April 2011 – Page 2 – The Aleph Blog

Book Review: Dig This Gig

Posted on 20 April 2011 by David Merkel

I liked this book because I am doing this myself.? I am trying to create my own gig.? Let me put it this way: you can try to serve one boss who carefully directs you, or you can try to serve multiple bosses (clients) who may have varying goals for your services.

Unlike most of those featured in the book, I am older, trying to start my own business for the first time at age 50.? It would be nice to be twentysomething, but could I afford to sacrifice the knowledge that I have gained?

I think not.? The book takes an approach of reviewing four young people each in seven areas of employment, followed by an elder statesman who is an exemplar in that area.

The seven areas are:

Healthcare
Entertainment
Doing Good (Nonprofit, Teacher)
Green (Environmental)
News
Government
Unemployed

The book is well-written, and will provide inspiration to those looking to carve out a new niche in the current economy.

Quibbles

I must admit skepticism that a large number of people can “Dig this Gig.”? Most of the needs of mankind are similar, and unless you find a special point of unmet need, unusual gigs are hard to find.? I view much of what is said here as trying to accomplish something difficult.? Most people would be better off trying to do something conventional.? After all, that is why it is conventional.

Who would benefit from this book:

If you have a friend out of work but who is energetic, this book could be valuable.? Or someone competent and employed, but frustrated… this book could be valuable.? But anyone who is not motivated to work hard — sorry, this book will be of no help.

If you want to, you can buy it here: Dig This Gig.

Full disclosure: This book was sent to me after the author asked if I would like to see 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.

Book Review: Financial Origami

Posted on 18 April 2011 by David Merkel

When I was a little kid, I loved origami.? My teachers gave me books on origami, and my parents reinforced it.? I did it all before I was 9 years old.? For a geeky little kid, it wasa lot of fun.

But not all origami is fun.? Brendan Moynihan, the author of Financial Origami describes how Wall Street transformed ordinary obligations such as mortgages in things that seemed different, but weren’t different.

After all, no matter how you fold it, it is the same piece of paper.? And, no matter how the bundle of mortgages gets divided, it is still a bunch of mortgages.? Financial engineering can change who takes the losses, but it cannot change the size of the losses.

This book describes the growth in private indebtedness, and describes how it was obscured by securitization, swaps, etc.? That obscuration allowed the debt to grow to heights unseen in the Great Depression, relative to GDP.

This is a methodical book that takes matters step-by-step, and doesn’t waste a lot of time on rabbit trails.? This is a very focused book.

Quibbles

None.

Who would benefit from this book:

Of all of the crisis books this is the shortest, but it handles the issues adequately.? Brevity is the soul of wit, and by that standard, this book has a lot of wit.? If you want to buy a short book on the crisis for a friend, this is it.

If you want to, you can buy it here: Financial Origami: How the Wall Street Model Broke (Bloomberg).

Full disclosure: This book was sent to me without my requesting it.

When I was Young

Posted on 18 April 2011 by David Merkel

I can’t place it, but when I was 5 years old or so, sometime in 1966, my Mom showed me The Milwaukee Journal, and pointed me to an entry for Litton Industries preferred stock.? She told me that I owned some shares of the stock, and that it was good for me if the stock went up, and bad if it went down.? This was repeated two years later with shares of Magnavox common stock.

Both ended up being large losses, and I puzzled about it when I was young.? It did not dent my confidence in the markets because my Mom was such a good investor, looking for? growth at a reasonable price.? And to me, 10-18 years old, watching Wall Street Week with Louis Rukeyser on Friday nights, I gained insights into the markets, and began to appreciate the wisdom of my mother.? The 70s were a tough time to gain a love for the markets, but I played around with paper portfolios until 1982, when I did my last paper portfolio, before heading of to grad school.? (Value Line helped — if you have time, curl up with it and look for neglected companies that offer promise.)

Before that, I took one of my Mom’s former favorite stocks which had dipped, James River, and used it in a class at Johns Hopkins, and made a case that an acquisitive paper company could be a good investment.? My case was good to my professor, Carl Christ, “I never heard of this corporation before, what a great company.”? And my Mom, who had sold out of the company, reconsidered and bought again at a lower price, making money until the firm itself was bought out.? (Hey, gotta help with the tuition.)

The paper portfolio that I created in August of 1982 proved to be fun for my students when I was a TA at UC-Davis in Corporate Financial Management.? I mentioned the portfolio in class, and a subset of students asked to see it.? By the time the class ended, the market was up 20%, but the portfolio was up 40%.? By this time the professor had heard about it, and he said, “Oh, you have a portfolio with a beta of two.”? I tried to explain to him that the beta estimates of the portfolio were much lower than that, and that I had “bought” the names cheaply.? but to no avail… once the religion of efficient markets takes hold, no amount of? facts will prevail.

Then there was the Value Line contest around 1984-1985, where I was in the top 1%, but missed the top 25.? I used the top 100 from Value Line (Timeliness Rank 1), but screened them for value in their volatility buckets, as the contest went.? To this day, I think that stockpicking contest was the best ever designed.? If I ever get wealthy, I want to do a series of such contests, using the same principles.

After that, I married my wonderful wife Ruth, and began investing for real, first with mutual funds, and then with individual stocks.? But I failed to follow through in one way — I bought penny stocks through a “bucket shop” and lost a moderate amount of money, which fortunately was dwarfed by the purchase of a home in Davis, CA at just the right time, such that two years later when we had to leave for a new job (AIG), we had made 4x our capital, net of CA taxes.

Then my Mom gave me a copy of Ben Graham’s “The Intelligent Investor,” and my life changed again.? I spent the next seven years analyzing small company value stocks in the midst of a market that favored large caps, and growth.? Still, my picks were good, and kept up with the S&P 500 (beating the Russell 2000 Value by 5% per year).

I appreciate the past, and use the lessons for growth today.? Mom, she keeps investing well, though she has more of a desire for yield today.

Today I think my best skills are company and industry analysis.? Yes, I am a quant, and can design clever ways to outperform the market with some probability, but prefer my own insights to mathematical likelihoods.

As for what I wrote yesterday, I prefer my own stock investing to moving between equity and debt markets, because my alpha exceeds that of the switching strategy, at least for now.? Volatility is higher, but I am in Buffett’s camp, where I will take a noisy 15% over a calm 12%.

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I did not bump into investing as an adult, but had to wrestle with it as a child.? I got to view it through the lenses of practical people who were bright, rather than academics who have a blunted view of investing.? This will bite the academics, but there is more wisdom outside of academia on investing than there is inside academia on investing.? Far better that you leave the confines of academic research and try to apply your methods to investing, messy as it is.? I dare you.? It takes a while to develop the practical knowledge behind good investing.? I’ve seen it from so many angles; if there is anyone with a more diversified career in financial services, I have not met him yet.

I was never attracted to MPT because I had seen my Mom beat the market regularly.? It was confirmed to me, when I found that I could do it also.

But still, I like MPT, and indexing — it sidelines a lot of the competition.? And for most, buying an index is the right way to go.? They don’t have an edge, so why pay the fees and accept the added volatility?

But to those that think they understand investing in academia, I would simply say, “Join the party.? If your ideas are? good, you will do well.? It is a lot harder to turn theories into hard cash, or gold, if you are so inclined.”

When I was young, I trusted my Mom.? That trust was rewarded.? Today, the game is a lot tougher, but I persevere because I know my principles work on average over time.? I have had a poor last eight months, but I will come back in time, because my methods have worked in the past, and nothing that I can see has changed that environment.

PS — I sometimes say, ” I am a good investor because I learned from my Mom, and I am a good businessman because I learned from my Dad.”? My Dad did excellent work for clients, and was never sued once in 35 years of work.? His reputation of doing quality work at a moderate price preceded him, and allowed him to survive in bad economic environments.? I hope that I can be as good.

Valuation & Momentum — The Impossible Dream

Posted on 16 April 201116 April 2011 by David Merkel

This piece is a brief and final update to the piece The Holy Grail Projects, which I have since renamed “The Impossible Dream” projects.? I have solved both of them, and with far less effort than I would have anticipated.? There is a way to gain superior bond performance, with one factor, at least as far as the past is concerned, but with higher volatility.

For equities, two simple factors are required, but they beat the market by 2%/year with 70% of the equity volatility over 130 years.

Personally, I find these two results surprising, particularly in the short time that I received them.? That said, I only passed over the data once for each project, which gives me more confidence in the results.

If you have interest in this, e-mail me.? In general, I have not favored tactical asset allocation in the past, but these measures have given me some confidence.

PS — from my days at Provident Mutual in the 90s, what I have replicated is similar? to what one firm I interviewed showed us who had the best track record.? I was really impressed with them and that gives me more confidence.

Book Review: Best Practices for Equity Research Analysts

Posted on 15 April 201115 April 2011 by David Merkel

My friend Tom Brakke, liked this book and said I would too.? He was right, and soon afterward, I heard the author speak at the Baltimore CFA Society.? Hearing James Valentine speak is an advantage here.? He summarized what is most important, which if you are reading the book, it would be chapter 20 (out of 27).? It is his FaVeS framework: Forecast, Valuation, and Sentiment, in that order of importance.? Remember that as a key to the book if you read it; it tells you what to focus on as an analyst.

Another key, since the book is long, is to look at the shaded summaries which are usually at the back of each chapter.? If stretched for time, read those first, and then read the chapter if you didn’t get it.

This book aims to focus analysts on information that matters.? Aim for information that makes a difference, and that few others have.? Create an information web that maximizes the value of your time, and creates value? for your research.

This book covers both the buy-side? and the sell-side, telling each how to best use the other side.? As a former buy-side analyst, to me it means fewer analyses, and better analyses.? Aside from that, it is a game: buy-side: identify the? better sell-side analysts and listen to them.? Sell-side: identify clients that will generate commissions and market their best insights to them.

Regardless, analysts must identify the few factors that account for 80% of the performance in a given industry, and focus on those intensely.? It helps to get into the industry organizations, which can help drive insight into the industry as a whole, and provide a backdrop for questions to ask when talking with executives in the industry.

Learning this will give an analyst a leg up on other analysts.? Analysts should also understand the basic accounting structures of their industry so that they can identify companies that are not playing fair — over-reporting income.? I would add don’t get negative too quickly.? Frauds can develop a momentum of their own.? Wait until the fraud gets large relative to the size of the industry before issuing a sell call — wait for price momentum to go to zero.? (Note: for investigative journalists, this does not apply.? Jump on early, so that you can say that you warned everyone.)

Basic forensic accounting skills help, as do modeling skills, and basic statistical skills.? I was surprised to learn a bunch of Excel shortcuts that I haven’t seen elsewhere, and I have used Excel for nineteen years at a high level.? The summary of accounting deviations is cogent, as well as pointing readers to Mulford and Schilit.

One idea that I heartily agree with: set up your spreadsheets to differentiate data and formulas.? Cells with data series should only contain data.? Formulas should have no numbers in them, unless they are trivial.? This makes analysis a lot easier and cleaner in the long run.

The book also brings out the need to consider multiple scenarios, which help an analyst to flesh out his analysis.? Being willing to consider what can go wrong, or right, richens an analysis.? Also, the book warns against common pathologies that overcome analysts, notably — Confirmation bias, overconfidence, Self-Attribution-bias, Optimism, Recency, Momentum, Heuristics, Familiarity, Snakebite (won’t go back to one that hurt you), Falling in love, anxiety, over-reaction, loss-aversion, etc.? I have experienced a few of those myself, and would have benefited from thinking these through before becoming an analyst.

Quibbles

I would warn any analyst trying to use simple or multiple regression that they are playing with fire, unless they understand the weaknesses of the data, and the limitations of the general linear model.? In twelve-plus years working on Wall Street, I never saw regression used right once.

The author seems to favor DCF over multiples.? Truth, neither works well, and one must live with the weaknesses of any approach.? DCF embeds a lot of assumptions that are known, though some may be wrong — multiples embed unknown assumptions.

The author does not like price-to-sales.? For industrials and utilities I would say look at a chart of price versus price-to-sales.? In most cases, they track, because sales don’t vary that much in the short run.? If you know the high and low P/S ratios for companies in an industry (P/B for financials) you have valuable information.? It gives you boundaries to look at in buy and sell decisions.

I would also warn analysts against using Damodaran and those like him.? I don’t think his models are wrong so much as impractical.? I would rather use a simple model that catches 80-90% of the action, versus one that catches 100% of the action, bet cannot practically be calculated.

Who would benefit from this book:

All equity analysts would benefit from this book.? It is detailed, and yet practical.? Some of our competitors will benefit from it, and if you don’t read it, you will wonder why.

If you want to, you can buy it here: Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts.

Full disclosure: This book was sent to me because I asked the author to review it after he spoke to the Baltimore CFA Society.

A Conversation with Dr. X — Why the Tax Code is a Mess

Posted on 14 April 2011 by David Merkel

I have a friend who I will call Dr. X, or DX for short.? He is a friend of mine who is involved in some but not all things that I am involved in.? We talked recently about taxes, and this is my stylized version of the discussion, because I did not tape it.

Me: So, DX, how did you make out this tax season?

DX: What do you think my federal tax rate was?

Me: Uh, 25%.? You’re a successful guy.

DX: Try again. Lower.

Me: 15%?

DX: Lower.

Me: 10%?

DX: I said LOWER.

Me: Uh, yeah… 3%?

DX: It’s lower.

Me: 1%?

DX: I’m sorry, LO-wer.

Me: O%, you paid nothing?

DX: I’m SORRY, lower.

Me: Wait, the government paid you?

DX: That’s one way to put it.

Me: Then I am clueless.? I have no idea what to do with someone like you who earns a lot, but pays no taxes.

DX: Negative 3%.

Me: How does that happen?? Why aren’t you caught by the AMT?

DX: Many deductions, and many children, with some in college, like you my friend.? Aside from that there is the swiss-cheese post-AMT that wipes out taxes.

Me: Wow.? Why would the government allow this to happen?

DX: Beats me, but I am happy to be wealthy and pay no federal taxes.? That’s been largely true for the prior two years as well.? It genuinely helps if most of your income is coming from sources of investments, and businesses that benefit from certain tax credits.

Me: This is ridiculous.? Why should you get off paying no taxes when our government is running huge deficits?

DX: That’s the fault of the government favoring certain actions.? As long as the tax code is a policy tool, there will be some that take advantage of it.? As for me, I made few active actions to take advantage of it, but also, the way that I do things paid off because I have a certain configuration of income that is presently favored, and a family structure and deductions that are favored.? It may not always be that way — look at the code from the Depression through the 70s; it would be the opposite for me.

Something in-between the two would probably be optimal, including taxing all income at the same rate, and limiting deductions severely.? Stop the games, and fairness becomes a? possibility.? Otherwise, you will have some well-off that pay virtually nothing, like me for the past three years.

Me: Indeed, DX.? You are the man, and have triumphed over the federal government. But what are the common men supposed to do?

DX: Do what I do, or, pay taxes.

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Dr. X is a bit of a “piece of work,” but he’s no Leona Helmsley.? (“We don’t pay taxes. Only the little people pay taxes.”)? Much of the reason for his low taxes stems from charitable giving, including donating appreciated stock.

But this helps to point out my point for what I call “true tax reform,” which I don’t think either side in DC would favor today.? Here’s the simple version of it:

Flatten out the tax rates, and apply the rates uniformly to all income.
Eliminate all tax preferences, and eliminate the estate tax.? Get people focused on growing the economy rather than employing clever people to eliminate taxation.
Tax all income, including capital gains/losses, whether realized or not.? For illiquid investments, where there are no prices, assume a 12% return on equity for taxation purposes, and true it up when the investment is sold.? In other words, tax everyone as if they were traders, and develop fair market value accounting to do this.
Tax corporations on GAAP income, which solves the problem on overseas subsidiaries.? If they act like private equity firms, then disallow the deduction for interest, or assume a 12% return on equity for taxation purposes.
Eliminate all ability to defer taxation.? No more IRAs, or anything like them.? Tax the pension earnings inside corporations, etc.

My main point here is that the discussion on taxation should shift from rates to the definition of income.? You can tax wealthy people as much as you like, but if the definition of income is loose, you can bet that the wealthy will take advantage of it in ways that those less well-off can’t.

My proposal will make the clever wealthy pay.? It will make the poor pay.? We all will pay.? And that is fair.? Even Dr. X would agree with that.? And it will lead to a growing economy, because we will release many clever people who spent time trying to reduce taxes into trying to be productive.

Vote Your Proxies

Posted on 12 April 2011 by David Merkel

Part of being a shareholder is corporate governance.? It is incumbent on us to vote the proxies we receive.? To my left, I have ten or so proxies I will vote tomorrow.

If we don’t vote our? proxies we have no right to complain about corporate governance.? And, for those who own mutual funds, have you told your mutual fund company what you care about?? They may or may not listen to you, but if they hear a decent number saying the same thing, they might take your position, multiplying your opinion by ten or more.

Voting proxies is a matter that helps keep shareholder capitalism morally legitimate.? Without it, corporation managements are tempted to do as they please, which generally leads to worse results for all but management.

And if I might get on the soapbox for a moment, I would like to say that we all as investors should begin to vote down management pay and incentive packages where we can.? Let’s engage in brinkmanship.? They are paid well enough already.? If they don’t get the increase, where will they go?? And, isn’t there a lot of talent in the wings that could replace them?? My view is the best management teams are those that love what they do for the challenge, rather than the money.

Incentives for the rank and file are another matter, and should be approved, unless they are excessive.? Also, ignore the special interests of the loony left who own stock only to affect corporate policy.

That’s all.? I have been traveling and am rather tired.? But vote your proxies!

The Holy Grail Projects

Posted on 9 April 201110 April 2011 by David Merkel

When I started my asset management business, I did not know what I was doing.? I probably still don’t, though finally I have a little more assets under management than I have of my own assets managed by my strategies.? I learned that I needed to manage both stocks and bonds, in order to provide both enterprising and safe investments, respectively.

But in an environment like this, where bonds are overvalued in general, is the safe option safe?? My methods of bond management produce rather blah yields at a time like this, because I am trying to preserve capital.

But then potential investors talk to me, and they ask two things of me.

1) Can’t you create a strategy that shifts between your stock and bond strategies, such that we can minimize losses and maximize gains?

2) Can’t you create a bond strategy that provides more yield on average, while still preserving capital?

I am tempted to say, “If I had such a strategy, I would be employing it from my yacht.”? Then again, the last time I went out on he open seas, I was as sick as a dog.? Time for a new analogy.? Okay, I am searching for the Holy Grail.? Not likely to find that… and as Calvin noted, if all of the alleged relics from the days of Christ were real, the amount would be a large multiple of what was there.

All that said, there are some cofactors for each problem that might work.? With bonds (problem 2), there are momentum effects, as well as mean-reversion effects.? Those can complement the intelligent bond manager who looking at the situation may see risk and return out of line, or fairly priced.

I may have a solution to this problem, which partially benefits from the ideas of Mebane Faber.? Buy the bond classes where the prices are above their 200 day moving averages.? This is an oversimplification, but it seems to work.

But stocks are more difficult, and I do not know whether I will end up with a solution here or not.? Here’s the trouble:

Stocks are driven by earnings expectations
Stocks are driven by valuation
Valuation is drive by cost of capital, as well as yield spreads.
Cost of capital is on average similar to BBB bond yields.
There are still momentum effects, as well as mean reversion effects

I don’t have a solution to the first problem, though I am struggling with it.? Truly if anyone had a good timing algorithm, would he share it?

Book Review: Surviving the Bond Bear Market

Posted on 8 April 2011 by David Merkel

This was an interesting book.? It is well written, and I share some of the points of view of the authors.? That said, there are a bunch of things that I take issue with in the book.

The style of the book was engaging.? I liked the way that the authors used two fictional characters, Elvin Greedo, and Neo Fyte, to illustrate the decision-making processes of amateurs.? I particularly appreciated the growth of the lesser/younger Neo, as he worked to learn, versus his initially more smarter/successful brother-in-law Greedo.

There is a problem, though.? This book takes an inflationist viewpoint.? I largely but not entirely share that viewpoint.? There is the bias, commonly stated as “What else can the government do but encourage the central bank to inflate away the debt?

There are other possibilities: the government could raise taxes dramatically and pay off all existing debts/claims.? Or, the government could pay off domestic claims, and refuse to pay foreign claims, or vice-versa.? It depends upon whom they are more afraid.

I think the inflationist view is most likely, but to me it is a two-out-of-three odds.

Thew book takes you through what you would do in order to preserve purchasing power in a bond portfolio through a crisis where there are significant municipal defaults amid inflation.? If that is not the scenario we get, this is not the right book for you.

That said, the book understands the complexities of markets.? Cycles aren’t simple; they don’t occur on schedule, and there are often fake-outs.? That said, the narrative with Neo and Greedo takes place too rapidly.? A crisis the size that the authors are purporting would take longer to play out.

Also, any crisis/recovery might be far more uneven than the book posits.? Think of the ’70s where no one knew what to do.

Quibbles

The book does not discuss the difficulties inherent in inverse and leveraged ETFs, in how they are short-term vehicles that do not necessarily achieve a long term result.

I also did not appreciate the plugs for Marilyn Cohen’s newsletter.? One or two would have been okay, but more is distasteful.

I also found it amusing that the author thinks Wisconsin and Maryland are safe states.? Also that they focus on a few sorts of bonds that are “full faith and credit” of the US government, to the exclusion of others.

I also did not appreciate the nuclear winter rhetoric.? There are things that balance in this world; if China starts selling Treasuries, the dollar will fall, and US exports will thrive.? That is what brings balance.

Finally, I could not use the flash drive that came with the book, which was okay, because I got the data from their website.? The password is in the book.? I did not try out the excel spreadsheet, because I personally don’t have a lot of bonds.? That is another solution to the inflationist problem.? Don’t own bonds denominated in US dollars.

Who would benefit from this book:

Anyone with a big bond portfolio that is sleepy and unconcerned about looming risks could benefit from this book.? The book isn’t perfect, but it will make you think more than most books will.

If you want to, you can buy it here: Surviving the Bond Bear Market: Bondland’s Nuclear Winter.

Full disclosure: This book was sent to me without my requesting it.

Book Review: Essentials of the Dodd-Frank Act

Posted on 6 April 2011 by David Merkel

Before I start this evening, I just want to say that as a day progresses, if I find a good topic, I prepare for it. If I don’t, I plan on doing a book review. As it is, I have 15 books that I have read and not reviewed. The majority of them are poor. It is tough to do a bad book review, but I guess I will do a bunch of them.

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My review of this book was shaped by its coverage of my own industry.? I am an investment advisor, and a small one.? I learned far more from other sources regarding what I needed to do to comply with Dodd-Frank than this book did.? If I had had only this book to help guide me in my regulatory work, I would have been sunk.

Now, as I read through the book it struck me as being a perfunctory summary of the law, without a lot of insight.

The structure of the book is this:

Introduce the Act
Explain the history and main goals
Go through the Titles (main divisions) of the Act, and give brief explanations of the main points.
Explain how various institutions are affected at a high level.
Then talk about how the various studies that the Act demands will be done, and how regulatory rules will be created.
How it affects all existing agencies, and the new agencies that are created by the Act.
What impact it has globally (not much)
How it affects various financial professions
How it interacts with SOX and Basel (not much)

I found the book to be weak, given what I know about my industry, and other financial industries.? It read like someone went through the Act and excerpted it.

Quibbles

I have no quibbles, I only have objections.? This book was put out too fast, and with too little thought.

Who would benefit from this book:

Better you should read the act; it is bad, but not that bad, as Washington goes.? The act is long, so if you are looking for an easy introduction to the act this book could be helpful, but you could probably clip the highlights of the act yourself.? It is only a question of the value of your time.

If you want to, you can buy it here: Essentials of the Dodd-Frank Act (Essentials Series).

Full disclosure: They asked me if I would like to get this book, and I said yes.? What a disappointment.