, and much more are really complex for me to understand, the learning is ON.

Somehow i decided that ” being good value investor and control the behaviour” is a gift of long practice and learning. So it takes time and for me the learning is still in lower phase. I am in middle of understanding Financial statements.

But before that i want to invest and enjoy the power of compounding. Till now i used Mutual Fund, Fixed Deposit (bank) for my wealth creation. As part of my milestone, i want to go ahead with shares for my Kids education and retirement.

I like to Buy Consumer staples like Nestle india, Gillete India, Glaxo Smith india which are past compounders. Given a India’s Economic growth and Population growth, I foresee these socks can do well. But it is already at very high PE (Nestle – 42, GSk consumer- 39, GSK pharma – 52, Gillette -141). I don’t foresee any panic selling on these stocks. What i will do? how i do buy Quality business with good valuation?

Kindly guide.

thanks for sharing such wonderful posts.

Dear Friend,

You have described the optimal situation: buy businesses that have well-protected boundaries, and buy them cheap.  I wish I could do that.  Everyone would like to do that.

But that is where judgment comes in.  I would rather own cyclical businesses with competent and honest management  teams, than own high growth businesses at very high multiples of earnings.  I would also rather own slow growth businesses at modest multiples of earnings.  Ask yourself: where am I getting a reliable stream of earnings and growth relative to what I am paying for the stock?

In general, with growth stocks, never pay more than 2 times the earnings growth rate  for the P/E of the company.

Often you have to look at companies that are neglected, and I would like to recommend a book to you: Investing in India.  The author avoids highly valued companies in India, and aims to invest in companies that are fair to outside minority, passive shareholders.

Look at more stocks than just the highest quality stocks, and look at the valuation tradeoff between highest quality stocks, and lower quality stocks.  Most value investors accept the lower quality stocks, if their ability to produce value relative to their price is better than that of higher quality stocks.

All that said, part of the question is how long will the high quality stocks have a significant advantage.  In the US, on average, that advantage has not been long.  Maybe things are different in India, but maybe not.  Be careful.  Remember, the cardinal virtue of value investing is having  a margin of safety, not cheapness.

Sincerely,

David

Book Review: Panic, Prosperity, and Progress

PPP I love economic history books, and I believe that most investors should read economic history.  History offers a broader paradigm for analyzing investment situations than mathematical models do.

Mark Twain is overquoted on this, but only because he deserves to be quoted:
“History doesn’t repeat itself, but it does rhyme.”

You can get a lot of insights into the present by reading this book.  So many disasters occurred because people presumed that the future would be much like the past, and they ended up being the ones that took the large losses.

Further, this book will point out that how an asset is held will make a difference in its future performance.  When there is not a lot of debt behind an asset, there may be good prospects.  But when there is a lot of debt behind an asset, prospects are not so good because those that own the asset are relying on the asset to perform.  Those who own an asset free and clear may get hurt if the price falls, but they won’t be ruined like the guy who has borrowed to own it.

This book takes on every major systemic crisis from the Tulip Bubble to the recent Housing/Banking crisis.  This is my bread & butter, but I learned things in many of the chapters regarding things I thought I knew well.  Truly, a great book.

What Could Have Made the Book Better

Financial crises don’t appear out of nowhere.  Leaving aside war on your home soil, plague, famine, communism, etc., there is usually a boom that gives way to a bust.  In some of his chapters, he could have spent more time describing the boom that led to the bust.  This is important, because readers need to learn intuitively that the boom-bust cycle is normal. NORMAL!

Ignore the economists who think they can control the economy.  They can’t do it, and this book helps to say that.  Economists are always behind the curve.  Politicians are even further behind the curve.  Regulators are still further behind the curve, and usually do the wrong thing during crises as a result.

The author could have done more to suggest how individuals and policymakers should respond to financial crises.  Better to have a book that advises us, than one that just reports.

Quibbles

On pages 421-422, he shows that he doesn’t get securitization, and blames the rating agencies, who were forced to rate novel debt for which they did not have a good model because the regulators outsourced credit risk measurement to them.

Summary

Most people would benefit from this book.  It will teach you about financial crises and their aftermath.  If you want to, you can buy it here: Panic, Prosperity, and Progress: Five Centuries of History and the Markets (Wiley Trading) (Hardback) – Common.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

 

Book Review: Reducing the Risk of Black Swans

71e0AKDi3XL This is a very short book. I read the whole thing in 40 minutes.  It has one main idea: what if you could create a less variable portfolio that returns as much as the traditional 60% S&P 500, 40% Barclays Aggregate blend?  Wouldn’t you want that?

Most of us would want that.  I would want earning more at the same level of volatility as the market, but that is another matter.

The authors take us through a variety of backtests, showing us portfolios that did well in the past, if you had invested in them.

They show how investors could have done better by tilting their portfolios toward value socks, small stocks, and international stocks, eventually showing a portfolio invested 60% in 5-year Treasuries, and 40% in stocks that tilt small, value, and international.

Voila! Same returns, with less volatility than the 60% S&P 500, 40% Barclays Aggregate blend.

But there is a catch here.  This is the past being amplified — will the future be the same?  Value stocks are undervalued on average, and small stocks outperform on average, but what if you are in an environment like now, where small stocks are overvalued, value is neutral to undervalued?  Tilt to value, yes, but maybe don’t tilt small.

Also, with yields so low on five-year Treasuries at 1.65%, that should be reflected into the future for the strategy, so maybe the amount of bonds should be reduced?

The biggest weakness that the book has, and this is true of many books, is that it follows a mean-variance framework.  The market is far more volatile than a normal distribution, with crises happening far more frequently than a normal distribution would anticipate.

Quibbles

Investing is not a science; it is an art.  Our principles are vague and subject to many forces beyond our recognition and control.

They make the rookie mistake of describing the calculation of long-term investment returns as a arithmetic mean (Page 16).  Pros do a geometric mean, which calculates the continuously compounded average return of a buy-and hold investor.

On page 18, their explanation of correlation is weak.  That said, even great publications like The Economist have blown that in the past, then using my explanation of correlation verbatim (back in the mid-90s).

Summary

This is a good book as it teaches you to tilt you portfolios to value and small companies on average.  The person who would benefit most from this book is someone who wants to get more out of his investments, but doesn’t want to spend a lot of time on it.  If you want to, you can buy it here: Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Understanding Insurance Float

Warren Buffett has made such an impression on value investors and insurance investors, that they think that float is magic.  Write insurance, gain float, invest cleverly against the float, and make tons of money.

Now, the insurance industry in general has been a great place to invest, but we need to think about float differently.  Float is composed of two things: claim reserves and premium reserves.

  • Claim reserves are the assets set aside to satisfy all claims that likely will be made as of the current date.
  • Premium reserves are the assets set aside representing prepaid premiums that have not been earned yet.

Claim reserves can be long, short or in-between.  Last night’s article dealt with long claim reserves — asbestos, environmental, etc.  Those reserves can be invested in stocks, real estate, long bonds, etc.  But most claim reserves are pretty short, like a year or so for most personal insurance auto & home claims — those typically get settled in a year.

The there are classes of insurance business that are in-between — workers comp, D&O, E&O, commercial liability, business continuation, etc.  Investing the claim reserves should reflect the length of time it will take until ultimate payoff.

The premium reserves are very short.  If premiums are paid annually, the average period for the premium reserves is half a year.  If premiums are paid more frequently, the average period for the float falls, but the premiums rise disproportionately to reflect the insurance company’s desire to have the full year’s premium on hand.  It usually makes sense for policyholders to pay at the longest period allowed — thus, thinking about premium reserves as having a  duration of half a year on average makes sense.  Except auto — make that a quarter of a year.

Earnings financed by float should be divided into two pieces — non-speculative, and speculative.  The non-speculative returns on float reflect what can be earned by investing in high quality bonds that match the time period over which the float will exist.  Short for premium reserves, longer for claim reserves.  So, the value of float is this:

Present value of (investment earnings of high quality duration-matched assets plus underwriting gains [or minus losses]).

This is a squishy calculation, because we do not know:

  • the number of years to calculate it over
  • future underwriting gains or losses

The speculative earnings from float come from assuming that float will stay at the same levels or grow over many years, and so the insurer invests more aggressively, assuming that float will be a permanent or growing thing.  He speculates by financing stocks or whole businesses using the float that could reduce, or that could become more expensive.

How could that happen? P&C insurance often gets very competitive, and the cost of maintaining float in a soft underwriting environment is considerable.  Also note the claim reserves mean that the company took a loss.  That the company earns something while waiting to pay the loss does not help much.  Far better that there were fewer losses and less float.

Smart P&C insurance companies reduce underwriting in soft markets, and in such a time, float will shrink.  Let aggressive companies undercharge for bad business, and let them choke on it, while we make a little less money.

Well-run insurers let float shrink – they don’t depend on float being the same, much less growing.  If it does grow, great!  But don’t invest assuming it will always be there or grow forever.  That way lies madness.

Berkshire Hathaway has benefited from intelligent underwriting and intelligent investment over a long period.  That is not normal for insurance companies.  That is why it has done so well.  Float is a handmaiden to good results, but not worth the attention paid to it.  After all, all insurance companies have float, but none have done as well as Berkshire Hathaway.  Better you should focus on underwriting earnings rather than float.

Underwriting insurance produces premium float.  Underwriting bad business produces claim reserve float.  Float is not an unmitigated good.  Good underwriting is an unmitigated good.  So focus on underwriting, and not float.

=-=-=-=-=-=-=-=-=-=-=-===-

Berkshire Hathaway has been in the fortunate position of having had wise underwriters, and and ability to expand into new markets for many years.  Guess what, that was AIG up until 2003 or so.  After that, they could not find more profitable markets to underwrite, and results began to deteriorate.  They ran up against the limits of their ecosystem.

Buffett is a brighter man than Greenberg; he can consider a greater realm of possibilities in how to run an insurance conglomerate, and the results have been better.  All that said, there is only so much insurance to underwrite in the world, and big insurers will eventually run out of places to write insurance profitably.

All that said — float is a sideshow.  Focus on profitable underwriting — that is what drives the best insurers.

 

 

On Berkshire Hathaway and Asbestos

Recently, a friend of mine from Canada came to stay with me.  We talked about a wide number of things, but when we talked about investing, I described insurance investing to him, giving my usual explanation on reserving.

Classical life insurance reserves are a science.  Death happens with regularity, it is only a question of when.  Short-tail P&C, health, etc, are almost a science — the claims come quickly, and the reserves get adjusted rapidly.  Long-tail Casualty and Liability is a dark art at best.  Mortgage, financial, and title insurance reserving is not even an art; there is no good theory behind them, as is true of life insurance products with secondary guarantees, particularly those dealing with variable products.

As an example of long-tail P&C, I told my friend about Berkshire Hathaway and asbestos — I mentioned to him how BRK has become the reinsurer of choice for insurers with uncertain asbestos liabilities.  Buffett has reinsured White Mountains, AIG, CNA, Equitas. and many others, the most recent being Liberty Mutual, which happened after the talk with my friend.

This is retroactive reinsurance, where an insurer purchases insurance from a reinsurer to cover business previously written.  This is an uncommon form of insurance, and most commonly used when the amount of claims is very uncertain.

Quoting from the Bloomberg article:

Liberty Mutual Group Inc. issued $750 million of bonds to help finance a payment to a unit of Warren Buffett’s Berkshire Hathaway Inc. (BRK/B) for covering the insurance company’s liabilities tied to asbestos.

The 4.85 percent, 30-year notes were sold to yield 160 basis points more than similar-maturity Treasuries, according to data compiled by Bloomberg. Standard & Poor’s increased Liberty Mutual’s rating one level to BBB from BBB- after Berkshire’s National Indemnity Co. agreed last week to provide as much as $6.5 billion of coverage for the insurance company’s liabilities for asbestos, environmental and workers’ compensation policies.

“This agreement covers Liberty Mutual’s potentially volatile U.S. A&E liabilities and largely mitigates potential risks from future adverse reserve developments,” Tracy Dolin, an S&P analyst, said in a statement.

Berkshire, which has grown over the last five decades by investing insurance premiums in stocks and takeovers, has assumed billions of dollars in asbestos risk from insurers including American International Group Inc. and CNA Financial Corp.

Liberty Mutual paid Omaha, Nebraska-based National Indemnity about $3 billion for the coverage, according to a July 17 company statement.

This is similar to the other deals, where the premium paid is roughly half the amount of what BRK could have ot pay out at maximum.  Note that BRK has capped its exposure to the claims.   If asbestos claims against Liberty Mutual exceed $6.5 Billion, Liberty Mutual will have to pay the excess.

I don’t think there is another American insurance company with more asbestos exposure than BRK.  That’s not necessarily a bad thing, though.  Let me quote from BRK’s recent 10-K:

We are exposed to environmental, asbestos and other latent injury claims arising from insurance and reinsurance contracts. Liability estimates for environmental and asbestos exposures include case basis reserves and also reflect reserves for legal and other loss adjustment expenses and IBNR [DM: Incurred But Not Reported] reserves. IBNR reserves are based upon our historic general liability exposure base and policy language, previous environmental loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.

The liabilities for environmental, asbestos and other latent injury claims and claims expenses net of reinsurance recoverables were approximately $13.7 billion at December 31, 2013 and $14.0 billion at December 31, 2012. These liabilities included approximately $11.9 billion at December 31, 2013 and $12.4 billion at December 31, 2012 of liabilities assumed under retroactive reinsurance contracts. Liabilities arising from retroactive contracts with exposure to claims of this nature are generally subject to aggregate policy limits. Thus, our exposure to environmental and other latent injury claims under these contracts is, likewise, limited. We monitor evolving case law and its effect on environmental and other latent injury claims. Changing government regulations, newly identified toxins, newly reported claims, new theories of liability, new contract interpretations and other factors could result in significant increases in these liabilities. Such development could be material to our results of operations. We are unable to reliably estimate the amount of additional net loss or the range of net loss that is reasonably possible.

Long tail P&C reserves are roughly 20% of the total gross P&C reserves of BRK, and this deal with Liberty Mutual increases it.  Again, that’s not a bad thing, necessarily.  Given the premium paid, even if BRK pays out the maximum on average 10 years from now, the deal is a winner if BRK earns more than 8% per year.  If 15 years 5.3%.  If 20 years, 4%.  Given the long period before the ultimate payment of claims, BRK can make money in most scenarios.

That said, if anything bad ever did happen to BRK, such that its solvency was impaired, there would be a lot of insurance companies hurting as a result.  BRK is critical to the payment of asbestos claims.  There is not a better company to entrust with this task.

Full Disclosure: Long BRK/B for myself and clients — we own the equivalent of one “A” share.

On Learning Compound Interest Math

When I read articles like this where people get scammed borrowing money, I say to myself, “we need to teach children the compound interest math.”

Even my dear wife does not get it, and she sends the children to me when they don’t get it.  But beyond learning the math, a healthy skepticism of borrowing needs to be encouraged, especially for depreciating items like autos.

The compound interest math is really one of the more simple items of Algebra 2.  Everyone should be able to calculate the value of a non-contingent annuity at a given interest rate.

Once people learn that, they might have more skepticism regarding the long-dated pension-like promises that the government makes, because they can look at the future payment stream, and say, “I can’t see how we fund that.”

All for now.

A Letter from a Young Investor

Before I get to the letter, I recommend reading, You’re Ready for Retirement, but Your Savings Aren’t by Jonathan Clement, if you have access to the Wall Street Journal.  Main point: if you can work until age 70, do that, and then retire.

Here’s the letter:

Hi David,

A little background about myself.  I am a 24-year male, and have been working for a little over a year.  The only knowledge I have on investing is passive index fund investing through the book Bogleheads.  I don’t really look at my holdings other than to re-balance every year.

I am currently investing for retirement by maxing out a RothIRA, maxing out a 401k  (that allows a Brokerage account) and some in a taxable Vanguard index fund.  My holdings consist of the total stock and total bond market index funds (90/10). From my current positions my portfolio return has been 20.6%. I calculated the return by return = (market_change + dividends) / total_money. I don’t know if this is a correct formula. The time frame of my holdings is from Jan2012 – June2014. 

I went to a finance workshop that my church was hosting and there was a panel of finance experts (CPA, lawyer, financial advisor) that were indirectly encouraging active investing over passive investing through personal anecdotes. 

Looking at my current portfolio performance, I have a hard time seeing the value in spending time in learning how to actively invest and about finance in general. Currently, I do not follow up on business and market news nor am I reading any economic/investing blogs or magazines. Again, my only investing knowledge is from the Bogleheads book, and so I feel that active investing would be a daunting task. 

Do you have a comparison of an active investment portfolio’s returns (that uses your 8 portfolio rules) against an index fund (such as the Vanguard total stock market) during a bull and bear market?  Also, do you have any advice on where to begin learning about active investing in general? How should one invest for different goals, say investing for retirement in 40 years vs. investing for a home purchase in the Bay Area in 5-10 years? I’m having a hard time seeing how I would balance time in regards to learning about investing, advancing my career through outside studying, serving in my local church, spending time to witness to family, friends and co-workers, and communion with God.  It seems like passive investing is a simpler solution with a decent average long-term return of 7%. I know I am young, have a lot to learn about life and sometimes stubborn in my thinking, so any thoughts and/or advice would be greatly appreciated.

These are the questions I will try to answer:

  1. Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?
  2. Do I have a track record that is publicly available?
  3. Where to learn about active investing?
  4. How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?
  5. Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

But  I will answer them in a different order.

Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

You can’t be good at active investing without putting time in at least at the level of a hobby, say, one hour per day, six days a week.  When I launched into studying investments at age 27, I already had two advantages — A mother who was self-taught in investing (and beat most mutual fund managers handily), and an academic background in economics and finance (which had its pluses and minuses).

But my commitment to learning about investing was one hour per day, six days a week.  After 5 years, I was an investment actuary, which was pretty rare at that time.  After 11 years, I was hired into the investment department of a medium-sized life insurer.  17 years later, I worked for a notable hedge fund.  23 years later, I started my own firm.

Now, there were some spillover benefits for serving the church.  I have served on various boards of my denomination, chairing some of them, but my knowledge of finance has been a benefit to many of them, and I have been able to prevent a wide variety of errors.  Even this week, a Christian group in western Pennsylvania reached out to me regarding a “too good to be true investment,” and I told them it was likely a fraud.  There are ways that we can serve the church with such knowledge.  Brothers and sisters that I know come asking for advice, and I do not turn them down.

Now, all that said — no, it is probably not worth your time to learn about active investing.  I wrote two articles a while ago taking both sides of the argument:

Decide what you want to emphasize in your life and service to God.  The church benefits from a few “numbers guys” (as some refer to me in my denomination), but it doesn’t need a lot of them, if the group trusts them, and they are wise and upright.

Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?

I don’t think you have to move to active management — you might move to some sort of tilt on you passive management, though.  Over the long run, tilting to value stocks and smaller stocks has been a smart idea.  Cap-weighted indexes have most of their assets invested in behemoths that like Alexander the Great, have “no more worlds left to conquer.”  Investing a disproportionate amount passively in mid- and small-cap stocks can be a wise idea, as can passive investing with a value bias.  Two sides of the issue:

But, maybe wait a while before you add some mid- and small-cap value index funds… valuations are relatively high for small and mid-cap stocks at present.  I have a hard time finding truly cheap stocks at present.

Where to learn about active investing?

As for books, you could look through my book reviews, and scan for the word “value.”  You could visit the website Valuewalk.com; I have to admit I am impressed with what Jacob Wolinsky has done — it is the “go to” site for value investing.

You can also read the letters of notable value investors — Buffett, Klarman, Marks, and more…

How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?

Let me tell you a story.  My congregation is near DC.  My congregation asked me to manage the building fund, and for years, I beat the market, but DC area real estate still appreciated faster.

At the same time, many congregations in the denomination, had received buildings for low prices, or virtually free, but those were mostly in rural areas.  So at prayer meeting in January 2009, after losing a large amount of the building fund, I asked God to drop a building in our lap, as I could not see any way that I would ever do it through my investing, good as it was.

Two months later, we bid on a short sale for a house with a church use permit.  We had the assets free and clear for it, and closed in May 2009.

Here is my point to you: geographically constrained markets like the Bay Area — there is no good way for the liquid stocks and bonds to keep up with real estate price increases. Buying a house in the Bay Area is a tough matter, and it might make sense to match assets and liabilities.

You might want to try to buy real estate related assets in the Bay Area — not sure how you could do that, but it would be the investment closest to funding what you want to own.

As for investing for retirement 40+ years from now, maintain a posture of 70-80% risk assets, and 30-20% safe assets.  I have been 70/30 most of my life.  Optimal is 80/20, but I take more idiosyncratic risk, and 70/30 just feels better to me.  My investments are more concentrated, and the cash levels out the jolts.

Do I have a track record that is publicly available?

Yes and no.  I send it to those who inquire after my services, but I will send you a copy after I publish this.  I’ve done well, but I know that it might be due to chance.  That said, my clients get the same investments that I have, so my interests are aligned with them, aside from the fee they pay me.  I have no other compensation from my investment management.

On Several Questions from a Reader

As time has gone along, I realize that my blog is different.  I do things that most bloggers don’t do, e.g. book reviews, answer e-mails publicly, and a few other things.  Also, my audience is far more international than most, with a large contingent from India.  Well, here is another e-mail from a reader in India:

Hi David,

I am a big fan or your articles and read regularly when I get time. I respect you for what you are trying to do with your blog – it is a free education for people like us. I also write a blog but it is mostly a commentary sorts than educating blog like yours.

I am writing to you today because I want to seek out your advice on my portfolio (and my ongoing investment education). 

Screening technique

I normally use Reverse DCF with 15% discount rate, 3% terminal growth rate and future growth assumption of a quarter of historical (5 or 10 years) FCF growth rate. For eg. if historical FCF growth rate of a company is 40%, and reverse DCF suggest market is factoring 10%, that company gets shortlisted.

I also try to invest in companies with 5 years avg ROCE of more than 25% – assumption being management being prudent and high quality will generate good returns on capital available to them.

When I am done screening the stocks, I read their previous 2-3 annual reports to get the feel of the business, how do they money and what are the underlying risks etc. I also read their commentaries on the business prospects and any extraordinary or hidden/ contingent charges they might have. I try to find out what makes the business earn so consistent results.

The screen I use normally allow me to avoid the folly of forecasting. I avoid making an elaborate model and try to forecast future earnings and cash flows. I just try to buy the security at a good discount to what my Reverse DCF model suggests.

Selling strategy

Now, lot of my stocks (8/13) have doubled in 1-3 years duration. I, as a rule, take out my capital when my stock doubles i.e sell half of my holdings. I assume that whatever I have thought about the future prospects of the business could be wrong. Some of my stocks are trading below the level I took out my capital and some of them have turn out to be multi-baggers. What are your thoughts on this selling strategy.

I also have issues with a stock if it has been on my watchlist and has run up a bit. I think this is anchor bias everyone talks about. But I still want to know your thoughts. Do you buy in a single trade or do you build your position slowly.

One more thing, I know you write a lot about portfolio structure, what do you suggest to do if the business you have made the highest allocation to is generating lower returns and vice-versa.

I know I am bothering you a lot, but knowing your thoughts will help me a lot.

I also tried my hands on liquidation analysis that Peter Cundill speaks about in his book – There’s always something to do.

I bought a stock, which was trading way below its liquidation value ( if you buy the entire market cap, sell all the assets at half the prices, and pay off all the liabilities, you still will be left with some cash). I have read their ARs and have found nothing wrong with management, of course their business is not generating lot of profits. I have put a google alert on company’s name if there is some news report or some analysis on the company that may alert me if they’re fraud. So my question is how do you (or a retail investor like me) make sure that management is not fraud or accounts are not cooked.

I know these are lot of questions – that too from a stranger sitting in India but I’ll be happy if you give me some sense of direction – whether I am doing things right or what should I change.

Keep writing and educating,
Thanks,

I don’t use DCF or reverse DCF because of the many assumptions employed in DCF.  I am happier using simpler techniques like P/E, P/B, P/S, and then trying to critique them considering what I know about the company and industry in question.

As for you insistence on a high ROCE — that can work in India, but is less likely to work in the developed world, because few companies can beat the 25% threshold, that have reasonable valuations.

I take out assets from companies as they rise.  I do it more regularly and slowly than you do — it is a risk control mechanism.  On the downside, it is a way to make more money, by buying quality companies when they are down.

For more thoughts on selling, look at my portfolio rules seven and eight.

Regarding watchlist assets that have risen in value, I follow portfolio rule eight, and only buy assets that would be a net improvement to the portfolio.  Timing will almost never be right, but if you have a favorable valuation for the asset in question, and a sound balance sheet, you will do well.

Regarding portfolio construction, I only look at the likely future.  I will hold onto a company that has done badly, but still offers an opportunity of doing well in the future.  The objective is to be forward-looking.

I buy positions all-at-once, or as close to it as I can, because a few positions are illiquid.  There is no reason to delay in investing if your thesis is a good one.

Regarding crooked managements — the first question to ask is how are you going to grow revenues.  If the answer is at all unbelievable, run away.  There are other tests:

1) look at their results over many years, and compare it to their commentary.  Don’t give any credit for one-time (negative) events because over the long run, managements that have too many one time events are bad managements.

2) use statistics like normalized operating accruals to see if the accounting is conservative or liberal.

3) Analyze growth in book value plus dividends versus earnings.  Growth in book value plus dividends is a better measure of value than earnings is.

4) look at management incentives — the best managers are idealists.  They love what they do, and would do it for free. if they could.  You want a management team that is hungry; you son’t want a management team that feels full.

Thanks for writing me, and I hope you prosper in your investing in India.

Sincerely,

David

On Current Credit Conditions

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

Book Review: The Risk Wise Investor

00001 What do you think about first when you look at an investment? Do you think of how much you might make, or how much you might lose?

Most successful investors think about how much they could lose, which makes this book a very good one to read, versus many investment books that spend little time on risk, but try to sell you on likely returns.

We win by not losing, while taking moderate and prudent risks.  This book encourages you in that direction.

Broadminded Wisdom

By broadminded, I don’t mean someone who is not willing to call some things right and wrong, but rather, someone who is willing to consider many facets of the problem as he suggests his advice.

He considers (chapter-by-chapter):

1) The modern problem of data overload, and how it distorts our decisions.

2) How good investment risk control is very much like the way we control non-investing risks in our own daily lives.

3) The long-term history of how financial risk management emerged, and how it has sharpened in the present era.

4) What level of risk are we trying to deal with?  Those that want to have no risk against extreme contingencies set themselves up for losses if society remains intact.  On the other hand, if you are only attempting to smooth out small setbacks, what happens when you face a true market crisis?

5) Should you consider risk to be a quantitative or qualitative matter?  The author opts for both.  I would argue you are better off with the qualitative, and a businessman’s instinct on the quantitative, as opposed to that of an academic.

6) Learn to train you emotions.  Do not give into fear or greed.

7) As a result, add to risk assets in bad times, lighten up in good times.

8 ) Think for yourself, and don’t follow the crowd.

9) Control what you can control, hedge what you can’t control, if it makes sense

10) Realize that not all risks are the same size — focus on the big ones that are within your capacity to minimize.

11) Risk management is a process.  Identify the outcomes you want to avoid and avoid them, considering what you might give up in the process.

12) Consider what great risk management looks like outside of finance, and use the analogies to aid your investing.

13) How good financial advice can help, and what that looks and feels like.  The book gives many good questions to ask those who might advise you.

14)  Dealing with financial panics and crises.  There are no easy answers here, but if you can invest more when things are at their worst, or when things stop getting worse, you can do well.

The book has a summary, where it draws all of the stands of thought together.  If after reading the book, you follow the summary, you will have a useful way of managing your investment portfolio.  Now that said, managing investment risk is not easy, because markets are not stable.  You need to be ready to not do so well during booms, while being willing to take risk when things look really bad.  (But maybe wait until prices cross the 10-month moving average…)

Quibbles

None.

Summary

This is a very good book on risk control in investment management, and most investors, retail and professional, could benefit from it.  If you want to, you can buy it here: The Risk-Wise Investor: How to Better Understand and Manage Risk.

Full disclosure: The author asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin