Month: April 2013

Classic: Using Investment Advice, Part 3

Classic: Using Investment Advice, Part 3

The following was published on 3/29/2004:

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Investment Advice

Time horizon usually correlates with return size.

It’s good to have signposts as the investment plays out.

Free advice is seldom cheap.

 

In analyzing any advice, investors have to consider the adviser, personal character issues and the nature of the investment proposed.

In Part 1 of this three-part column, I focused on the adviser. In Part 2, I looked at issues centering on your personal character.

In Part 3 today, the emphasis shifts to the investment itself.

Many Things to Consider

Good investment recommendations give some idea of how much to play for and the likelihood of getting there, even if the appraisal of likelihood is subjective and squishy. Are we looking to scalp a dime, a buck, 10%, 100%, or are we looking to score the elusive ten-bagger?

Most often, the time horizon of an investment corresponds to the amount targeted to be earned. Under normal circumstances, gains are made a little at a time. Bigger gains ordinarily take more time. How long will it take to earn what is expected from the proposed investment?

What risks exist in realizing the value inherent in the investment? What could go wrong? Nothing is certain in investing, so beware of advice that tries to sell hard on the idea of safety. Appeals to safety, particularly with investments that are touted to earn an above-average return, are often dangerous. The price adjustments with supposedly safe investments that disappoint are sometimes severe. I experienced this firsthand with corporate bonds: The most dangerous bond was the one everyone knew was secure, and then accounting irregularities popped up. The price would drop 10% to 20%, and liquidity would drop to nil.

If the investment is going properly, what signposts will you see to validate that the investment idea is on track? Aside from price action, what will yield clues that the investment thesis is wrong or right? What should earnings look like? When is that new product going to be introduced?

What factors in the macroeconomic environment does the investment rely on? If inflation rises, what will happen? Does this investment resist recessions well? If the market falls, will this investment fall harder?

Finally, how well does this investment fit into your portfolio? Does it reduce risk for you, or increase it?? Too much of a good thing can be wonderful, but the more concentrated your bets become, the closer you must watch your positions. The higher the degree of concentration in a portfolio, the higher the amount of expertise relative to the market the portfolio manager must possess.

No one will give you all of this in advice, but these are things to keep in mind to aid in the evaluation of advice that comes your way. In general, a conservative and skeptical posture will serve you best. Keep a tight hand on your wallet, and remember that those who stay in the game the longest often do the best.

Finally, you can remember Ferengi Rule of Acquisition No. 59: “Free advice is seldom cheap.”

Classic: Using Investment Advice, Part 2

Classic: Using Investment Advice, Part 2

The following was published on 3/26/2004:

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Investment Advice

You have to understand the advice to use it.

Can you implement or monitor the idea?

Analyze your own personal motives.

 

In analyzing any advice, investors have to consider the adviser, personal character issues and the nature of the investment proposed.

Yesterday, in Part 1 of this three-part column, I focused on the adviser. Today, in Part 2, the emphasis shifts.

It’s About You

Do you understand the advice? There is no shame in not understanding every investment concept under the sun. Only rare individuals can do that. If you can’t understand what is being proposed, walk away from the idea until you can understand it. People who don’t understand an investment concept, but invest anyway, can’t react rationally to the volatility in the market, and they fall prey to fear and greed. They become the noise traders that professionals profit from.

Some strategies suffer from what I call “too smart for your own good risk.” In Britain, the phrase is “too clever by half.” This problem affects both individual and institutional investors. Some strategies are very complex, and some people are intrigued by complexity. I think most investing is simple, and complexity signifies a lack of understanding. The more complex a strategy is, the more likely it is to break down in one of its many steps. Be careful with complex strategies.

Can you implement and monitor the investment idea? Does it fit your character? I did risk arbitrage on an amateur basis for several years, but even though I did well at it, I found that the amount of time it took detracted from my family and work, so I stopped.

Some people don’t have the time, talent or personality for strategies that require rapid trading or rapid shifts in strategy. Other people don’t have the stomach for high-risk strategies, even if they understand how they work. You have to pick strategies you can sleep with.

Does the investment support your ethical standards? This applies to both the management and the business.? In general, your ability to make rational decisions in investing will be hindered if you are long a company that you think harms society. The same is true of management that you believe acts dishonestly, particularly toward shareholders. It doesn’t matter how cheap a company is: If you can’t trust the management, it will be almost impossible to unlock the value trapped there.

Also, from my personal experience, if management is dishonest to some other stakeholder group, such as customers, eventually shareholders will get bad returns. Dishonest management often has underlying business models that are unfavorable, and which they are trying to enhance unethically.

Analyze any personal motives you might have for making or not making an investment. I had a large number of usually intelligent friends who gave up their investment disciplines in late 1999 in order to buy into the bubble. Many seemed driven by envy of less capable friends who were racking up impressive profits on paper. Motives for investing that rest in uncritical admiration or dislike for another person and their prosperity usually lead to bad results.

How much of an unrealized loss could you take in the short run? Do you have the capability to carry the position through a rough period, even if the eventual result will be good? The answer depends on your liability structure. Do you need the value of the assets in question to throw off cash for you in the short run? Are you investing on margin, or have significant external debts to service? Safe is better than sorry here. At minimum, set stop orders if you can’t bear losses beyond a given threshold. It is better to avoid strategies that force you to take any action, so if you can’t take short-term losses, reduce the risk level.

Next time, in Part 3 of this three-part column, I’ll take a closer look at the nature of the investment itself.

Classic: Using Investment Advice, Part 1

Classic: Using Investment Advice, Part 1

Dear Friends,

I am republishing some old pieces from my days at RealMoney during this busy time that I am in.? If there are significant changes in my opinion since it was first published, I will spell out the changes.? As for this series, there are none.

Originally published 3/24/2004

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Investment Advice

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You have to trust your investment adviser.

Look closely at the track record, too.

You want realistic advice you can use.

 

Advice bombards all investors. Some is good, some is bad, and much of it is indifferent. In this three-part column, I’ll show how to use the advice you receive so you can be a more effective investor. In analyzing any advice, investors have to consider the adviser, personal character issues, and the nature of the investment proposed. In Part 1 today, I’ll focus on the adviser.

Sought-After Qualities

The first issue is always one of trust: Do you trust the competence and business ethics of the adviser? No one is perfect, but has the adviser made sound decisions in the past in areas similar to where the adviser is proposing advice now? What’s the adviser’s track record? If he’s a professional, does he have a clean record with the regulators and his current and past clients?

Even if the adviser has a great track record, did he get it accidentally? In a past job, I had the fun of interviewing a large number of money managers. We had a need for a large-cap growth manager, and our manager adviser brought in a manager who had a stellar, though short, track record.

The principal of the growth manager was a former pro athlete who had developed an entirely quantitative, momentum-driven management method. The presentation was short, and I asked a few questions about earnings quality and how the process might do in nongrowth-driven markets. I received a very terse set of “we can do no wrong” answers.

After the presentation ended, I pointed out three companies in their portfolio that I knew had weak earnings quality. They politely blew me off. I wasn’t impressed with their processes, and my colleagues were not impressed with their demeanor. Then I had my accident; the next week, two of the companies I pointed out blew up. Their accident followed soon after, which was a significant loss of assets under management. The accident of their prior performance evaporated. Persistent good performance happens for the reasons that the adviser specifies in advance, not by accident.

Even if the advice giver is competent and ethical, what incentives does he have in the situation? Full disclosure allows you to decide whether the adviser’s judgment might be shaded by other concerns. Then you can take that into account in making your decision.

Is the adviser cocky? In my experience, pride goes before a fall. One way to measure this is to see whether the adviser admits to errors. The best advisers admit fallibility, and even try to reduce your expectations. You want realistic advice from someone you can trust. Big claims may draw some clients in the short run, but in the long run, clients are kept through dependability.

Next time, in Part 2, I’ll examine how your character affects how you evaluate the investment advice you get.

Stable Value Versus Rising Rates

Stable Value Versus Rising Rates

If you own a short-to-intermediate term bond portfolio, and you did not need to tap the cash for a few years, would you prefer rising short interest rates, or falling rates?? The correct answer is rising rates, because you will be able to reinvest interest payments paid in higher yielding securities.

That’s why I take issue with the following article on stable value funds from the Wall Street Journal.? Some might remember my “Unstable Value Funds” series.? Though the worst never happened, many funds came close to “breaking the buck.”

I once designed a substitute for Stable Value Funds, one that could trade on Schwab’s platform.? But the math of the product meant that it could be blown apart by a very rapid rise in short rates.? To try to remedy that, I rewrote the pension services contract to put in? a Force Majeure clause that would allow? the insurance company to alter many terms of the contract to avoid “breaking the buck.”?? (In 1997-8, I thought ahead, and designed a contract that had modes for normal and abnormal environments. Hey, Nationwide Insurance, it’s your intellectual property now. Use it.)

My main point is that stable value funds will lag in a rising rate environment.? Yes, it will not appear that you are losing money in the short run. but the credited rate will lag for 2-3 years, while returns to the short-to-intermediate term bond portfolio will be hurt in the short-run, but do well in the intermediate-term.

Be wary.? Even though Stable Value funds do not face credit risk problems now, rising rates would invite anti-selection by making short-to-intermediate term bond funds look attractive, even with the 90-day switch into equities or longer bonds.

Remember, Stable Value funds are bond funds that pay a little extra to guarantors, so that payments for death, disability, fund switching, etc., go out at book value.? They have to pay the fund management fees and the small guarantor fees.? The short-to-intermediate term bond fund can invest a little more aggressively, and only has to pay out the management fees.? Over the long haul, the short-to-intermediate term bond fund will beat most Stable Value funds, but the ride will seem more bumpy, because except in the worst scenarios, the Stable Value fund acts like a savings account, slowly accruing value, while the underlying investments actually behave like a short-to-intermediate term bond portfolio, with all of the volatility.

Sorted Weekly Tweets

Sorted Weekly Tweets

US Fiscal & Monetary Policy

 

  • Obama?s Budget Would Cap Romney-Sized Retirement Accounts http://t.co/3xC4YflVFO Might indirectly harm smaller accounts, article states Apr 05, 2013
  • Obama Budget Plan Would Curb Social Security Growth http://t.co/3wvyDuN3tE Small curbs; reinforces idea: can’t trust Govt on inflation Apr 05, 2013
  • Obamacare Sticker Shock: Are You Ready to Pay Double? http://t.co/hKaBmRzQMZ Getting bad enough that the Democrats might undo Obamacare… Apr 04, 2013
  • ?Greatest bond bubble in history? will burst in economic chaos, says Stockman http://t.co/SuFObaenCK Collins & Aikman makes him Cassandra Apr 04, 2013
  • How the Fed fueled an explosion in subprime auto loans http://t.co/g7r3Likl56 Cheap AAA financing + personal stories of aggressive lending Apr 04, 2013
  • Who will be the next Fed chair? Here are Wonkblog?s odds. http://t.co/44Bqhho05m Every one of these is a horrible idea, especially Yellen $$ Apr 03, 2013
  • Krugman should be careful tossing out the phrase ?cranky old man stuff.? It tosses like a verbal Boomerang. #livesinaglassshouse $$ #stones Apr 01, 2013
  • Stockman Warns of Crash of Fed-Fueled Bubble Economy http://t.co/wsxbP1tsTe Krugman called Stockman?s piece ?cranky old man stuff? $$ Apr 01, 2013
  • Fannie Mae and Freddie Mac Face New Problem: Profitability http://t.co/KobaLaMezt Some in Govt plan on keeping F&F under govt control $$ Apr 01, 2013

 

North Korea

 

  • Understanding Kim Jong Un?s Tantrums http://t.co/EeGXEUuvcH Has 2 prove tough guy bona fides to generals, while pushing modest reform agenda Apr 05, 2013
  • North Korean Nukes: How Worried Should We Be, and What Is Kim Jong Un Thinking? http://t.co/vsoaHvzQvI Mutual deterrence of first move Apr 04, 2013
  • Scooping Up North Korean Coins http://t.co/Sokc9jIfZe Jimmy Rogers picks up some unusual numismatic coins from North Korea. $$ Apr 01, 2013

 

Eurozone

 

  • Merkel Losing Allies in $700 Billion Shift to Renewables http://t.co/CEh2j8TE4p For a science PhD, she certainly tends 2 magical ideas Apr 05, 2013
  • Draghi Considers Plan B as Sentiment Dims Post Cyprus Fumble http://t.co/Wbu9ggM2cd Unwinding the Euro would be appropriate #unforcederror Apr 05, 2013
  • Le Fracking for Geothermal Heat Drawing Ire of French Oil http://t.co/5KHqRtfdO9 The French tie themselves in knots: irrational policies Apr 05, 2013
  • EU Unemployment: Titanic in Perspective http://t.co/uSxKOfNLn5 Summary of the EZone unemployment problem, culled from many websites Apr 04, 2013
  • A weakening Germany in a weaker EU http://t.co/CsuZ3KQ86x But can Germany rescue itself; whole EZone slowing down; time 4 action Mario! 😉 Apr 04, 2013
  • World from Berlin: ‘Germany Isn’t Living Up to EU Responsibility’ http://t.co/ozzZJbr5xR But what will Germany do when it has2rescue France? Apr 04, 2013
  • Audi Wants to Change a 45-Year-Old U.S. Headlight Rule http://t.co/V0aOqzGRi0 Only high & low-beams r allowed; Audi wants more variety Apr 04, 2013
  • Cyprus Turks Share Pain as Banking Crisis Revives Talk of Unity http://t.co/VmHELItCED Serious talks will come through younger politicians Apr 04, 2013
  • The ECB Fragmented Monetary Policy http://t.co/o8o8d0nucY Eurozone no longer has single monetary policy; euros not worth same everywhere $$ Apr 03, 2013
  • Euro Zone Unemployment Hits Record High http://t.co/lLgg6ZQVKg Fringe Europe suffers from the political dreamers post-WWII $$ #breakup Apr 03, 2013
  • Money Funds Meet Zero Yields by Breaking Buck Taboo: Euro Credit http://t.co/uD672kwCfP Short-term finance hits the wall in Eurozone $$ Apr 03, 2013
  • Slovenia?s Jazbec Inherits Bank System to Avert Bailout http://t.co/MDrCmuYmEk Don’t care how smart u r; pain involved in deleveraging $$ Apr 03, 2013
  • Texas wants its gold back! Wait, what? http://t.co/HuH7vg53Z8 This is a rational response to kleptocracy a la Cyprus. $$ Apr 02, 2013
  • Developing Nations Retreating from Euro as Reserve Currency http://t.co/tH91Uw76SC Predictable; can reserve currency allow confiscation? $$ Apr 02, 2013
  • President Hollande Failing to Control Unemployment Crisis http://t.co/XojVG1pZMl It would require considerable deregulation 2fix France $$ Apr 02, 2013
  • Sundown in America http://t.co/hpeIDbcvzl Much as I have not liked Stockman, the logic is decent; he is arguing for the free markets. $$ Apr 02, 2013
  • Mitch McConnell Prepares To Give Barack Obama The Political Shellacking Of A Lifetime http://t.co/AqOqm1Vwey Worth a read, PPACA is a dog $$ Apr 02, 2013
  • Wrong: Confessions of a Keynesian heretic http://t.co/MnUyIqdIZ2 Another believer in monetary alchemy, but not fiscal alchemy $$ #endthefed Apr 01, 2013

 

Japan

 

  • Wrong: Japan?s Brave New Monetary Era http://t.co/NxIU0Ovc4J Doing the same thing over & over & expecting a different result. Won’t work Apr 05, 2013
  • Japan’s Yen UnCompetitveness – Fukushima and the Yen – Hara-Kiri http://t.co/4UfjiH40XM Export > Import favors yen fall; now is vice-versa Apr 05, 2013
  • Kuroda to Bernanke: My Bazooka Is Bigger Than Your Bazooka http://t.co/4d2ocM3BJN “I can destroy my nation faster than u can. Nyaah! Nyaah!” Apr 05, 2013
  • Bank of Japan in Bold Bid for Revival http://t.co/DyKXQFLpsC We must devalue & inflate our way to prosperity! Apr 04, 2013

 

Church v State

 

  • Next few tweets will b controversial: Founder’s thoughts on “No establishment of religion” applied to the National govt, not the states Apr 04, 2013
  • Laws favoring certain churches persisted in various states until 1850s, & some had religious test oaths for officeholders into 20th Century Apr 04, 2013
  • The “test oaths” died for lack of use, clean up in the 1900s, was largely perfunctory. The next tweet contains today’s story Apr 04, 2013
  • Proposal would allow state religion in North Carolina http://t.co/SZIXiT2Xht Won’t pass modern constitution muster, but would in early 1800s Apr 04, 2013

 

Other US Politics

 

  • Seven Dumb Things Bankers Say http://t.co/2A5GTQn59w Among them that the big banks aren’t too big, & that the economy is not 2 financialized Apr 06, 2013
  • Deep in the Red of Texas, Republicans Fight the Blues http://t.co/UP2ZmRA4Fi Texas, future blue state, must motivate voters to care Apr 05, 2013
  • ‘Dear Airline, Here’s the Problem…’ http://t.co/6fBnR48kb0 Customized surveys home in on problems so airlines can fix complaints fast Apr 04, 2013
  • Pro-Gun Laws Gain Ground http://t.co/QXGXNbDwyZ Since Newtown Massacre, More States Ease Regulations Than Bolster Them Apr 04, 2013
  • Tough Calls on Prenatal Tests http://t.co/I4037KsAt8 Beware false positives; If u get a positive, do a 2nd invasive test 2 check Apr 04, 2013
  • 5 big Dodd-Frank battles http://t.co/Z7CfTuUVUA Volcker Rule, consumer bureau battle, random ratings, derivatives fight all on agenda Apr 04, 2013
  • Health Insurers Prevail in Medicare Fight With Washington http://t.co/Z8TskpLoi6 Another example of the perversity of the PPACA $$ #abolish Apr 03, 2013
  • Court says Stockton, California may proceed with bankruptcy http://t.co/DTgMt85Er1 Largest muni bankruptcy will challenge guarantors $$ $AGO Apr 02, 2013
  • Banks Win Dismissal of Substantial Portion of Libor Suits http://t.co/HzdRoTIYS8 Difficult 2 prove particular damage 2 claimants. $$ #toobad Mar 31, 2013
  • Frats Worse Than Animal House Fail to Pay for Casualties http://t.co/ViKN3I1Tb8 Very long article: national fraternities avoid liability $$ Mar 31, 2013

 

Financials

 

  • Wrong: Beware of those who cry ‘bubble’ about bonds http://t.co/DHvp60swjB Article argues about wrong classes of bonds; Tsys not bubble Apr 05, 2013
  • As Business Lending Rises, Concerns Emerge About Profit http://t.co/D8bdwXm5Re May b no defaults now, but loan pricing tighter than exp loss Apr 04, 2013
  • The Lurkers of Wall Street http://t.co/odjuKYZodt @reformedbroker Of “desk analysts” that turn to Stocktwits when they can’t find news Apr 04, 2013
  • Freeh Says Corzine?s Risky Strategy Helped Fell MF Global http://t.co/wSDrswvoYB B wary when companies pursue biz askew from main biz Apr 04, 2013
  • HSBC Converts Loan Clients to Enter Junk Top 10 http://t.co/2yj8hHMW4E Pay more in yield, but gain flexibility from fewer covenants Apr 04, 2013
  • Bond Traders Club Loses Cachet in Most Important Market http://t.co/7Hw4frsFOn It’s just not worth it 2b a primary UST dealer w/direct bids Apr 04, 2013
  • Financial ETF Falters Amid Bearish Bets as Bank Earnings Loom http://t.co/axMByUp3Zd Ratio of $SPY to $XLF is rising http://t.co/zz0tdIslzq Apr 04, 2013
  • I miss working in a life ins investment dept. You get to see all of the prospectuses for bizarre credit deals; u *feel* the credit cycle $$ Apr 04, 2013
  • Bitcoin?s largest market crashes after wild price swing http://t.co/SAEdfFOmAN Smile when u say Bitcoin & “crash course” in same sentence $$ Apr 03, 2013
  • Gross Says Buffett, Soros Careers Fueled by Expansion http://t.co/1WaBuu49bu Honest Gross; Taking 2much credit risk briefly looked good $$ Apr 03, 2013
  • Mortgage Gamble Pays Off for Wells http://t.co/S82N3MwglF Doing balance sheet lending w/an option to sell if conditions r good $$ FD: + $WFC Apr 03, 2013
  • Willow Fund as a Cautionary Tale for Investors http://t.co/UUsO9xUE2n Large strategy changes r always red flag; invalidates track record $$ Mar 30, 2013
  • Does Blame Predict Performance? http://t.co/K79d7gJgqS “Blame cultures” can improve investing by identifying &fixing problems w/foresight $$ Mar 30, 2013
  • Carl Icahn Unleashed: Wall Street’s Richest Man Is On The Attack — Just Ask Michael Dell http://t.co/Nck6h50plR Was interviewed 4 this $$ Mar 30, 2013

 

Other

 

  • Is Jeffrey Loria the Worst Owner in Sports? http://t.co/B5qrnvM9c3 & Rent-seeking in professional sports http://t.co/QmhopqxwAw ?cc @munilass Apr 04, 2013
  • Gold Slumps Toward Bear Market as Investors Cut Holdings http://t.co/2dOeIfPl4r Positive self-reinforcing liquidation of ETF units, mebbe Apr 04, 2013
  • A Man in the Mirror http://t.co/85QSn5dSSM Bill Gross says great investors have had a huge tailwind from growth of credit. What comes next? Apr 04, 2013
  • Firefox 20 is giving me fits w/a Javascript bug keeps popping up boxes that say “Error: missing ( after for” Also no posting 2 stocktwits Apr 04, 2013
  • Visa Demand Jumps http://t.co/MlszY9pJ9y Employers Set to Quickly Reach Cap on Skilled Foreign Workers $$ Companies race to get ltd # visas Apr 02, 2013
  • Republican Born Roosevelt Digs Deep for Texas Oil Found With CO2 http://t.co/DJ0DBx6YGV CO2 injection liberates tight oil in West Texas $$ Apr 02, 2013
  • Buffett?s Missed Airlines Bet http://t.co/eEf37K7iOI Remember Buffett invests like baseball w/”no called strikes.” No fat pitch 2 swing @ $$ Apr 01, 2013
  • Suzy Weiss: To (All) the Colleges That Rejected Me http://t.co/5jzMZGzSe9 Satirical article:useless things colleges look 4 in applicants $$ Apr 01, 2013
  • Airline Returns Refute Buffett Aversion 2 US Carriers http://t.co/CD3fFjhcOo Dead cat bounce & that qualifies2undo the history of losses? $$ Apr 01, 2013

 

Overly Large Nonbank Financials

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  • $NLY $GLD $SPY $VWO ticker list 4 publicly traded Miscellaneous Financial Services companies w/ > $50B in assets $$ http://t.co/OIrnSfE5jY Apr 04, 2013
  • $AMP $BLK $BAM $SCHW $MS $UBS list of tickers 4 publicly traded Investment Services companies w/ > $50B in assets $$ http://t.co/6QiByewpnV Apr 03, 2013
  • $AIG $BRK/A $CB $CNA $HIG $L $TRV list of tickers 4 publicly traded P&C Insurance companies w/ > $50B in assets $$ http://t.co/2jVlnE5oVT Apr 03, 2013
  • $GNW $LNC $MET $PL $PRU $UNM list of tickers 4 publicly traded Life Insurers companies w/ > $50B in assets $$ http://t.co/cSoZnSL3LZ Apr 03, 2013
  • $AFL $CI $PFG $UNH $WLP list of tickers 4 publicly traded Acc & Health Insurance companies w/ > $50B in assets $$ http://t.co/5JFJCzxZOm Apr 03, 2013
  • $DFS $GE $SLM list of tickers 4 publicly traded Consumer Financial Services companies w/ > $50B in assets $$ http://t.co/4KPicolqgc Apr 03, 2013

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Replies & Retweets

 

  • @probability_wtd Many things concern me, including this. Really difficult 2c the government keeping their hands of pension monies. Apr 06, 2013
  • Buffett isn’t simple RT @researchpuzzler: my latest #wsjexperts comment, on lessons from Buffett http://t.co/vA3sdSIp11 HT @alephblog Apr 05, 2013
  • @LaMonicaBuzz They have both assets & liabilities in the yen; they try 2 keep it even, effect should b small | FD: + $AFL Apr 05, 2013
  • All significant energy use improvements have been more efficient use of oil, gas&coal RT @finemrespice: http://t.co/oBrHYmgszO <- Insanity. Apr 05, 2013
  • I would be fine w/that RT @Nonrelatedsense: @AlephBlog strikes me as better to eliminate dividend taxes for C corps Apr 05, 2013
  • “Just a market for speculators, because nothing physical is traded that producers want to hedge?” ? David_Merkel http://t.co/2IvwG2nAt9 $$ Apr 05, 2013
  • @neilbarofsky Really glad for you. I rarely get to meet any heroes. She was prescient. Apr 04, 2013
  • RT @DavidSchawel: MOAR mREITS: Blackstone backed Ellington Mortgage $EARN files for $100mil IPO. Let no yield hog be left without a 12% … Apr 02, 2013
  • @The_Analyst 15-20 years ago Apr 01, 2013
  • ‘ @The_Analyst Real-time, this is 18-20 years ago, but it illustrates modern problems. It will get closer to the present as I move along $$ Mar 31, 2013
  • RT @DavidSchawel: CS lessons from Cyprus: sr. bank debt no longer safe, uninsured bank deposits have been nailed in, and capital control … Mar 30, 2013

 

FWIW

 

  • My week on twitter: 44 retweets received, 3 new listings, 58 new followers, 45 mentions. Via: http://t.co/cPSEMLXpb8 Apr 04, 2013

 

Why should REITs and MLPs have an Advantage?

Why should REITs and MLPs have an Advantage?

Some companies need to reinvest a lot and some don’t.? Thus the creation of tax-favored vehicles like REITs and MLPs.? A high percentage of taxable income must be paid out, but it is not taxed at the corporate level.

With REITs and MLPs, they don’t need to reinvest much, so the structures work most of the time.? But what if we changed corporate tax policy to mimic REITs and MLPs?? Maybe end corporate income taxation, but require corporations to pay out what they don’t reinvest.? They all become pass-through vehicles, but some with delay due to reinvestment.? That would give growth companies a small advantage.? Personal tax rates would likely have to rise, unless we are willing to cut federal spending.

Note that this would move tax policy for public companies closer to that of private equity.? It’s not the same thing, but delaying taxation on reinvestment would promote growth.? If we have to balance this out, a small rise in personal tax rates would do it, and more rise for the rich.

Personally, I would prefer a simpler system where everything gets taxed the same way, but this might not be a bad approximation of a good system.? If the tax system is rigged to pass through income for free at the corporate level for some vehicles, then delaying taxation on reinvestment is not a horrible idea.? After all, we do the same with IRAs of all sorts, where nothing is taxed until the assets are used for consumption.

All for now; just a few thoughts.

 

Value Investing Flavors

Value Investing Flavors

I ran across this article, Value Investor or Value Pretender: Which Are You?, by who puts out The Manual of Ideas, along with Oliver Mihaljevic.? I appreciate what they do — you can learn a lot from their organization.

I told him that I was going to write this, and he said to me:

The piece was meant tongue-in-cheek but feel free to rip it apart 🙂

I will rip it apart, but gently, because every point he made is mostly true for value investors, but there are variations in the way that value investors operate, so you can do some of the things he says you can’t do, and still be a value investor — what matters is how you implement them.

There will be more parts to my “Education of a Risk Manager” series, and one of them will deal with all of the different managers that I met, and how much they varied in terms of what they thought were factors that mattered.

Thus, as I developed my own theories of value investing, I considered the range of opinion, and realized that there is a single model for value investing, but that it is complex enough that different parties use different approximations of the full model, and those approximations do better and worse in different environments.

Like a David Letterman-style Top 10 list, John Mihaljevic listed and described things that made you a value pretender.? Time to go through them:

Reason #10: You invest based on chart patterns

I don’t use chart patterns, but I do use momentum both positively & negatively.? There is decent evidence that investors are slow to react to new information, and so stocks with strong price momentum over 200 days tend to do better.? There is some evidence where there is lousy price momentum over a 4-year period, that things tend to mean-revert.

Granted, there is a tendency among some value investors to troll the 52-week low list.? I like doing that too, but you have to be careful, because maybe you are missing something that cleverer investors know.? The same would be true of short interest figures.? Whenever I see one of my stocks gain a high short interest ratio (shares sold short / volume, or % of mkt cap sold short), I do a review to see what I don’t know.? That’s why I am not afraid of the high level of shorting on Stancorp Financial.? This is a conservatively run firm that manages risk up front.? Even though disability claims rise when unemployment is high, they underwrite better than most of the industry.

There have been some very successful value plus momentum investors.? The balance is tricky, but blending two of the most powerful anomalies does bear fruit.

Reason #9: You assume multiple expansion in your investment theses

I never assume that, but if you are buying them “safe and cheap,” you often do get multiple expansion.? The challenge is figuring out where things are less bad then the implied opinion of the depressed valuation.

Reason #8: You try to figure out how a company will do vis-?-vis?quarterly EPS estimates

I don’t do that either, but I have known some value managers that incorporate prior earnings surprise data, because past earnings surprises are correlated with future surprises.? Often, near the the turnaround point for a company’s stock, there are some earnings surprises.

Reason #7: You base your decisions on analyst recommendations

I have few arguments with this, except negatively.? Sell-side analysts are trailing indicators.? I like buying companies where the sell-side is negative, but not very negative.? With very negative opinion, there are often reasons to stay away, unless you possess specific knowledge that the sell-side analysts do not have.

Reason #6: You use P/E to Growth (PEG) as a key valuation metric

I’m sorry, but PEG works, if indeed you have the growth rate right, which is a challenge.? I do try to analyze sustainable competitive advantage for the firms that I own.? That often leads to growth.? Now I am a growth skeptic, so it takes a lot to make me pay up for growth, but occasionally I will do so, when the PEG is low enough.

Reason #5: You use EBITDA as a measure of cash flow

EBITDA is not cash flow from operations, or free cash flow, but it is a valuable figure in value investing when it divides into Enterprise Value (Value of Debt + Value of Stock – Cash).? Low ratios of Enterprise value divided by EBITDA are very effective at identifying promising investments — it indicates cheap assets, and in a time when M&A is hot, it can really pay off.

Reason #4: You would worry about your portfolio if the market closed for a year

I could live with the market closed, but there are advantages to having it open.? With any given stock, there are times in a year to increase or reduce exposure — if you have a firm idea of what the firm is worth, you can buy more during dips, and sell a little into strong rallies.? Short term (one month) stock price movements are fickle, and commonly reverse.

Reason #3: You make investment decisions based on the activity or tips of others

But Manual of Ideas tracks the 13F filings of great investors.? I get good ideas from the best investors also, but you have to do your own research.? Many bright investors chat with each other, and I had many occasions at the hedge fund that I worked for where I disagreed with a friend of the boss.? I was right more often than I was wrong.

Perhaps a better way to phrase it is “choose your idea generators wisely, but do your own research as well.”

Reason #2: Your investment process centers on the market opportunity

This is largely true, but when I know a industry or sector is in horrible shape, I often buy the strongest name in the industry, realizing that they will do well as the competition dies, and they don’t.? Also, there are times when few recognize that pricing power has shifted, and it is time to take a position on a misunderstood industry that is about to grow faster than expected.? Particularly with cyclical companies this idea can be promising.

The same applies to countries where the markets are washed out.? Don’t try to time the bottom, but when a country is cheap, buy a promising/safe company in the country after things have turned up for 100 days or so.

Reason #1: Your investment theses do not reference the stock price

At some points, I like to own companies with strong management teams relative to their industry.? I will let valuation stretch at those points, because there is more of a sustainable competitive advantage there.? You get more positive surprises, and that definitely aids total returns.

That said, a focus valuation is key to all investing.? The only thing more important is margin of safety.

Margin of Safety

There are three elements to margin of safety:

  1. Sustainable Competitive Advantage (Strong Gross Margins)
  2. Strong Balance Sheet (Conservative Accounting)
  3. Cheap Price vs Likely Value

This is different from other formulations of margin of safety, because one has to take into account factors that make it less certain that we can calculate value.? Many value managers were buying cheap financials up until September 2008, only to realize that their estimates? of value were wrong because credit losses would be far worse than expected.

Good stock analysis begins with good bond analysis.? If you wouldn’t buy a bond from the firm, you probably shouldn’t buy the stock.? Value investing is conservative, and looks for situations where there is little credit risk.

Conclusion

If you want to read? summary of my portfolio rules, you can find them here.? I am a firm believer in value investing, but I realize that there are many ways to approach the process.? I watch other value investors, and continue to learn.? Good value investors are lifelong learners, and generalists with broad knowledge.? It is not a narrow discipline, but one that can accommodate new knowledge.

Full disclosure: long SFG

 

The Education of an Investment Risk Manager, Part V

The Education of an Investment Risk Manager, Part V

One thing that came out of our “employee empowerment project” was a need to improve our equity and bond fund offerings.? At the same time, a fund manager manager [FMM] came out of the woodwork and suggested to us that we could do multiple manager funds.? They had analyzed many managers and had found some that they thought were great.

The more we thought about it, the more we thought it would be a great idea. Here’s why:

  • Our own abilities to find superior managers were limited.
  • A few members? of our team (including me) possessed ability to analyze what FMM would bring us.? We thought we could add value.
  • We came up with a clever name, “The All Pro Funds.”
  • We also thought we could add value? in changing weightings every now and then, and firing managers that we felt had become uncompetitive because they were now running too much money, had critical staff losses, or were underperforming style-specific indexes by a wide margin.
  • We could increase our fee a little to pay FMM and us for the additional work entailed.

And whaddaya know?? It worked.? The portfolios in aggregate? outperformed? their indexes even after fees, and fund flows increased dramatically.? The representatives had a story to tell.? Morale improved everywhere.? We were rolling, until…

A day came where we heard from one of the underlying managers that FMM had recommended their termination because they wouldn’t rebate more of their fees back to FMM.? I would not say that we went ballistic when we heard this — instead, we went cold on FMM.? Act fast?? No, act deliberately.? The senior officers tasked me and the #2 guy in marketing to deal with the problem.

We had a rule in our division — we will pay disclosed compensation, or we will pay undisclosed compensation, but we will never pay disclosed and undisclosed compensation.? Why?? We wanted our clients to know that if compensation was disclosed, that’s all there was.? If there is no “sticker price” but you are happy with the services provided, and don’t need to know what any agent is making that’s fin with us.? But we will not pass more money quietly to those that have said, “This is the sticker price.”

FMM had violated our sense of ethics to the core.? The two of us decided to put out an RFP, asking them to bid to help manage the now $1 Billion of assets. We excluded FMM.? We chose 10 well known manager consultants. Most responded to the RFP and we invited 5 to come present to us on a given day in spring.

-=-==–=-==-=-=-=-

I need to mention one other thing.? When we first started dealing with FMM, we appreciated their qualitative research, which seemed to have some punch.? After a year, they discovered returns-based style analysis.? This allowed them to analyze many more managers just by looking at their returns, and correlating them to a variety of equity and other indexes.? They stopped the qualitative research.

The first time I saw it, I thought it was hooey, even as I think MPT is hooey.? When you have a lot of highly correlated indexes, any attempt to intuit the style of a given manager is problematic; the error bands get too wide.? It is too difficult to determine what the correct answer is.? The optimal answer mostly represents happenstance, and not fact.? Tiny tweaks to the data produce big changes in the answer.? Not a good system.

There was one incident where I met with their new quantitative analyst, a woman 10 years younger than me.? She ask if we understood how the method worked.? I replied with some mathematical jargon regarding the method, leading her to say, “Oh, so you *really* understand this.”

Also, when I analyze a manager, I like looking at what they own.? I like looking at their trades.? I want to see consistency with what they claim is their strategy.? I also like to hear why they do what they do, and what sustainable competitive advantage they think they have.? There is value in that style of analysis.? There is little value in analyzing returns.

=-=-=-===–==-==–

To our surprise, one well-known consultant [call them STAR] that had no for-profit clients was one of the five.? The leader said it was a one-time experiment, so they were evaluating us, as much as we evaluated them.

On the day when they came to present, the presentations were all over the map, from highly professional to “did not prepare.”? Some big names could not answer basic questions about what sustainable competitive advantages they brought to the process, or were fuzzy about how they earned their money.

STAR had the best presentation, services, model, ethics, etc.? It was almost “no competition,” and they liked us as well.? We hired them, much to the chagrin of FMM, who begged us to keep them.? It had the following positive results:

  • Management fees down by 60%
  • Fund manager fees down by 50%
  • Far better marketing cachet
  • Better models for investment analysis.

We reduced client fees, but had better margins, and still greater growth.? Our division was transformed thorough the two projects.? Before we started our ROE was around 8%, and we were growing AUM at a 5-10% rate.? By the time all these changes occurred, our ROE was 25%, and our growth rate was not far from that.? We were now the stars of the firm, even though the firm culturally could not acknowledge that, because the life division was so big.

I learned several things from this five-year escapade:

  • Creating a desirable investment product takes work.? If you do something different that seems to add value, it will attract clients. (“We manage the managers for you, so you don’t have to”)
  • Focus on ethics in those you work with.
  • Reduce fees where possible, both your own, and that of suppliers.
  • Name recognition helps.
  • Be careful what you accept as analysis.? Just because there is clever math does not mean it represents how reality works.
  • If you don’t take chances, you won’t achieve anything great.? We didn’t have to burn our old strategy, and move to multiple manager funds, but we did it, and it made clients a lot happier.? The added work was work that that we liked to do.
  • Even if you have a supplier that did something good for you, do not tolerate breaches in ethics.? Find someone else to help you even if it costs more.? That it cost us less was merely a plus.
The Education of an Investment Risk Manager, Part IV

The Education of an Investment Risk Manager, Part IV

One day, when I was least expecting it, the Spanish Inquisition arrived, otherwise known as internal audit.

IA: You run the GIC business.

Me: Yes.

IA: What functions do you control here?

Me: I market, price, cashflow test, and reserve the GICs.? I also direct hedging and investment policy.

IA: Isn’t that too large of a concentration of power in your hands?? You do everything.? There are no checks and balances.

Me: It allows us to run a better operation, because we feed back our results into our underwriting.? Besides, my boss reviews my work regularly.? I am not the only one analyzing my work.

IA: But leaving reserving and pricing in the hands of the same person is wrong.

Me: In many cases I would agree with you, but these are GICs; I have little freedom in setting reserves for them, the answers are formulaic, I can’t vary them.? Besides, take a look at our cash flow testing opinion.

IA: Huh?

Me: after reading this, you will see all the controls we put on the process.? We run far more rigorous tests than other insurers do to ascertain the profitability of our business.? Have a read.? Beyond that, our financials are reconciled to the penny every night.? It would be very difficult to have fraud here.

IA: You really seem to have too much power…

Me: We are not a large division.? We have four actuaries total.? We have different functions, and we can’t spare the effort to split pricing and reserving.? The boss watches over us; go ask him for his view of what? we do.

IA: I have, and he sounds like you.

Me: And he is the best.? He built this place, and it runs more smoothly than any other division of the company.

IA: Your division is funny.? You do things that we recommend against, but we can’t find anything wrong.

Me: We’re just doing our jobs.

IA: (Sigh) Okay, thanks, but our objections will be in the report to management.

Me: That’s fine; if the boss says to change things we will do it.

One of the most important aspects of insurance is to let the results of underwriting flow back into reserving and pricing.? You want to try to change your pricing of new business such that it reflects the true risks undertaken.

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

Then there was the minor panic that happened in late 1993, early 1994.? Rates had been low for a long time, and the investment department decided to buy some 10- and 30-year Treasuries, because they couldn’t find anything with enough yield.? Thus my conversation with the manager of my portfolio:

Me: Why are we holding 10- and 30-year bonds?? The duration of my longest liability is five years.

IM: Well we couldn’t find anything you buy.? These are just placeholder assets.

Me: You could hold cash, or 3-year Treasuries.

IM: But we wouldn’t get the yield we need.

Me: I am less concerned about our income than that we cover our risks.? You have made my interest rate risk higher by a factor of two.

IM: That much?

Me: This is a leveraged operation.? We ordinarily run at a duration of 2.5.? You can’t give me assets with durations near 7 or 14.

IM: Don’t worry, assets that fit your need should show up soon, just give us time.

Me: I would rather wait in cash, but okay.

+++++++ Two months later +++++++++++

Me: We’re sitting on 10% losses on the long Treasuries now.? You are killing my year.? What are you going to do?

IM: (makes a gesture of praying)

Me: that’s not good enough!? You said you would find something soon and now the Fed is tightening.

IM: We’re looking, we’re looking.

Me: (sigh) I know, but put yourself in my shoes.? We control risk first and then seek yield.? This reverses our priorities.

IM: I know, but relative yield is hard to find these days

Me: I know, but absolute yields are rising, and we are losing in the process.

+++++++++++++++++++++++++++++++

We closed out the position two months later for a loss of 18%.? Had the bonds been held longer, it would have been worse.? As it was, once we cleared that out, I started selling GICs rapidly, and did not hedge the sales, because I had figured out that rates would keep rising for a while, as I wrote about here.

As noted in the article just cited, 1994 eventually ended up being a winner of a year, but it started with that inauspicious event.? Who could tell?? My main point is this: don’t give up your risk control discipline to make a few measly bucks.? In tough situations, focus on the risks, and ignore the yields.

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