Recently, I made a visit to the Cato Institute, and I bumped into a guy who indicated he was interested in investing with me.  We exchanged cards, and around 10 days later he called me, telling me about his scheme for investing the money of (my and other) IRA investors in wind farms that he had in upstate New York.

He talked for a while, and I said, “So are these limited partnership interests?”  He said no and rattled on about the opportunity.  I then asked, “Is this a private company, and you are offering shares?” He said no and rattled on about the opportunity.  I then asked, “Are these general partnership interests?  He said no and rattled on about the opportunity.  I then asked, “Is this some sort of structured note?”  He said no and rattled on about the opportunity.

I then said, “Stop.  If after five minutes, I can’t tell what it is that you are doing, it can’t be anything good.  I have worked in almost all areas of the securities markets, and if you can’t tell me the legal form of what you are doing, I have no interest, particularly not for my clients.” He rattled on about the opportunity, and I hung up on him.

Note: confidence is not a bad thing, but hyper-confidence is.  If someone is not willing to quickly trot out the risk factors on an investment, avoid them.  All investments have risk.  REPEAT: ALL INVESTMENTS HAVE RISK.  There, I feel better now.

I have said before, and I will say it again, “Don’t buy what someone is trying to sell you.  Buy what you have researched and want to buy on your own.”  Hey, I got cheated on penny stocks when I was young and inexperienced.  Many of us make mistakes when our knowledge is immature.

Also, even in institutional investing, I can tell you that complexity is the enemy of the one receives it.  I avoided most complex transactions when I was a corporate bond manager.  While working for the hedge fund, I happily set up a structured note that reflected my view of the world, after refusing one the broker created.  We won on that one.

So avoid complex investments.  Particularly avoid investments that you don’t understand.  At minimum, find a competent friend, or some neutral party that will look at the deal.  If you can’t find such a friend/party, don’t do the deal.  The friend is important, because he does not want you to come to harm, or lose you as a friend if things go bad.

I have a friend, the son of a dear deceased friend of mine, who seemed to attract Nigerian-style scams the way dryer traps collect lint.  I finally took him aside and said to him, “Ignore these.  If it is too good to be true, it most likely is too good to be true.”  Happily, he took the hint, and did not lose a dollar to the scammers. (I lost a couple hours proving the opportunities were bogus.)

Financially, this is a dangerous world, outside of the well-established channels for investment.  (I write this as one with significant private equity investments.)  Be careful in how you allocate your funds, and don’t give into a slick pitch that promises high returns (over 7%), or extreme safety (no way you can lose), without significant due diligence.

Update: One more note.  I often find it useful to ask the seller to send me all of the documents, and tell him that that I might pass them by my lawyer.  I don’t have a lawyer; for practical purposes, I am my own lawyer on securities matters.  I can read the documents myself as well as any lawyer.  But that usually cools the ardor of any con man; he knows that the deal will not get done, and he gives up.

January 2011March 2011Comments
Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.Shades up their view of GDP. They are much more bullish on employment.
Growth in household spending picked up late last year, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising,Household spending and business investment in equipment and software continue to expand.Household spending is no longer constrained by high unemployment, modest income growth, lower housing wealth, and tight credit?   News to me.
while investment in nonresidential structures is still weak. Employers remain reluctant to add to payrolls.However, investment in nonresidential structures is still weak,More bullish for employment, which I think is premature.
The housing sector continues to be depressed.and the housing sector continues to be depressed.No real change.
Although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer-term inflation expectations have remained stable, and measures of underlying inflation have been subdued.They note that measured inflation is not going down, and that commodity prices have risen.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.No change.
The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.New paragraph.  They have to say something about commodity price inflation.  It is certainly showing up in grocery stores and gas pumps.
Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.So progress isn’t disappointingly slow anymore?  News to me.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.No change.
In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.No change.

They will stealth-fund the US Government to the tune of $600 Billion.

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.No change to this meaningless sentence. What? You would do otherwise?
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.No change.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.No change to this meaningless sentence.

Would you do otherwise?  If we know that the opposite is impossible, why have the sentence at all?

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.No dissent.  Where are the so-called hawks?

Bye, Warsh.

Comments

  • The FOMC seems a lot more bullish on the strength of the economy, especially employment.  I would be reticent to raise my views by that much.
  • They highlight that they have a “statutory” mandate, and a “dual” mandate.  They are trying to say that they are required by Congress to do these things, and that it is a tough job.  The flip side is that they admit the Congress has the right to tell them what to do, which they may stop saying if Ron Paul gets too noisy.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • Where are the so-called hawks?  This report does not give a fair rendering of the rising risks of inflation, driven by commodity, agriculture, and energy costs.

I’m in Chicago today giving a talk on Who Dares Oppose a Boom? Here is a copy of my presentation.

The main idea is this: enough people benefit from credit bubbles in the short run that it is impossible to oppose credit bubbles once they get started.  They have political, economic, and societal support.  The nature of man is to seek free money, whether as consumers, businessmen, or politicians.  People are willing to suspend disbelief when times are good.

All for now.  Will write more in the next two days.  Remember, Japan has much bigger problems than the quakes and nuclear incidents, which should make you more bullish on Japan; the current problems will fade.

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, though I can never find companies that I can understand.

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.

That’s why I’m not digging through any red zone stocks this time.  I don’t see the value, especially if we have a slowdown globally, and/or in the US.  I don’t trust this economy.

Insurance is a part of my life.  I’ve spent more than half of my life working with insurers in one way or another, and when unusual events happen, my phone rings, or I get e-mails, with people seeking insight.  Recently it has been regarding AIG, but in the last day it has been regarding reinsurers.

Full disclosure: my clients and I own shares in PartnerRe [PRE].  I may take positions in other reinsurers, but I am not planning on that anytime soon.

So, one friend of mine who writes a pseudonymous blog wrote me, saying:

Hi David – perhaps you can shed some light on this – for years I’ve heard the logic that catastrophes are bullish for insurers, as it allows them to raise rates.  I REFUSE to believe this.  I cannot for one second imagine that insurers would choose A) catastrophic payouts and rate increases vs B) no payouts and lower rates.

Here was my response:

They are bearish for insurers with large exposure to the contingencies, and bullish for insurers with no/little exposure to the contingencies.  But in aggregate, it is bearish – think of the “brick through the window” fallacy on GDP.

David

PS – the better managed, less levered insurers/reinsurers do tend to do relatively better out of big crises, because they will have the capital to write the juicier business in the next year…

Now, PartnerRe was off a little today, but that doesn’t surprise me much — they usually have a little exposure to everything.  Very diversified in their liabilities, and conservative in the way they run their business.  My kind of reinsurer.

But then Flagstone Re was off over 12% today.  I owned this at one point in time, but don’t now.  After today’s losses, I may revisit them, but I am not in a rush.

Story: in 2004 and 2005, working for a hedge fund, I found the reinsurers to be some of the most intriguing companies to invest in, or short.  Particularly in hurricane season, there were a lot of trading opportunities.  Whenever there are significant events, you start keeping a spreadsheet, and as companies report likely losses, you populate your table.  You have to talk with investor relations, or the CFO, to see whether a company plays in that area of reinsurance, and to what degree.  Most of this is not in documents filed with the SEC, until results come afterward, through press releases, and 8Ks.

In 2005, one company, Montpelier, admitted no significant losses after Katrina, and it really stood out as an anomaly on my spreadsheet.  This was the only time I have ever gone from long to short on a company, ever.  Eventually Montpelier admitted the claims that were coming, and the stock price adjusted lower, and we covered.

Now, I am not up on all of the exposures of reinsurers at present.  Were I back in the saddle as a buyside analyst, I would be building my spreadsheet, and calling reinsurers to get an idea of how much exposure (not losses per se, but did they write business there?) they have to the recent troubles:

  • Last year’s New Zealand earthquake
  • Flooding in Australia in December and January
  • Tropical Cyclone Yasi (Northern Queensland)
  • This year’s New Zealand quake
  • The current Japan quake

Now if I were more of a trader, after research I might be inclined to take positions in Aspen, Axis, Flagstone, and Platinum.  But there is a lot of research to be done here, and I would not take any positions without significant due diligence, which I have not done here.

So be careful.  Rule number one is don’t lose money.  Rule number two is don’t forget rule number one.

Full disclosure: long PRE, for me and for clients

I was pleasantly surprised by this book.  Given the nature of the authors, for McKinsey & Company, I was predisposed to dislike it.  But I liked it.

What is the value of a corporation?  It is the value of the free cash flows discounted at the cost of capital.  That’s basic.  And yet, they unpack this simplicity into basic elements, without going overboard into a ton of detail.  Value derives from:

  • Return on invested capital
  • Revenue growth
  • Cost of capital

But value does not derive from growth in EPS.  I think that Peter Lynch brainwashed a lot of investors, and made them think that growth in EPS is everything.

What this book suggests is a need to unpack accounting statements to get a sense of whether value is being created or not.  Following the income statement is not enough; reviewing the level of accruals on the balance sheet helps a lot.

There are many things that don’t affect value:

  • Capital structure
  • Earnings management
  • Accounting rules

What does matter is finding new products and processes that change the value of the future free cash flow stream.

Quibbles

They spent little time on the cost of capital.   They could have done more there.  That may seem small, but given all the errors that have occurred there, particularly from those that took on too much debt, it would have been valuable to spend more time guarding against aggressive liability structures.

Who would benefit from this book: Most investors would benefit from this book a little.  If you are familiar with the arguments, as I am, there is no benefit.  If you are inexperienced, the book is probably too advanced for you.  Those who would benefit the most have moderate experience with fundamental investing.

If you want to, you can buy it here: Value: The Four Cornerstones of Corporate Finance.

Full disclosure: The publisher sent this to me after asking me if I wanted it.

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.

A few notes before I begin for the evening.  First, I have two piles of books sitting next to me — one pile of mediocre books, and one pile of lousy books.  Should I review them, at least in summary form, or should I leave them unreviewed?  It’s ten books in all.  I never know what to do with books that are marginal at best.

Second, with the aid of one of my children, I have completed categorizing my book reviews.  All of my book reviews are ranked within their categories, with links to my reviews, and commentary on who the books might be useful to.

Onto tonight’s thoughts with an email from a reader:

I’m a big fan of your blog and have kept up with it since I started in the investment industry 3 years ago.  I was wondering if you had any advice on standing out in the Defined Benefit world as far as process and investing goes.  I’m on a team that has developed an investment style and philosophy that is highly unique to retirement planning for individuals/families, but it has become very difficult to translate that into the DB world.

I’ve been on both sides of the table here.  I’ve worked with DB plans, Trustee-directed DC plans, 401(k) and similar plans, and individuals.  Personally I would like to work with more DB plans myself, but I will share with you what I know or believe.

The first distinction with DB plans is do they retain a investment consultant or not?  If the answer is not, it means that they might not be slaves to modern portfolio theory, and might think about investment in a more businesslike way.  They would probably be more responsive to the way you do things.

If they have a consultant, then you have to approach them through the consultant.  The consultant is in a tough spot.  Most of them don’t know much about investing, but they have a wide variety of quantitative tools that have been developed by academics that allow the consultants to protect themselves while delivering little-positive-to-large-negative results for clients.

All of the statistics that the fund management consultants calculate assume a world where risk is equivalent to variation, rather than permanent loss of capital.  The consultants would rather see someone that outperforms by a tiny bit each period, than a manager that outperforms by a lot over the same set of periods, but with a lot of variability.  They are the opposite of Buffett’s phrase, “I would rather have a lumpy 15% than a smooth 12%.”

With DB plans, all they care about is investment results versus their benchmark.  They don’t care so much about winning, because they can blame and remove underperforming managers who consistently miss by a little.  What they do care about is those that miss by a lot, because that could cost them their cushy jobs.

This is one area of investing that I would purge if I could; in general, the fund manager consultants do little for the plans they serve.  Far better if the consultants actively analyzed risk, and encouraged plans to take more/less risk when circumstances favored/disfavored it.

Instead, they propagate views that are risk-neutral, as if all styles are equally valid all of the time, and all asset classes are equally valid all of the time.

Now with individuals the game is different, because there are ways to add value through tax-management, and in some cases, ethics management.  With pension plans, those issues are moot.

Now, if you have a good track record of delivering alpha with little variation versus some sector of the market, or the market as a whole, advertise that to the fund management consultants.  Get in the databases.  It’s all a performance game, and one with little tolerance for variability versus their benchmark indexes.

So, part of the reason for your difficulty stems from this: the market to serve individuals is a free market, albeit one where there are a lot of charlatans plying their trade.  The market for DB plans is a bureaucratic market for the most part, one where sponsors who don’t know investing abandon their responsibility to other who have modest math skills, but who also don’t know investing.

That is your problem, and mine as well.  More is the pity for the sponsors of DB plans.  They are the ones who get hurt in the long run.  A pity they never learn, but only terminate.

A few notes before I start.  This last month was probably my sickest month in 30 years.  I’m on the upswing, but not up to 100%.  Makes me grateful for how healthy I have been most of my life, and also how healthy my large family has been — this was a rare time when we were all sick.

Note two: I ‘m going to be in Chicago on 3/15, and NYC on 4/11.  Those who might like to talk with me should e-mail me, and we can discuss it.  Note: I am frequently in western Pennsylvnia — those from there who would like to speak with me can email me anytime.  Beyond that, I know that I will be in central Indiana in late June, and San Diego in early July.  Want to meet with me?  Let me know.

-==-=-=-=–=-==-=-=-=–=-=-=-=-=-=-=-=-=-=-=-==–=-=

I’m afraid tonight’s topic is too plebeian.  Because I don’t think in “budget cut” terms the way DC does, I am not impressed with what is being discussed in DC, and in most of the states where there is a shadow of budgetary furor.  Also, because I don’t think about budgets in the “cash” accounting terms that so many do, I am not impressed with what so-called radicals are proposing.  We need to start thinking in full-fledged accrual “net present value” terms with discount rates in the 4-5% range.

To me the Democrats and Republicans are Frick and Frack.  There is little true difference in what they are proposing.  Until I begin to hear real proposals on Medicare and Medicaid, or lesser proposals that are shocking: “We propose to end the departments of Interior, Agriculture, Commerce, Labor, HHS, HUD, Transportation, Energy, Education, Veterans Affairs, EPA, and Homeland Security.  The other departments will be cut in half at minimum, including Defense.”  (There has not been a war I have been in favor of in my lifetime.)

I believe in shared sacrifice.  I would accept the Bush tax cuts being sunsetted.  The budget holes are so big on a long-term basis, that if real cuts aren’t proposed, much less made, that there is no way that the budget will come into balance in the long run.

Cuts like this would result in large job losses in the short run, while in the long run, intelligent labor would get released to more productive uses, leading to far more growth in the long run.  Face it, when so many work for the US Government, it is no surprise that the economy grows so slowly.

So many radical and rational decisions founder because there will be job losses.  I say look past the initial troubles, and think of Eastern Europe.  The nations that took the pain recovered the most rapidly.

Even as our monetary policy has been messed up for over 25 years because central bankers thought we couldn’t take any pain, so should fiscal policy assume that we can take pain.  It is troublesome in the short run, and beneficial in the long run.  One weakness of many macroeconomic models is that they don’t take account of the long-term resilience of economies, but focus on short-term losses, as if that were all that goes on.

When the budget is this far out of balance on a net present value basis, every sane proposal sounds insane to those who think the past should continue.  And many insane proposals sound sane, thinking that the past is prologue.

Okay, who is willing to step up, and balance the budget in the long run?  Who?

The silence deafens.  Maybe we will get some who say it never has to be balanced, or that we just have to get deficit growth below nominal GDP growth, or that we can do an external default that sabotages the rest of the world, while we get our house in order.

Sadly, our time of flexibility has escaped us.  Aside from the concept of an external default, or creating a dual currency, things are probably so bad that we are simply waiting for the crisis to hit, and that there are no measures that can prevent the crisis now.

(Still, the easy way out is eliminate Medicare and Medicaid.  But who would have the guts to try that?)

I ordinarily think of the world as messy, but it is unusual when the world validates my opinions.  Civil war in Libya?  Whouda thunk it?

But that is why prior preparation is valuable.  Not that I have a anti-mess portfolio trading as an ETF.  That’s not the way I think.  Besides, it is very difficult to come up with negative plays of any significant size.  And that is the nature of the world.  With global trade so large, we are one big happy world.  Wars anywhere tend to produce losses, and even if you own energy equities in size as I do, the losses are still significant.

This is yet another reason why I argue that it is important to invest with a provision for adverse deviation.You can’t tell what the global situation will kick up.  So adjust your portfolios for flexibility, recognizing significant constraints, like energy and agriculture.

My but the time passes rapidly.  When I was invited to write at RealMoney, because of compliance issues, it was several months before I wrote there.  And i wrote there for about four years, never thinking that I might write anywhere else.

But I had a guilty pleasure of very occasionally trolling Cramer’s blog comments, and occasionally commenting myself.  A few commenters encouraged me to start my own unvarnished commentary, and so I began what would become this blog.

Once I started blogging, the advantages of independence were apparent.  Lack of relevancy, editor, necessary business purpose could go out the window.  Though I think I was liked as a columnist for RealMoney, I don’t think that most of the stuff that I have blogged would have made it there.

The Aleph Blog is an expression of the character of David Merkel, no more, no less.

I get a lot of requests for offering guest content, but I turn them all down.  Maybe other bloggers do well with that, but I don’t.  My blog is an expression of me.  And that is why I blog — to give something back to the general public and media who do not get most things financial.

Don’t get me wrong, if someone asks me to come and speak, generally I will, and presently, at my own expense.  I will be in Chicago in 10 days, and in NYC in April.   (Note: if you would like to meet with me, let me know.)

Two notes:  Abnormal Returns has had me on video two times.  Here’s the first time:  And here is the second time.  Though I am not always rapid in my responses, I give very active responses to Tadas.