For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.


If you have read me for a while, you have heard of my eight rules of stock investing.  Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.  I thought it was a good idea, so this is the first of what is likely to be eight episodes.  Here’s portfolio rule one:

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

I always get a little look of surprise the first time that I mention my main idea to consultants or other equity managers. I sometimes say, “Some managers are top down, others are bottom up — I am middle out.”  The idea is that I don’t rely on a view of the economy to drive my investing, nor do I just look for cheap stocks, wherever I might find them.  Instead, I look for industries that are hated, either absolutely or relatively.

In my view, paying attention to industry fundamentals is always superior to viewing the economy as a whole, because:

  • The industry cycles as compared to the overall economic cycle are not exact comparisons, both with respect to timing and amount.
  • Among other reasons, demand outside the US can be decidedly different than demand inside the US.
  • New entrants and company failures and acquisitions can affect the industry economics more than the general economy.
  • Major innovations like the Internet can turn stable cash flow generators like newspapers and parts of the telephone industry into permanent losers.

If I were allowed to turn back the clock, and teach those who allocate equity assets how it really works, I would have told them to ignore value and growth, large and small.  I would replace those with industries.  Industries tend toward value and growth, large and small, but the aggregation hides a lot of valuable information.  But the consultant community is a sucker for simple explanations that explain little of a more complex reality.

Think about it, ideally, when to you want to buy shares in an industry?  When the hatred is thick.  Valuations are crushed to the degree that they can’t go much lower.  And at such a point, the risk lover buys the dodgiest company in the industry — high fixed costs, bad balance sheet.  Clever, but what if the recovery takes too long, and it goes broke?  Such a strategy makes a short-term bet.  Those with a longer time horizon, and reasonable expectations, buy the high quality company.  If the downturn prolongs, more competitors will fail, and they will pick up pricing power.  If the downturn ends quickly, and pricing power returns, the high-quality company will still do very well relative to the market as a whole, though a lower quality name that might have died under other circumstances will do much better.

The second-best place to buy are industries in the midst of improving pricing power that will persist, but many think it will not persist.  In that case, since there is only a low threat of companies going into financial stress, buying cheap companies of moderate quality will result in very good gains.  The risk is that I am wrong in my estimate of continuing pricing power, but if I am wrong, the cheap name typically won’t do that badly, and I can trade away for the small gain, or not much of a loss.

All of this means spending time watching industry economics, looking for places that will outperform market expectations.  This isn’t always easy, but there aren’t so many players asking those questions, compared to those doing top down or bottom up investing, and so I have a better chance of profit, in my opinion.

PS — For those with access to RealMoney, some of my best articles on portfolio management are listed here.

When I wrote yesterday, I did not consider everything that I regard as unfair, just a small portion of it, and I thank my readers for responding and expanding my view.  Some thoughts:

  • I was decidedly not a a fan of the Bush II Administration on economic policies.  They pushed us further into debt, and were generally in the pocket of the wealthy.  My views on taxation are nonstandard, but they would be far more fair to all Americans than what we have today.  I can hear Buffett scream from Omaha, if this were passed.  Gates from Seattle, too.
  • My comment that we are in peacetime stands, because we have asked no sacrifice of Americans to stand behind the war effort.  And why not?  Because it is too difficult to get people to sign on that they are behind the war; the benefits of the war are unclear at best.  They may be behind individual soldiers, but support for the war is unclear.  When the war has no obvious cost, people don’t complain about it much.
  • I was also not a fan of the Clinton, Bush I, Carter, Ford, Nixon, and Johnson Administrations on economics.  None of them addressed entitlement reform, which was the biggest long-term issue.  And worse, the Reagan Adminstration listened to the lightweight Greenspan regarding Social Security, who has done more harm to the nation than any since FDR.  Making unfunded promises is inherently dishonest, and now we are nearing our endgame for Medicare and Social Security.
  • Do I blame politicians more or voters?  I still blame voters more, because they do not act out of principle, but they vote their pocketbooks.  Pocketbooks are important, but ethical issues more so.  If we don’t do what is right, we will end up in the ash heap of history, with many other failed nations like the USSR.  We vote into power losers who lie to us and tell us that everything will be okay, even though tax rates are inadequate, and monetary policy is encouraged to be loose on average.
  • I have never been behind our defense or intelligence buildups, much as I have friends in both areas, as I live near DC.  I was against Gulf War I, much less II and Afghanistan.  None of those wars were needed, or protected us.  They may have increased our terrorism risks by making us a more obvious enemy.
  • Though I think that war is legitimate, I rarely find actual wars to be so.  Far better to stay at home, and wait until we see real threats against us.
  • I don’t back Nixon in his economic policy; he was as bad as Bush II.
  • I did not back the bailouts of banks, the automobile companies, or any special interest.  I opposed them.  I have always argued for policies that are fair to all Americans.
  • Keynes is misunderstood for what an intellectual lightweight he was, pursuing stimulus and encouraging low interest rates. He did not look at the long-term, which is what a statesman does.
  • Though I am nominally a Republican, I do not always vote that way.  I voted for Bob Casey, Sr., when I lived in Pennsylvania, though I was not crazy about his economic policies.  I vote primarily on my view of who will be the best person, as measured by the Ten Commandments.

My views are complex, but in general, I think that people are wrong to look to the government for help, and instead should act to rein in the government so that it can’t harm.  On a strict constitutionalist basis, much of what the US Government does is extra-constitutional; the powers not explicitly given to them are denied to them.

My first piece was not primarily geared toward giving my political views, but explaining the gap between the intelligentsia and the t-party.  Fairness is the main issue, and those who care about it are firing at those who are in power, the Democrats.

If I have offended any, I am sorry.  It is not my way to be rude.  I have hated the excesses of both Republican and Democratic administrations as they have trampled on average Americans, even if average Americans di not know what hit them.

Time out.  Time to have an elementary school education for those that lead us, who have pretensions to understanding economics, at least in terms of how people really work, not the idealized Homo Oeconomicus of the introductory economics textbooks.

Time for them to get a dose of behavioral economics form books like Priceless and “Secrets of the Moneylab” (soon to be reviewed).  People don’t care as much about improving their position in life as much as they do about fairness.  Why? If I did not believe in Jesus, I would say that people assume that the games that they play will be repeated in life, and so they punish those that cheat, because they prize the integrity of the system more than short term results.

There is a simpler explanation, though.  Men/(Women) were created to judge their surroundings and rule it.  Man was created on Earth for moral purpose primarily, not for increase in consumption.  When ethics are transcendent rather than a question of economic advantage (more is better), men will act against their short term interests to promote the long term good.

This is yet another reason why people don’t necessarily act on average to maximize their short-term pleasure.  People will not normally enter into deals that they find morally repugnant even if they would gain from it.  Ask a liberal if they would encourage the Nature Conservancy to sell land to Plum Creek Timber, or one of its peers.  They will object.  Wait, couldn’t they take the proceeds, and buy up more forest elsewhere?  Sorry, this is a sine qua non for them.  They don’t deal with the enemy.

I could come up with many more examples, but I am sure that I would make a lot of people angry, and that is not my goal here.  I am just trying to make people think a little more broadly about economic policy.

So the central bank decides to finance a certain financing market in a panic.  Fairness asks this: why them, and why not me, or everyone?  We don’t care if the economy would supposedly collapse without the aid of the central bank.  Things should be fair; if you are offering it to them, you should offer it to me, or everyone, or you should not offer it.

The same applies to fiscal policy.  Stimulus, should it exist at all, should apply to the broadest category of applicants.  Don’t target troubled industries, particularly those whose products are in oversupply.  Send the stimulus to average people equitably.  Let industries fail, but let consumers choose what they need.  Why should we support industries that are not needed by the public?

So when I read Daniel Henninger in the Wall Street Journal arguing that average people don’t respect spending beyond the budget of the government, I get it.  I GET IT!!!  They have an interest in fairness, which stems from their moral sense that we can’t spend beyond our means, printing press or not.  Yes, the printing press may print, but it does not create value as much as redistribute value into the hands that the government favors, and the average person suspects they are getting none of it.

I am no fan of the Republicans, but do the Democrats understand what fury they have unleashed?  What do average people think when the government runs huge deficits in peacetime?

They look at it and wonder, Why can’t I do that? Why can’t we all do that?  The moral/ethical question pops to the top, regardless of other concerns.

The model of man that economists use is flawed.  Rather than focusing on the weak concept of more is better, they should look at fairness, and other relative comparisons of well-being that people care about.

What’s that you say?  If we do that, all the pretty math doesn’t work?  The pretty math doesn’t work already.  Tests of both microeconomic and macroeconomic theory as currently construed get rejected by the data when they attempt to apply the broadest tests of the general equilibrium theories.  If I am wrong here, please forward onto me the studies contradicting this, because this is what I learned in Grad school economics in the third year — very disappointing to save it until then… why not mention it in Econ 1 & 2?  Oh, you want to keep your jobs, because it beats working for a living?  Aye, laddie, I ken, I ken.  What I don’t get is providing intellectual cover for politicians to run a huge pork barrel.

Many people are sick of the government trying to assure prosperity and failing, to the degree that many are now thinking that the government is not trying to assure prosperity, but merely help out favorites, because that is how a lot of the policy of bailouts, stimulus, credit easing and radical quantitative easing appear.


I write this because there are many politicians, economists, and journalists/bloggers who don’t get why a large number of people are angry over what the government is doing in the midst of this crisis.  They think that everyone should be grateful that they are applying the Keynesian/Neoclassical remedies that the academics imagine will work.  They aren’t like me, where I think that most of the government’s actions are long-term harmful, and it would be better to do nothing. My hope is that one day average people will know that the government cannot assure or aid prosperity, aside from providing courts and police.

But average people look at fairness, and the snake oil “remedies,” regardless of their validity, do not provide that.  That is why many are annoyed, if not angry.

Early Warning and Quick Response

If you are not into accounting, you can skip this review.  Before you skip it, though, ask yourself a question.  Do you rely on financial statements?

Most of us do whether we admit it or not, but accounting rules for most of us are like plumbing.  We need to use bathrooms, and sinks in our kitchens, but that doesn’t mean we would know how to set up the plumbing in a kitchen or a bathroom.

In the same way, most users of financial statements don’t have the vaguest idea of all the assumptions underlying financial statements.  Modern financial reporting today is a hodgepodge of rules straddling two eras: the Renaissance/Reformation era, and the modern era.

In the R/R era, accruals were almost always short, liquidating within the next few accounting periods.  Few items on the balance sheet were traded, or would have prices that would adjust materially before they would be used or sold.

In the modern era, accruals are frequently longer and less certain.  Many items on the balance sheet are tradable, and prices often move materially before the items are used or sold.  What is more, there are often hybrid financing instruments that make the estimation of equity versus liabilities difficult.

David Mosso grasps the nettle, and says that modern accounting must move entirely to a fair value basis.  Net worth is the difference between the fair value of assets and liabilities.  Net Income is the change net worth.  No more obfuscation.  No more AOCI.  No more goodwill.  The values of assets and liabilities derive from the future cash flows they will generate.  Even claims against equity must be done on a fair value basis, where hybrid instruments get decomposed into an equity claim and a debt claim, and the split gets re-evaluated each period as market prices change.

All measurable assets and liabilities must go on the balance sheet, and all nonmeasurable assets and liabilities must be disclosed.  Beyond that, financials should be segmented by major lines of business or marketing channel or geography in order to give users a greater sense of what is going on.

Measuring wealth, and the increase in wealth is the main metric.  This would apply to all entities — nonprofits, governments, etc.  No longer could we do a monstrosity like “cash for clunkers,” where we destroy autos and do not record the loss in GDP, but we add to GDP the sales of autos generated.  I can think of many transactions at a usually scrupulous company that I worked at, where the new and unscrupulous CEO and CFO found ways to convert capital losses into operating income, giving ROE a big boost –> R up, E down, and letting management take home large bonuses as a result.  That said, the only real loser was another mutual life insurer that bought the company after insufficient due diligence.

The book has much more to it than this.  It delves into how to set accounting standards better, and spends time more closely defining fair value with respect to assets, liabilities, and equity claims.

The changes would be sweeping, and widely opposed by much of industry, as well as utility and financial businesses.  The government would never let such standards be applied to them; honesty is alien to them.

I have a hybrid proposal, which I would view as transitional, that I proposed to a commissioner of IASB at a Society of Actuaries meeting five years ago.

I said, “I am a user of financial statements, and we need an upgrade in the quality of data that we receive from accounting.  What we need are five main financial statements.  Book value balance sheet and income statements, supplemented by Fair value balance sheet and income statements, with a cash flow statement to round them out.  This would give us the flexibility to chose our own accounting basis.”

The lady had a horrified look on her face, and said “But that would be so costly to do.”

I replied, “Most of these estimates are being done already by companies.  This would formalize it.  Besides, to my friends here (turning around to the back of the room, catching grins, and then looking at her) this is the actuarial full employment act, because the work of estimating long-dated accruals is something that needs professionals like actuaries.”

No comment, and they went to the next question.


The devil is in the details here.  Anyone who has read me closely for a long time knows that I am of two minds when it comes to Fair Market Value accounting.  My experience is that managements, when given freedom to estimate the value of assets, tend to estimate them too high, and liabilities too low.  Historical cost accounting may be wrong, but it is relatively determinate.  There is comparability when managements don’t have a lot of latitude to change values.  After that, it is the job of investors to figure out how good the accruals are.

But on the plus side, fair value accounting does give the snapshot view of net worth, which managements resist in a crisis.  They want book value accounting that presumes the likelihood of reversion to all claims being paid.  Sorry that doesn’t always happen, and accounting should probably reflect it, even if it ruins comparability across firms.

Who would benefit from this book

Users of financial statements that want to think a little more broadly about accounting should buy this book.  Note that the sticker price of this book is stiff, at roughly $1 per page.  Accounting mavens, whether they like the ideas should buy the book so that they can understand the issues involved.  Even if they never become the standards, the ideas are the exemplar for fair value, and represent the opposition view in accounting.

If you want to, you can buy it here: Early Warning and Quick Response: Accounting in the 21st Century (Studies in the Development of Accounting Thought).

Full disclosure: The publisher sent two copies, after I asked to receive a review copy.

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.

PS — The book looks mush nicer than the cover that I scanned, with the abuse that I gave the book.

I like my son Peter.  He works hard, but is occasionally overconfident.  (Where does he get that from? 😉 )  A typical example:

Peter: No, Dad, I am right on this Precalculus problem.  The book is wrong.

Me: Peter, don’t sell me an antigravity machine.  I had one once, but it floated away.  The book is right, and I will show you.

After which, I would write out the answer longhand, and show him that the book was right.  And at the end of the year, when he took the final, I scored his test, and found a wrong answer, so I wrote out the right answer to show it to him, but I got his answer, not the book’s answer.  So I did it another way. Same answer.  I solved it numerically, not analytically — same answer.  The book was wrong. But I never told him, because I did not want to reinforce the overconfidence.

But often, people trust in antigravity machines in the economic arena: ideas that sound good, but have no basis in fact.

1) Start with Japan intervening on the yen.  This is but stage three on the five stages of grieving.  Why does Japan think that it can successfully intervene by itself in the currency markets?  The history of such actions supports the idea that Japan will lose the battle without help.  Also, they were working against momentum, and without economic news that would support a stronger yen.  The intervention should not work, and what will the BoJ do with all the new Dollar bonds that they bought?

2) Or think of Cisco Systems.  They are going to pay a dividend.  Hooray, maturity has come!  Okay, it has come 10+ years too late.  The question is not whether Cisco has excess cash, but whether its management is good at allocating capital, and the answer is no.  Cisco has spent years buying up marginal firms and buying back stock, with no sense for what their company is really worth.  I might have interest at a price near $15.

What most investors don’t get is that earnings matter, but what firms do with retained earnings / free cash is even more important, because that directs the path of future profits.

3) Then there is Social Security Disability — what a foolish program.  If you can’t control the benefits, don’t start the program.  Yet here are three articles:

I’ve seen able bodied people on SS disability.  I’m not saying that all of it is a scam, but some of it is, and the government should make many requalify for aid.

4) One casualty of quantitative easing is DB plans.  The value of their liabilities rises as high quality interest rates fall.  And that drives investment in alternative assets, because it is that much tougher to earn the needed returns in a low nominal rate environment.


This environment is particularly fertile for financial “antigravity,” because many hope against hope in a time of scarcity, and believe that they will do well, even if they have done nothing truly defensive in their investing.

Hope is not a solution.  You may as well believe in antigravity.

When life gives you lemons, make lemonade.  Over two dozen people that survived losing a lot of their money in the Madoff Ponzi scheme wrote down their stories.  For one thing, I’m sure it was cathartic to do so.  Something that many regarded as being one of the most dependable parts of their lives ended up proving utterly undependable.

Out of loss, many of the writers rediscovered the simpler joys of life — family and friends.  Even new friends, as many of them banded together to figure out which end was up.

The tales that the authors tell are not identical, but they certainly rhymed.  Here would be my stylized example of the outline of one of their stories:

  • Growing up in a lower-to-middle class family
  • Being taught to work hard and be frugal
  • Achieved some degree of success
  • Was not sure what to do as the excess assets grew
  • A family member or friend introduced me to Madoff
  • Looked like a smart deal; Madoff always seemed to do well, so the person put most to all of his investable assets there.
  • Sometimes even borrowed money rather than tap the Madoff funds.
  • Life was good; he was charitable, enjoyed life, was generous with friends.
  • The shock came that Madoff was a fraud, a Ponzi scheme.
  • Adding insult to injury, learned that the SIPC would not pay off much at all of the losses, seemingly contrary to their prior actions in other cases.
  • The best option for many was to file as a total loss, and recover back taxes.
  • Retirement dreams turned back to work, and who would hire an old person?
  • Friends and family often proved helpful, but it is hard to go from being a giver to being dependent.

Personally I would like to meet most of these people, give them a hug, and affirm to them that true wealth isn’t money, but relationships.  Poor people are poor because they lack the connections the they can trust, and have the power to help them.

Now, I don’t want to say they should not have seen this coming.  This blog is about risk control in investing.  Remember, you are your own best defender when it comes to investing, and saying “no” is almost always safer than saying “yes.”  Let me quote from a piece written near the time that Madoff was sent off to the pokey:

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.  This man looks successful.  He has a great story; a way to make money that others do not know about.  There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.  Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

  • How are the returns earned?
  • Who checks the results?  (Auditing — should not be a small firm.)
  • Who has custody of the assets?
  • Is the trustee a reputable third party?
  • Is liquidity proportionate to the asset class invested in?
  • Is this under US law?
  • Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
  • Is this marketed to everyone, or just a select few suckers?
  • Is the profit motive of the sponsor obvious and standard?
  • How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

You are ultimately responsible for losses that you receive.  Yes, no one can know everything, but if you don’t have any idea of how someone investing for you is making money, you probably should not invest with that person, because you are incapable of evaluating what they do in broad.

No one with a serious risk control discipline invested with Madoff or Stanford.  These are cases where paying a little for expert help would have paid off big.

Does that mean I look down on those that lost?  Not at all.  Most ordinary investors don’t have the vaguest idea what they are doing.  They are blessed because no one they knew would introduce them to Madoff.  For those that lost, I only have sorrow and pity.  I wish that you had friends and family that would have steered you better.  We all rely on friends, but there is still a danger in that reliance.


As I read more of the book, it felt like some of the authors had rehearsed story lines with each other.  Now, that is natural, because they talked with each other and planned strategy together regarding the SIPC and other hurdles.  So, I don’t begrudge that much.

What I do begrudge is the 8-page investment “analysis” at the end of the book that says that no one should have been suspicious of an 11%/year return, because equity funds from many major mutual fund companies earned 11%/year over the same period.  Total hooey.  Few would have invested with Madoff given the lack of disclosure had not the returns been so regular on a monthly basis.  The mutual funds had large runs up, and large drawdowns.  Investors, not savers, would buy such mutual funds.  The attraction of Madoff’s scam was that it was designed for savers, not investors.  No volatility, high returns, no worries.  Thus someone with the personality of a saver could put money there, and not worry, because Uncle Bernie was a genius who was taking care of them.

And indeed, Madoff took care of them, with malice.  The underfunded SIPC could do little to help, given the enormity of the fraud.

Who would benefit from this book

Anyone who wants to sympathize with and support those who lost to Madoff would benefit from this book.  It does a fairly complete job, and is not long at ~230 pages.  As I write this it is, out of stock at Amazon, but when available, you can buy it here: The Club No One Wanted To Join-Madoff Victims In Their Own Words Barnes & Noble does have copies.

Full disclosure: An author sent me a copy, after asking if I would like to receive a review copy.

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.

When Microsoft decided to do its special dividend in 2004, I was interviewed by  I commented here:

In addition, the stock may avoid falling a full $3 because many investors believe the cash is better in their wallet and not in Microsoft’s. “Some people might say, ‘Well, good, that means Microsoft can’t waste the money on an acquisition that might not be so good,'” said David Merkel, a senior investment analyst with Hovde Capital and columnist for “So it might actually make Microsoft’s stock price go up a little bit.” (Merkel’s firm does not hold Microsoft shares.)

“Cash is worth more in my hand [than the company’s hands] almost always,” Merkel added.

And then at the same time here:

“In a case like Microsoft, where management has committed to returning cash to shareholders, you can value that cash at face value,” said David Merkel, a senior analyst with Hovde Capital and columnist for He believes the only time to deduct a company’s cash on a dollar-for-dollar basis is when there is a definite liquidity event, such as Microsoft’s special dividend, that truly gives investors control of the cash.

In the early 1980s, cash had that dollar-for-dollar value because so many corporate raiders were putting the cash on their balance sheets for use in buying other companies.

But in today’s world, a more likely use of cash might be buying back stock — a step Microsoft is taking in addition to its special dividend. But announcing a buyback plan is no guarantee a company will buy the shares, Merkel noted. Hence, he would only deduct 90 cents for every $1 of cash from a stock’s price to value a stock because of uncertainty as to whether management will use that cash as it says.

Another situation in which you might not give a company full credit for its cash is if you don’t fully trust management, perhaps because it has a bad track record with acquisitions or expanding into new markets, Merkel said.

My view was that Microsoft was a mature business that needed to return cash to its shareholders.  The more, the better; cash in the hands of management was leading to poor acquisitions and overpriced buybacks.

Now consider the returns on MSFT stock from August 2004 through August 2010:

Microsoft Returns

Less than 1%/year does not make it, particularly when the stock is basically a wasting trust.  I don’t have interest in the company, because they have consistently bought back shares at high prices — near $34/share over the last four years, considering issuance to employees.

Also, Microsoft may look cheap on an earnings basis after deducting cash, but much of the cash is not free to be dividended.  Microsoft would have to pay taxes to repatriate the money.  (Can’t they find a clever transfer-pricing accountant?)  Why pay more than six times tangible book for a company that is not growing its earnings rapidly, and misuses its free cash on buybacks and acquisitions?

So when I hear that Microsoft will borrow money to fund dividends and a buyback, I say, “Why pay money for financial engineering?  Better you should look for genuine organic growth.”  There is nothing good to be found in Microsoft, look elsewhere for value among tech companies.

Every 100 posts or so I try to look back and think about where we have been.  At the last century mark, things were very different.  I was employed, though I wondered about the staying power of my firm.

Since then, I have spent time with the staff of the Congressional Oversight Panel regarding AIG.  They used a decent amount of my work in their report.  I have also spent some time talking with regulators, congressional staff, over a variety of things that I write about.  Proximity to DC helps.

Proximity to DC also allowed me to attend events at the Cato Institute, American Enterprise Institute, and Heritage Foundation.  I must admit that I was generally disappointed by what I saw there.  I am basically a libertarian, but one that appreciates that there are some areas that is impossible to be “hands off,” places where average people can’t accurately estimate the deal that they are entering into.  Also, many of the problems of our society are more complex than dealing with tax, spending, and regulatory policy.  In many cases social issues would have to be solved for the economic issues to be solved.  But politicians tiptoe around such matters, because they are not willing to risk their careers without any significant chance of reward.

Since the last century mark, I wrote the “Education of a Corporate Bond Manager” series, and added to my “The Rules” series.  I also appeared on StockTwits TV, interviewed by the estimable Tadas Viskanta.  A half hour never moved so fast.

One more change for  me.  Though I still work from home, I now have an office in my home.  Two of my children moved out, and after shuffling around the remaining five children as they would like it, I ended up with the small room that allows me to concentrate better while my wife homeschools.  I like it a lot, but I miss being able to comment on history, science, and math.  That said, I am guiding the oldest remaining through Calculus.

In terms of new things for the blog, I was sad when my old WordPress format broke and I could not fix it.  I like the new format, and that it loads fast.  I will be doing a lot of book reviews in the near term, and I will be adding a new page to summarize my book reviews by category.  Let me know if you like it, of if it is wasted effort.

I am also looking to do a few small blog fixes to increase contrast, type size, and add a print article option.  I am open to other ideas for improvement, so please comment, and I will consider it.

Changes for David

I have settled on setting up my own asset management shop.  I will manage separate accounts, including services to help minimize taxation.  I will only be managing equities, though I will offer the equities two ways: long only and fully hedged, where I sell futures contracts against the equities, to eliminate market exposure.  My next steps are:

  • Incorporate as an LLC in Maryland.
  • Set up my RIA.
  • Set up an arrangement with a clearing broker, who will provide brokerage, custodial and client communications services.
  • As things get close to being set up, I will talk with those who have expressed interest in the past.

A question to readers already providing separate account management services.  Is there anything material that I have left out here?  If so, would you e-mail me?

My initial minimum is likely going to be $100,000.  Fees will be 1%/year for accounts below $1 million, and slide down from there.  I have some preliminary marketing documents available for discussion purposes only.  E-mail me if you might have interest.  Please understand that all figures in the documents have not been audited.  That said, those that evidence serious interest can look at all of my account statements over the last 10 years, and receive an Excel file that reconciles all of the results to the penny.

Now I may get my track record audited when I get big enough, or if enough people tell me that I have to do it.  I am reluctant to do it before I know that I have a sustainable business.  The auditors charge a lot for what they do, and personally, I’m not sure I would trust the non-forensic audits that they do.  So you tell me, do I need the audit?

Later, once I get going, I would look to set up a mutual fund for smaller accounts, perhaps by buying up the management contract for a failed mutual fund, and using the tax losses to shield initial income for my shareholders.  There are also cheapish ways to set up a series trust for those that want to start a new mutual fund.  I would try those if I can’t recycle an old mutual fund.

So if you have interest in learning about what I am up to, you can e-mail me here.  Beyond that, I live near Baltimore and DC.  If you have a significant interest we can meet.  I will also be in NYC the third week of October, and am available to meet people then, and in Denver the second week of November  for similar meetings.


Finally, as I always do, I want to thank my readers and commenters, even those that disagree with me.  You make my blog a richer place, and I am grateful that you take time to consider what I think.  I write my blog primarily as a means of giving back for all of the good that I have received in society; I hope and pray that it benefits you a lot, and that God would bless you in all matters.



PS — By the way, do I need to take the series 65 exam?

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.  Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

I have been invited to speak twice in the next two months on the efficient markets hypothesis [EMH].  Once in Denver, once in NYC.  Fortunately for me, the folks in Denver are paying my way, and I will take a regional train to NYC and back.

I grew up on the idea that the EMH in its weak form was true, no doubt.  No one can make money looking at past price movements.  As for the semi-strong form of the EMH, which says that you can’t make money off of any past or present public data, I believed it with some reservations.  My mother was a self-taught investor who regularly beat the markets.  She used a discipline of half utilities (“they are my bonds”) and half “growth at a reasonable price” [GARP] stocks.  She is why I went to Johns Hopkins, rather than the University of Wisconsin.

The EMH in its strong form, that no one can make money off of insider information, was doubted by almost all.  Even today, we track insiders, and there is money to be made by following them.  Even following 13F filings of successful investors is profitable to many.

Yet, the EMH is compromised even in its weak form.  When one reads academic research on the markets, what is the most durable and powerful of all of the anomalies? Price momentum, which violates the weak EMH.  That said, a lot of economic actors know that price momentum works well, and so it gets used.  And overused.

Any strategy can be overused.  Before a strategy peaks, the overuse of a strategy makes the strategy work overly well, as prices for stocks are pushed above equilibrium levels through strategy momentum.

In the long run the stock market is a weighing machine, so the short-term overshoot will correct itself eventually.  But when too many follow momentum, the market goes wild.  Volatility rises; daily moves tend to be up or down a percent or more.  During such a period, price momentum stops working for a time, until enough abandon the strategy.

The same applies to longer term strategies, like value investing, or overweighting small companies, or overweighting companies with sound financials, or low price volatility, etc.  Any one of these can be pursued too much.  When any of them is pursued too much the stocks involved will overshoot and plunge.

There is no magic strategy that works all of the time.  Smart investors have to be aware of almost all of the strategies that exist in the market, and understand when they are underplayed (buy) and overplayed (sell).

Healthy markets have multiple strategies that work.  When the strategy becomes monoculture, e.g. tech stocks, then beware.  When there is only one road to wealth, the market is in a bad place, and smart investors will hold cash, or invest conservatively away from the one thing that is working now.  Broad leadership is needed in a true bull market.  When leadership thins to one idea, it is time to take profits.

Don’t confuse brilliance with a bull market.  Try to understand where you are in the cycle of your stock picking strategy.  It does not work all the time, so when things are at the best that you have seen, wait a bit, and then take two steps back.  When things are horrible, wait a while and redouble your efforts.

Factors in investment returns move in cycles. Be aware of where you are in the cycles, and maybe you can profit from them.

This is the first time I have done something like this, but I am interviewing an author of a book on Risk Management, which delves into the nature of the current crisis.  My interview occurs before the book is published, and lends to its publicity, which I don’t mind because I think it is an excellent book. The book is entitled, “Risk and the Smart Investor,” and is written by David X. Martin.  Anyway, here are the questions that I will ask him:

  1. Imagine you are talking to a bright 12-year old girl.  How would you explain to her why and how the financial crisis happened?
  2. I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.  The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.  How did you hit upon this intriguing and novel way to write your book?
  3. Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?
  4. As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.  They did not like answers like, “I don’t know, it could have six significant effects on our company.”  How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?  How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?
  5. In your experience, how good are the managements of financial companies at establishing their risk tolerances?  Better, how good are they at enforcing those limits, such that they are never exceeded?
  6. How do you create a transparent risk culture in a firm?  How do you get resisters to go along, even if it is management that does not see the full importance of the concept?
  7. Are most cases where a person or a company fails to diversify intentional or unintentional?  Do we put too many eggs in one basket more out of ignorance or greed?
  8. Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?
  9. I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.  Was it the same for you at Citigroup when your “Windows on Risk” got tossed out the window?
  10. Can culture and personal judgment work in risk management ever?  Take Berkshire Hathaway – risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.  If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?  (Remember, you don’t want to disappoint Warren.)
  11. How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?
  12. Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?
  13. Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.  Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?
  14. Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.  Why did they miss such an obvious area of risk management?
  15. How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?
  16. I have often turned down shady deals in business, saying that you only get one reputation in this world.  How do you encourage an attitude like this in financial firms among staff?
  17. A lot of portfolio management and risk management is juggling different time frames.  Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?
  18. Most developed country economic players assume that wars will have no impact on their portfolios.  Same for famine, plague, or environmental degradation.  What can you do to get investors to think about the broader risks that could materially harm their well-being?
  19. Are Rob’s more common in the world than Max’s?   That’s my experience; what do you think?
  20. At the end of your book, one of your friends dies.  Did you mean to teach us that even if we manage our risks right, we still can’t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?