December 2010 – Page 4 – The Aleph Blog

Changes for David — IV

Posted on 3 December 2010 by David Merkel

My goal is to open for business at the beginning of January 2011.? I could have started earlier, but I didn’t feel that giving clients an additional bit of tax data was worth the early start.? In general, I have spent the extra time trying to make sure that I get things right at the start.

Here is my remaining to do list:

Decide on Custodian/Clearing Broker ? Any thoughts from Dailey?
Compliance Strategy, Including Web Compliance Strategy, CFA Document Retention
Procedures for suitability ? CFA notes, Investment Policy Statement
E&O Insurance
Marketing ? and deal w/e-mail, Linked-in day, other contacts, Press Release
Strategy for Illiquid names ? DIIBF, PCCC, IBA, NWLI

Deciding on the custodian/clearing broker is the biggest item, and affects #4 as well.? I am leaning toward Interactive Brokers, because I like their cost structure for small accounts, and they offer a lot of tools to be able to trade cleverly, particularly in an era of high frequency traders.

The downside is that they aren’t good on the service side, which means that I will have to compensate, and be the friendly front end for my clients.

Proxy Voting Policy

I modified the proxy voting policy of one of my readers, and I thank him for his help.? I disagree with him on a few issues, so I don’t want to name him or explain where we differ.? Instead, here is my proxy voting policy, and I solicit your comments.

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Aleph Investments, LLC Proxy Voting Procedures

The Chief Investment Officer shall responsible for voting all shareholder proxies. It will be the Chief Investment Officer?s responsibility to ensure that all proxies are voted in a timely manner. Proxies shall be voted in the best interests of shareholders, with an emphasis on voting against any management proposals that act in general to insulate companies from the discipline of the market or accountability to shareholders.

Specific Policies:

A. Corporate Governance

1. Unless exceptional circumstances exist Aleph Investments will vote against proposals that make it more difficult to replace Board members, including proposals to:

a. Stagger the Board;
b. Overweight management on Board;
c. Introduce cumulative voting;
d. Introduce unequal voting rights;
e. Create supermajority voting;
f. Establish pre-emptive rights.

Aleph Investments will vote in favor of any proposals to reverse the above.

Generally, Aleph Investments will withhold its vote for directors who hold little or no stock in the company and have been on the Board for three years or longer, or for new directors who appear to be primarily political or show appointments who do not appear to possess skills or knowledge that is relevant to the company’s business.? Aleph Investments also favors separating the roles of Chairman and CEO, and not having the CEO on the nominating committee.

For companies that have not given us an adequate rate of return (subjectively determined), we will vote down all questions and positions proposed by management, including the auditor.

B. Takeover Defense and Related Actions.

Aleph Investments generally will vote against proposals that make it more difficult for a Company to be taken over by outsiders, and in favor of proposals to do the opposite. The reason for this is that we believe that corporate management should be subject at all times to the incentives and punishments of the market, not insulated from them.

C. Compensation Plans.

Aleph Investments generally will vote against most large incentive pay proposals, with the exception of those that are meant to apply to ordinary employees.? Most of the time, management teams are paid well enough; it should be enough incentive for to have moderate incentives, and know that if you can?t deliver, you will be replaced, just like the rest of us.? Once management teams get too well off, they tend to underperform.? Also, we prefer management compensation to be tied to things management/workers can work on, like net operating income or change in book value, rather than stock valuations, which they can?t affect much.

In addition, Aleph Investments will vote against any compensation that would act to reward management as a result of a takeover attempt, whether successful or not, such as revaluing purchase price of stock options, golden parachutes or handcuffs, etc.

D. Capital Structure.

Aleph Investments generally will vote against proposals to move the company to another state less favorable to shareholders interests, or to restructure classes of stock in such a way as to benefit one class of shareholders at the expense of another, such as dual classes (A and B shares) of stock.

E. Noneconomic Proposals

Aleph investments will generally vote against noneconomic proposals.? We expect firms to follow the law in the places in which they operate, and to observe general ethics beyond that.? We don?t want firms to follow the ethics of tiny minorities who submit proxy proposals.

F. Size of Board

Aleph Investments will vote against any proposals that act to increase the size of the board beyond
12 – 15 members. We believe generally that large boards have a more difficult time with major changes and other important decisions, and that responsibility is more easily avoided and diffused among too many members.

G. Appointment of Outside Directors.

Aleph Investments will vote against any proposal to allow the CEO to appoint outside directors, and in favor of any proposal to eliminate this ability. The Board’s outside directors should not owe their position or allegiance to a member of management, but to the shareholders and/or independent board members alone. For the same reason, we may vote against any outside Board member who has business dealings with a company on whose Board he sits. Allowable exceptions may be venture capitalists who helped bring a company public, and have a great deal of industry knowledge; senior management of companies in industry sectors served by the company, and who may have valuable insight to contribute regarding industry competitive and business factors; and similar factors that may contribute to the knowledge level of the board members.

H. Multiple Director Positions

Aleph Investments will generally vote against any Board member who is also a Director of four or more different companies. Multiple directorships are time-consuming, especially for senior management of other businesses who have other full-time jobs. We find it difficult to believe that in such cases the Director can adequately fulfill his or her responsibilities to the shareholders.

I. Incentive Stock Award Programs:

Aleph Investments will vote against incentive stock awards that act to concentrate significant amounts of stock in the hands of upper management. While we understand the need to incentivize management by placing a significant amount of upper management and director compensation and net worth at risk in the stock market, this needs to be meaningful only at a personal level. It should not necessary to set aside a significant proportion of shareholder capital for a limited number of upper management personnel in order to incentivize them.

Aleph Investments will support proposals that force executives to put their own money on the line in company stock in exchange for other incentives.? We are putting our money on the line, so should managers.

J. Conflicts of Interest.

Due to the nature of our business and its small size, it is unlikely that conflicts of interest will arise in voting the proxies of public companies, because Aleph Investments, LLC does not do investment banking, or manage or advise public companies.

Full disclosure: long DIIBF, PCCC, IBA, NWLI

Industry Ranks December 2010

Posted on 2 December 20102 December 2010 by David Merkel

I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I like technology names here, some utilities, and healthcare-related names, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

I?m looking for undervalued and stable industries.? Human resources ? sure, more part time workers.? Healthcare information?? A growing field, even with the new ?health bill.?? Same for Biotech.

Even in a double dip, phone calls will still be made, and the internet will still be accessed.

I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is more highly cyclical than I have seen in quite a while.? I will be very happy hanging out in dull stocks for a while.

This report I will continue to publish after my firm commences operations at the start of 2011.? But I will delete my portfolios at Stockpickr.com, and will only report trades after all of my clients have their orders filled.? More to come on all of that.

Nonidentical Twins: Solvency and Liquidity (III)

Posted on 1 December 2010 by David Merkel

This is the third part of an irregular series on solvency and liquidity.? This time, though, I am not focusing on corporations, or accounting rules, but on countries and municipalities.

With the crisis in the Eurozone, there are times of calm, and then times of panic, with seemingly little warning for transitions.? Let me try to explain why this happens, even though it won’t explain why it happens on a particular day.

A country with a profligate fiscal policy builds up debt beyond its ability to repay if bad times were to come, but times are good, the country is growing rapidly, and most think that there will be more than adequate ability to repay given the growth of GDP.

Or, the financial sector grows of a nation far more rapidly than GDP, abut again, in boom times, the profits of the banks are roaring ahead, and only cowards or bears would question the prosperity of a boom.

But the truth is, during a credit-driven boom (whether governmental, financial, or other), much of the supposed prosperity is a mirage.? The additional leverage pushes up asset prices until the cost of financing the assets exceeds the yield the assets throw off by a small margin.? Economic agents have to rely on capital gains to make money, and that is where bubbles pop, and go into reverse, with a vengeance.

With nations, an overleveraged situation is revealed during a bear market.? Asset prices shrink.? Incomes shrink.? Demand for welfare payments rise.? Governments that relied on expanding asset prices are revealed to be the spendthrifts that they are.

Now, when a government is overleveraged, but interest rates are low, the situation is potentially unstable.? A rise in rates could tip the scales.? Market actors would conclude that they can’t survive at rates high than a certain threshold, so sell the debt now, in case rates would get so high.? That action forces rates higher, leading to a self-reinforcing panic.

Sometimes this happens in advance of a debt refinancing, leading some politicians and bureaucrats to say the forever bogus phrase, “This is not a solvency crisis, this is a liquidity crisis.”? Sorry, if you play near the cliff, don’t complain if you happen to fall off.

Liquidity crises do not happen to governments with low debt levels.? Liquidity crises are solvency crises during the panic phase, before they are revealed to be solvency crises alone.

It is difficult to change government behavior, because the politics of reducing spending, or raising taxes is tough.? Once a crisis hits, there are protests.? People point at shadowy interests that are denying them the illusionary prosperity of the boom; conspiracy theories thrive.

With the Eurozone, there are contagion effects; panics in one nation prompt investors to look at other nations, and leave weak situations.? Crises separate good and bad credits.? That may push bad credits over the edge.? Again, never play near the cliff; always ask, “Could we survive easily in bad times?”

The difficulty for the strong nations of the Eurozone is that their banks lent a lot to the fringe nations that are failing.? Thus the strong are likely to bail out the fringe, though a more prudent course would be to bail out their own banks after a promise limiting lending abroad.? The real political question is what is the price that Germany will charge to bail out the Euro?? What sovereignty will the fringe have to give up?? And what will the German and Fringe electorates tolerate?? Perhaps the intersection set is null.? No agreement.? At that point the Eurozone shrinks or ends.

The proper solution for the Eurozone fringe, and other deadbeats in this crisis, is to negotiate writedowns of debt, and cut them off from borrowing at the rate they were accustomed to receive.? Recognize losses, and wean them off credit.? If not, let them fail, and bail out your own banks, which is cheaper than bailing out the fringe.

Pressures are building.? If the Eurozone survives in its present form, it will be because Germany bailed it out, at some political price that they will specify.? Investors should look at cash financing schedules and balance sheets to evaluate the future solvency of Eurozone nations.

And, lest the US smirk, the same exercise will come here, reserve currency or not.