From a reader:

Was reading a history of AIG and it was discussing the early years. There was a line to the tune of ‘anything Hank reinsured paid off’.

You’ve written many times usually in the context of LTC, that insurers should not insure anything where the customers have a better idea of future claims than the company does. How is this rule not violated by reinsurance? Are reinsurance actuaries better, or are most deals in agreement about the risk and more about regulatory arbitrage/capital relief?

My response:

Which history are you talking about?

His response:

Fatal Risk – “They pretty much hit it perfectly. Whatever they laid off risk-wise seemed to result in claims and it was during a period where reinsurance was fairly cheap. They got the best part of the deal, by far.”

Okay, now I get it.  I’ve reviewed Fatal Risk, and have the most helpful 5-star review at Amazon.  I also have a special discussion with Roddy Boyd here.  I regard him as a friend of mine.

If insurers are supposed to be conservative, their reinsurers should be doubly so.  But AIG was a big company, and a plum to have as a client, many imagined.  But AIG would hand off underpriced risks to reinsurers, and there was a saying current when I worked at AIG 1989-92 “Never give a reinsurer an even break.”  This varies from the clubby reinsurance world pre-1980, where reinsurers and insurers would adjust terms of agreements in order to be fair, whatever that means.

AIG broke from that, and stressed the strict letter of the contract, and did not compromise.  An example from my time at AIG: a reinsurer of annuity business was caught short when Congress implemented the “DAC tax,” which was really a tax on new insurance premiums.  The reinsurer lost and asked us to compensate them.  We refused; there will always be more reinsurers.

Much reinsurance on the life side does cover regulatory arbitrage and capital relief.  With P&C, that’s not a big factor; rather it is risk reduction.

Reinsurers see more of the industry than a single insurer, that partially compensates for the reinsurer not having as much detail as the ceding insurer.  Reinsurers underwrite insurance companies and their management teams, in addition to the exposures at hand.  If an insurer gets a reputation for being too slick, reinsurers back off.

AIG may have been different because they were so big.  But even AIG had rough times with reinsurers: rescission of annuity treaties with Lincoln National in the mid-90s (costing hundreds of millions), and earnings management with General Re, on a reinsurance deal that did not pass risk, which led to the downfall of Hank Greenberg.

P&C reinsurers have other ways of mitigating risk as well, for example, requiring the company to take the first $XX million of losses, and limiting total losses covered.

So, no, reinsurers aren’t brighter than insurers, but they have to be selective, and not write business just to deploy capital.  If they are disciplined, they will turn down business when they can’t make money on underwriting, and send shareholders the excess capital.

Countries are firms that produce claims on assets and goods

If I were rewriting this today, it might read, “Countries are firms that produce claims on assets, goods, and income, and anything else they can dream of, in order to retain their privileged position.”

Countries exist for defense and internal justice.  That’s the bare minimum; think of it this way: can there be rivals for defense and internal justice without a civil war?  With many other issues, countries may be willing to share the load — charities that deal with the poor, in addition to welfare programs.

Countries have unique taxation rights, and though big businesses and other interest groups may bend countries to their will, the countries still have their rights.  In a crisis, that could be significant.

FDR confiscated gold during a crisis.  Cyprus swiped bank deposits in a crisis.  Argentina meddles with pension monies.  What could governments do as entitlement (welfare) payments rise more rapidly than taxes?  I don’t know for sure, but you can bet there will be some desperate moves made, tapping many sources of income, transactions, and assets, as well as limit benefits via benefits taxation and other methods.

You could even see widespread purging of the SS Disability Insurance [SSDI] rolls in a real crisis.  I think of an former neighbor, on SSDI because of a bad back who was regularly on his roof putting up and taking down Christmas lights.  He always seemed hale & hearty to me, but there he was on the government dole.

To the extent that they can, countries establish the rules of the economic game. reserving the right to change the rules.   It has to be this way, because aside from God, there is no greater power that can make countries change their ways by fiat.  Yes, there are wars and civil wars, but those have no determinate outcome.  No one orders a country around directly.  Indirectly, things are different, as diplomacy may bring pressure that makes another country compromise.

The model where countries rule over others to get “a piece of the action” is a fair approximation economically of how countries act.  Consider it as you invest, especially with foreign investing.

Companies & Industries


  • Falling gas prices this Fall Pollution requirements fall, people drive less, overcomes geopolitical effects $$ Aug 30, 2013
  • Wal-Mart vs Costco, Why My Critics R Wrong $WMT offers more variety vs $COST | thus more people lower wage rates $$ Aug 30, 2013
  • Brazilian Billionaire Who Controls Your Beer, Condiments, & Whopper Long piece on Jorge Lemann $$ #Heinz $BRK.B Aug 30, 2013
  • New York to Seattle Buyers Tap Brakes After Rates Rise Rising prices & mortgage rates mean loan payments 2 high $$ Aug 30, 2013
  • US Bank Legal Bills Exceed $100B Bloomberg Just think how profitable they will be when the dust settles 😉 $$ Aug 29, 2013
  • Cheap Corn Deters Buyers in US Sugar-for-Ethanol Plan Corn scarcity becomes corn glut, reinforcing sugar glut $$ Aug 29, 2013
  • Why Wal-Mart Will Never Pay Like Costco $WMT has much wider diversity of products, so more workers @ lower pay $$ Aug 29, 2013
  • Why Is Chicken More Expensive? Ask McDonald’s When $MCD adds a new ingredient to their menu, drives prices higher $$ Aug 29, 2013
  • Xerox Can Fix Number-Switching Scanners, but Not Altered Docs Could b a lot of work 2 re-scan originals if u havem $$ Aug 27, 2013
  • JPMorgan Worth 30% More If Broken Up, KBW Says Pure play financial institutions always get better valuations $JPM $$ Aug 24, 2013
  • Apple, Samsung, IBM, World’s Universities in Graphene Gold Rush Crystalline Carbon 1 atom thick sheets are amazing $$ Aug 24, 2013
  • College is like gasoline, demand for it is inelastic. Thus any subsidy gets captured by the college, & taxes get eaten by gas consumers $$ Aug 24, 2013
  • The Real Reason College Costs So Much Richard Vedder explains how federal subsidies push up the price on college $$ Aug 24, 2013
  • djco_corresp-031513.htm Munger’s law firm explains y $DJCO shouldn’t b viewed as an investment company. Well done! $$ Aug 24, 2013

US Politics & Policy


  • Obama Is About 2Undermine His Mideast Doctrine Obama has mostly tried 2disengage US from Mideast, this reverses it $$ Aug 30, 2013
  • The Rising Cost of Social Security Disability Insurance SSDI’s trust fund runs out is 2016; 2EZ 2get on disability $$ Aug 29, 2013
  • And Next Year There Will Be an Eighth Budget “Showdown” Rate of budget growth slowed, but scope of govt expands $$ Aug 29, 2013
  • Regulators Ease Mortgage Rules Swiss cheese regs destroy direct incentives 4 originators 2 produce quality loans $$ Aug 29, 2013
  • Regulators Back Away From Tougher Mortgage Rules More capital needs to be held against exotic mortgage loans, good $$ Aug 29, 2013
  • Obama Meets Panel Reviewing US Surveillance Programs Repeal the Patriot Act; modifications r not enough $$ Aug 28, 2013
  • College Leaders Wary of Obama Plan Linking College Aid to Rank Plan could hurt the very parties Obama wants 2 help $$ Aug 25, 2013
  • Samantha Power on the Duty to Intervene This argues that the US should be the cop of the globe 4 the worst things $$ Aug 25, 2013


Rest of the World


  • Sinopec-Apache Deal Shows China’s Resource Appetite China learns how 2negotiate minority stakes in oil properties $$ Aug 30, 2013
  • Hollande Draws Heat From Biz 4 Tax-Driven Pension Revamp France’s tax burden is ~46% of GDP, 3rd highest in Europe $$ Aug 30, 2013
  • Scandinavia’s Weakest Nation Finds Welfare Habits Too Costly Denmark looks forward, realizes it must cut welfare $$ Aug 30, 2013
  • The Abenomics Mirage: In Reality, Too Many Challenges? Japan imports on net so a lower yen doesn’t help much $$ Aug 30, 2013
  • Schaeuble Snubs Greek Plea for Direct Bank Recapitalization Perhaps Greece needs 2 establish effective taxation $$ Aug 29, 2013
  • Spaniards Fleeing Jobless Scourge Seek Jobs in Morocco Can’t earn as much but can earn something as Spain shrinks $$ Aug 29, 2013
  • Start-Ups Fill Void Left by Spain’s 26% Unemployment Rate If u can’t work 4 someone else u can work 4 yourself $$ Aug 28, 2013
  • Czech Zero Percent Lending Rate Feeds Home-Buying Frenzy Bad things happen when there is seemingly free $$ available Aug 28, 2013
  • Vietnam Rises as Middle Power at Defense Summit Wants to stay neutral btw the US & China, while protecting itself $$ Aug 28, 2013
  • Teachers Roil Mexico Capital Maybe it’s time 2 move the capital out of Mexico City, to someplace more hospitable $$ Aug 28, 2013
  • Emerging-Market Rout Intensifies on Syria Jitters Jitters affect oil mkt & it spills over in to weak emerging mkts $$ Aug 28, 2013
  • Fed Officials Rebuff Coordination Calls as QE Taper Looms Emerging markets whipsawed as US monetary policy shifts $$ Aug 28, 2013
  • Veteran Saudi Power Player Prince Bandar Works To Build Support to Topple Assad Islamic proxy war continues $$ Aug 27, 2013
  • Emerging Europe Is a Haven in Selloff Hard to damage nations w/more orthodox fiscal policies, but still part of EZ $$ Aug 27, 2013
  • Emerging market slump highlights Fed’s global reach The US sneezes & the world catches cold, again $$ Aug 27, 2013
  • Charlene Chu Interview with Goldman on China’s Credit Bubble Excellent Interview showing future China weakness $$ Aug 27, 2013




  • Scientists Shed New Light on Black Holes The speed w/which gas is pulled toward a black hole repels some entering $$ Aug 30, 2013
  • Is It Evil to Send Your Kids to Private School? Parents will always find ways 2keep children out of subpar schools $$ Aug 30, 2013
  • Age-Related Forgetfulness Tied to Diminished Brain Protein This may have some promise in reducing dementia $$ Aug 30, 2013
  • Definitive merger agreement between 2 business journalists Do some R&D, & create subsidiaries that will b spun off $$ Aug 30, 2013
  • How Haute Vegetables R Conquering $500 Tasting Menus Borage is a well-known medicinal herb; interesting 1st course $$ Aug 29, 2013
  • Six Reasons the US Will Dominate Immigrants, more workers, entrepreneurship, labor flexibility, <Financing, strong $$ Aug 28, 2013
  • P2P lending pulls in big investors – should you bite? Soon 2 come, a peer2peer lending closed-end fund $$ #ohno #FTL Aug 28, 2013
  • Shoeshines Keep Wall Street in the Black (or Maybe Brown) A unique institution stays alive on Wall Street $$ Aug 27, 2013
  • Sometimes I think Federal education policy is designed to weigh down the system, making it easier 4 private & home schools 2 outperform $$ Aug 27, 2013
  • Biggest Changes in a Decade Greet Students Some Teachers, Parents Push Back on New Standards “Common Core” $$ Aug 27, 2013
  • Home Births on the Rise for New York Families Fascinating trend, though I think the best is a midwife @ a hospital $$ Aug 27, 2013
  • Midwives provides far better care than doctors w/normal deliveries, & they r cheaper. Being @ a hospital provides insurance if trouble $$ Aug 27, 2013
  • Are You Ready for the Post-College SAT? College is not valuable to some employers -> a new test 2 show your smarts $$ Aug 27, 2013
  • Regarding that last tweet, could testing replace college? Credentialing is important, but do we need to waste four years to credential? $$ Aug 27, 2013
  • Jail Becomes Home for Husband Stuck With Lifetime Alimony Debtors prison returns in a new form $$ long article Aug 27, 2013
  • Muriel Siebert, First Woman to Buy Seat on NYSE, Dies at 84 Used to have an account w/her firm; good company $$ Aug 27, 2013
  • Ben Franklin Gets a Makeover Ben Franklin owned slaves?! Whouda thunk it! New presentation about a complex guy $$ Aug 25, 2013
  • Dishwashers Beat Clothes as US Moms Use Hand-Me-Downs People buy things w/longer-term value, reduce luxuries $$ Aug 25, 2013


PPACA / Obamacare


  • A New Kind of Insurance Head-Scratcher: Estimating Future Income Incentive will b2 under-report until checked $$ Aug 30, 2013
  • The Young and the Healthy One more calculator 4 Obamacare subsidies 4 young & not well-paid $$ Old win, young lose Aug 30, 2013
  • Senior Discounts Interesting illustrative calculator on premium subsidies under Obamacare. Incentives to earn less $$ Aug 30, 2013
  • Thus PPACA will have an incentive 2 destroy working, & the exchanges will fail, as they will only attract the sick, young ppl stay away $$ Aug 30, 2013
  • Also, look at this graphic As incomes go from 25K to 55K, subsidy is lost & an implied 17% tax from the loss $$ Aug 30, 2013
  • Subsidies for Older Buyers Give Health Insurers a Headache Subsidies will will older poor in2 exchanges, not young $$ Aug 30, 2013


Harbinger Group Life Insurance IPO
·  Falcone Insurer Said to Seek $1 Billion Valuation in IPO – Bloomberg & my tart comments: $$ Aug 30, 2013

  • Harbinger’s insurance unit files for $100M IPO $HRG pays itself a dividend; dig the 28pp of risk factors @ the SEC $$ Aug 29, 2013


Market Impact


  • Pimco Sees Taper in Worst MBS Slump Since 1999 Bond market summary, particularly noting taper effect on MBS market $$ Aug 30, 2013
  • Some IPOs Aim for Small Investors Keep your hand on your wallet, alternative stock distribution methods untested $$ Aug 30, 2013
  • Currency Spikes at 4 PM in London Provide Rigging Clues All human systems r gamed; need 2 acct 4 that w/benchmarks $$ Aug 28, 2013
  • How ‘black squirrels’ infested Wall Street Efforts to level playing field made it more opaque & hazardous $$ #complex Aug 27, 2013
  • Cyclical Stocks Looking Historically Cheap Yes, cheap. What will happen 2 cyclical earnings if the economy slows? $$ Aug 25, 2013


Central Banking


  • Fed’s IG says central bank violated document rules Issued minutes of policy meeting a day b4 the scheduled release $$ Aug 30, 2013
  • Did Fed’s Forward Guidance Backfire? Paper Says Probably The idea that clear Fed communication works is unproven $$ Aug 25, 2013
  • Summers as Obama Voice of Authority Rides Car Rescue in Fed Race Good piece on y Obama may pick Summers 4Fed Chair $$ Aug 25, 2013


Wrong, Etc.

  • Wrong: CLO Rule Aimed to Pass Retention to Banks Won’t Work, RBS Says Will shrink the # of issuers, that’s not bad $$ Aug 29, 2013
  • Bad title: Why Is Vladimir Putin Acting So Crazy? He’s acting rationally in response to changing conditions $$ Aug 29, 2013
  • Wrong:Will Obama Make the Fed Even Worse? Not well argued. More about his view $$ policy is 2 tight, less about Obama Aug 27, 2013
  • Sort of: The Strong Case for Optimism About US Growth Except it is optimism after 5 more years of deleveraging $$ Aug 27, 2013


Retweets, Replies & Comments

  • RT @EddyElfenbein: Happy 83rd Birthday to Warren Edward Buffett @WarrenBuffett. The Dow was at 240.42 eighty-three years ago. Aug 30, 2013
  • #FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Aug 30, 2013
  • Thanks @OGMarcusC @Metalbanker for being top new followers in my community this week 🙂 | insight by Aug 30, 2013
  • @ledbetreuters If you had your own website, & had a Google Page Rank over 5, u would get around two of those per week. Very pesky. Aug 30, 2013
  • RT @azizonomics: Nobel War Prize Aug 30, 2013
  • RT @ianbremmer: Knock knock. Who’s there? The international community. The international community who? Precisely. Aug 30, 2013
  • RT @treehcapital: Yet another reason to love New Zealand @pkedrosky: New Zealand bans software patents Aug 29, 2013
  • Thanks @researchpuzzler @AndreCimini for being top engaged members in my community this week 🙂 | insight by Aug 26, 2013
  • @alisonforns And I see the glass as 70 fewer than 140. What a wonderful world! Aug 26, 2013

I like questions from readers, if they are general enough for a blog post.  Here’s one for tonight:

Mr. Merkel,

Following reading your blog here:

It occurs to me that attaining money in the first place is only half the battle.  A well known fellow among engineers; Nicolai Tesla was great at this.  He made many millions in his life.  He also constantly reinvested most of his income into new inventions and new ideas.  When he died, he was pretty much destitute.

Starting a gas station requires about $300,000 ($150-200k to buy the store/land, 40k to furnish the store, 40k to buy the gas) in startup capital.  In technology, and in software; you can start making money with a good idea and next to no start-up capital… assuming you don’t get crushed by a larger company in the process.

How do the super rich store their massive income?  How do they invest it?  Buying up ever more companies and taking their profits off the top?  What is a minimum threshold amount of money that you need to start to do this?  Can you recommend any good books?

There are several classes of assets that the wealthy like to preserve their wealth.  Here are some examples:

  • Real Estate
  • Municipal Bonds
  • Businesses in necessary industries that throw off a lot of cash flow.
  • Businesses in which they have significant inside knowledge, and can continue to benefit from the knowledge.
  • Occasional equity investments in private ventures that seem promising.

After a certain amount of wealth is acquired, intelligent wealthy people tend to turn to things that have predictable cash flows, rather than take a large amount of business risk.  They’ve made their fortune.  Now it is time to conserve it, and receive what some consider to be rents — passive income that comes with little volatility.

Even Goldman Sachs did this with excess profits, buying safe securities, and throwing them into the BONY box. [BONY == Bank of New York, now BNY Mellon]

In essence, the wealth is converted to ownership in what is likely to be a growing income stream.  What is not used is reinvested.  That is how wealth is preserved during the life of the wealthy.

As for books, you can look at “The Millionaire Next Door,” and its series. Also, Rich Like Them.

But remember, not all rich try to preserve their wealth.  Some lose it through over-consumption, and others through bad investments.  The investments that I list above require a degree of humility, and thus, only wise rich people will follow such a strategy.

Before I start for the evening, I would like to mention that Aleph Blog ranked #120 on Onalytica Indexes  Top 200 Influential Economics Blogs.  The post doesn’t mention it, but Aleph Blog was tied for #86 in terms of popularity.  More people read me than cite me or link to me.

This is more of a finance & investing blog than an economics blog, largely because I am a dissident in the land of neoclassical economics.  This blog is a melange of my varied interests, and is a bit of an acquired taste.  This will be true tonight as well, because tonight’s topic is trading illiquid stocks.

I regard a stock or bond as illiquid if dollar volume traded is low relative to the market capitalization of the security.  Why would I want to own such a security?  Neglect.  There are few eyes analyzing a security that cannot be sourced in size.  Thus, if you have a strong opinion on the security, and it is neglected, you have the opportunity for some strong returns.

In the portfolios I manage for clients, roughly 10% of the assets are illiquid, as I define it.  I have generally had good results with neglected stocks, but many stocks are neglected for a reason, typically a management team that is unfair to outside passive minority shareholders.  Who wants to put cash into a “roach motel?”

In dealing with illiquid stocks, I typically use discretionary reserve orders.  A discretionary order displays the price at which you want to buy or sell, and what degree of latitude you are willing to compromise on the price.  Here’s an example:

Bid: 10.40 Ask: 10.50

A discretionary order might say, “Buy 1000 shares @ 10.39, with 0.06 latitude.”  Any sell order flashing through at 10.45 or lower would trigger the discretionary buy order.

A reserve order says, “I want to sell a large number of shares, but I only want to display a small number, to avoid scaring the market.”  It could be “Buy 1000 shares, show 100 @ 10.40.”  If someone comes in with a larger order than 100 @ 10.40, it will execute up to 1000 shares.  Makes you look small to everyone but the market makers and specialists, who know how much you really want to do.

And that is a difficulty, and I learned it the hard way — I tried a trade where  was offering 20,000 shares and showing 100 on a NASDAQ stock, and the market for the stock went down on what was an otherwise calm day.  Other retail investors couldn’t see my size, but the market maker could, and he adjusted his bid down considerably.  So now I break up my trades, and don’t exceed a certain normal size for the liquidity of a given stock.

A discretionary reserve order combines the two.  For less liquid stocks, I use it frequently, because it erases some of the advantages that high frequency traders have.  My example would be: “Buy 1000 shares, show 100 @ 10.39, with 0.06 latitude.”

So for an illiquid stock was buying lately, I was doing the following (using the same market as before):

  • Buy 1000 shares, show 100 @ 10.40, and,
  • Buy 1000 shares, show 100 @ 10.39, with 0.06 latitude

The idea is to be ready to buy the sell orders that flash through the market at 10.45 or less, while being ready to buy shares cheap if someone decides to lift the bid.  The combination allowed me to buy 20% of the volume across two days, and not budge the stock price — it declined until the seller exhausted himself, after which, the stock started to rise, and I could get nothing more done.  I got 80% of the position on and will wait for a better opportunity for the balance.

Moving from Micro to Macro

So I have my own techniques for coping with market complexity.  I don’t complain about high frequency trading [HFT]; I fight back.  I don’t trade much, so trading is not a core way in which I add value.  That said, I do what I can to minimize the total costs of trading, which is a balance between paying up and getting the stock, and not paying up and the stock gets away from you.

As this article points out HFT is the result of squeezing market makers & specialists through decimalization and a few other regulatory changes.  Intermediaries lost margins and large traders lost the ability to do large trades without revealing their intentions to the world.  Thus in a free market, alternative execution sites come into existence.  Providing liquidity deserves some sort of reward, because it is a good.  HFT is one way for a liquidity provider to get paid, even if some of the tactics are questionable.

The competition to trade the same stocks in different venues led to complexity, such that data exchanged across execution venues must all run on the same clock.  If that is not so, it can lead to the “Flash Crash,” or the recent shutdown at NASDAQ, which ostensibly happened to avoid a repeat of the “Flash Crash.”

Complex systems require some degree of cooperation or regulation in order to operate well.  I have suggested that we don’t need microsecond liquidity to make things work.  Liquidity once per second, or even once per minute would do.  Having one central order book for each stock also would do it, together with tiny fees on orders that get cancelled.

Willingness to offer liquidity deserves a reward, and the more so for orders of size and duration.  They act similarly to what market intermediaries do, so let us come to a market system where such offers of liquidity, whether to buy or sell, get properly rewarded.  That might bring stability to the markets, together with a reduction in complexity.

Let’s trot out the promoted stock scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 7/25/13DeclineAnnualizedSplits





















































































































































Tonight’s loser in waiting is the same one that I wrote about last time, North American Oil and Gas [NAMG].  This time the Washington Times was spreading the garbage of Tobin Smith via email, as opposed to Bloomberg last time.

But wait, the stock has gone up 45% since I wrote about it.  Doesn’t that mean I am wrong?

No, that’s happened a number of times with the above stocks.  When the promotion ends, so does the stock price.

Two final notes:

1) iTrackr is dead.  Total loss.  Not the next Microsoft or Google.

2) Nova Mining has renamed itself The Radiant Creations Group, Inc. [RCGP].  They have changed their focus from mining to a company that:

engages in the development of various skin protection and hydration, anti-aging, liver health, weight balance, and OTC products. It provides day creams, anti-aging night creams, acne gone and sports block products, and wrinkle repair creams; and weigh control and weight loss products, as well as liver detoxifiers.

Usually, when a promoted stock changes strategies, it changes owners, and that is happening here.  It also likely means there will be a new promotion, where a new pump-and-dump occurs.  You might think that it is a new time for speculating, but the company is trying to buy in shares at a price below the current market price.  Closely held promoted companies offer up all manner of bad surprises for the minority shareholders.  Don’t risk investing here.


While doing some work today, I ran across this resource from Morningstar. Morningstar values stocks by projecting the free cash flows of the companies, and discounting those free cash at a rate that reflects the riskiness of the company.  Free cash flows are the amount of cash you can take from a corporation over a period, an leave it equally well off as it was at the beginning of the period.  Some analysts summarize it as:

  • Earnings then add back
  • Interest, Taxation, Depreciation, Amortization, and subtract
  • Maintenance Capital Expenditure

When you see firms talk about their non-GAAP earnings, this is what some are trying to approximate, showing the true earnings power of the assets.

They project the free cash flows in three phases:

  • Phase 1, the analyst projects the next five years
  • Phase 3, every company is the same, growing at the same rate with no competitive advantage
  • Phase 2 grades from Phase 1 to Phase 3, with wide moat companies having a transition period of 20 years, narrow moat companies 15 years, and “no moat” companies a lesser amount.

What does Morningstar use for its free cash flow discount rates?  They started with CAPM, and moved to something more simple, where companies are divided into four buckets, with rates of 8, 10, 12, and 14%.  I’m no fan of CAPM, but it would be a lot smarter to have a system that reflected:

  • the bond yields of the companies, if any, and
  • the relative riskiness of the enterprise without reference to the market as a whole.  The implied volatility of the stock could play a role.

At the end, Morningstar calculates the ratio of the current market price to the discounted value of the free cash flows per share.  If it is greater than one, is is overvalued.  If it less than one, undervalued.

Morningstar does the calculation company by company, but then aggregates the results by super sector, sector, industry, aize of moat, fair value uncertainty, and equity index.

What I particularly found interesting were the aggregations by industry.  I decided to look at the industries that  were overvalued and undervalued by at least 15%.  Here they are:


  • Aluminum
  • Asian Banks
  • Coal
  • Gold
  • Latin American Banks
  • Pollution & Treatment Controls
  • Steel


  • Auto & Truck Dealerships
  • Auto Parts
  • Broadcasting – Radio
  • Business Services
  • Computer Systems
  • Electronics Distribution
  • Financial Exchanges
  • Footwear & Accessories
  • Home Furnishings & Fixtures
  • Insurance Brokers
  • Internet Content & Information
  • Long-Term Care Facilities
  • Luxury Goods
  • Marketing Services
  • Medical Distribution
  • Regional US Banks
  • Regulated Gas Utilities
  • REIT – Hotel & Motel
  • Scientific & Technical Instruments
  • Semiconductor Memory
  • Solar
  • Trucking

Morningstar as 147 industries, of which only two did not have fair value estimates.  Seven industries were undervalued (5%), 22 industries were undervalued (15%).  The undervalued industries were mostly cyclical in nature, while the overvalued industries were not, supporting the idea of this Wall Street Journal article, which argues that cyclical stocks are looking relatively cheap.  It is possible to overpay for certainty, just as it is possible to overlever companies with reliable cash flow.

At this point you might be asking, “Okay, this is nice, but what companies does this imply I should buy or sell?”  Can’t tell you for sure, but I can show you this.  This table is interesting enough, but what you can get are the companies behind each industry group if you click on them.  Note that Morningstar is global in its orientation, so many of the companies that it uses are not US-domiciled.  Some may have nonsponsored ADRs that trade infrequently.

My main point is that you can look at the underlying companies of each industry for buy or sell ideas of of their own discount or premium to fair value.  Morningstar’s fair value analysis is not perfect, but it is a straw blowing in the  wind, and is adequate for some relative value judgments.



  • Boehner Tells Caucus House Will Keep Fighting Health Law If the company mandate is delayed, y not the individual 1 $$ Aug 24, 2013
  • California Health Exchange Might Face Online-Enrollment Delay More glitches as we get closer to Obamacare fiasco $$ Aug 24, 2013
  • Jeffrey Singer: The Man Who Was Treated for $17,000 Less You have to understand how negotiable medical costs are $$ Aug 23, 2013
  • UPS to End Insurance Coverage for 15,000 Working Spouses This is the future as Obamacare comes into existence $$ Aug 22, 2013
  • Jeffrey Singer: The Man Who Was Treated for $17,000 Less First party payment reduces health costs, not ins/govt $$ Aug 22, 2013
  • Republicans in Echo Before Big Burn Defy Affordable Care In this era, it probably helps the Reps, LBJ’s era not $$ Aug 22, 2013
  • Obamacare exemption — none dare call it treason Congress and Administration r exempt from the PPACA $$ #FTL Aug 20, 2013
  • GOP keeps needling Obamacare in key Senate states Complexity of PPACA makes it its own worst enemy; ez 2 thwart $$ Aug 19, 2013
  • Norquist Says Obama to Take Health Delays, Avoid Shutdown House can block things, Senate cooperation unlikely $$ Aug 17, 2013
  • Obama Suspends the Law. What Would Lincoln Say? Article made me sympathize with Lincoln. Could Obama be Impeached? $$ Aug 17, 2013




  • Wrong: Why the US Power Grid’s Days Are Numbered Overstates the green case. More difficult to dismantle grid $$ Aug 24, 2013
  • Wrong: How To Invest Like Carl Icahn U can’t invest like Carl Icahn b/c u can’t b big enuf 2 bully mgmt teams $$ $IEP Aug 23, 2013
  • Word to Fed: Less Talk, More Action When u have 2 re-explain what u r doing a # of times, u probably don’t get it $$ Aug 22, 2013
  • Wrong: Janet Yellen called the housing bust and has been mostly right on jobs Yellen did not call housing bust $$ Aug 19, 2013
  • Wrong: Summers-led Fed might raise rates faster than Yellen Forces being dealt w/r larger than individual ideas $$ Aug 19, 2013


Politics & Policy


  • Has Eric Holder Found Wall Street’s Nightmare? 2 early 2 say; tough to prove that people had bad motives vs stupid $$ Aug 24, 2013
  • Ivory Tower Types Fall for Bigger Inflation Fix Inflation is tough to eliminate once it gets entrenched $$ Aug 22, 2013
  • Obama to Propose College Ratings System on Bus Tour Haven’t we distorted incentives on college enough already? $$ Aug 22, 2013
  • Secret Court Faulted NSA for Collecting Domestic Data If govt can’t tell us about it, they shouldn’t b doing it $$ Aug 22, 2013
  • Why Science and Politics Don’t Mix Science is compromised when observers cease 2b neutral & overstate conclusions $$ Aug 22, 2013
  • Justice Department Plans New Crisis-Related Cases nothing serious here, just late grandstanding & posturing $$ Aug 21, 2013
  • New Details Show Broader NSA Surveillance Reach Giving up liberty 4 security means that we will have neither $$ Aug 21, 2013
  • More Than Half of U.S. College Students Get Federal Aid If we reduced the aid given 2 students, tuition would fall $$ Aug 20, 2013
  • Fannie Mae, Freddie Mac Ignoring Write-Offs, Report Says Reported earnings may b overstated, as dud loans persist $$ Aug 20, 2013
  • Raising Kids? Your Taxes Are Far Too High Especially counting value of kids future contributions 2 entitlements $$ Aug 20, 2013
  • Congress gets a bunch of general and basic nostrums about how financial risk modeling is done and implemented $$ Aug 20, 2013
  • Fed Finds 18 Large Banks Weak in at Least One Capital Area Fed’s study shows moderate knowledge of risk mgmt $$ Aug 20, 2013
  • Greenwich Stilt Houses Foreshadow Impact of New FEMA Maps Think of the taxpayer subsidy from premiums that r2 low $$ Aug 20, 2013
  • Treasury Faces Coupon Conundrum With 5Yr Sale, Wrightson Says We have computers now, not everything has 2b eighths $$ Aug 20, 2013
  • Last Bernanke Years Shows No Sign of Buyer’s Remorse Why should he? Providing liquidity easy; taking it back hard $$ Aug 20, 2013
  • The other part of the story is that people who work have a purpose, and that makes them happier. Shame about younger people not employed $$ Aug 20, 2013
  • Mailman at 72 With America’s Longest Route Long story showing future, where old people keep working til they die $$ Aug 20, 2013
  • NSA broke privacy rules thousands of times per year, audit finds NSA search abuses r not rare; we need to end NSA $$ Aug 17, 2013
  • The Baby Penalty Female PhDs who have children lose opportunities. True 4 all who take time from work 4 family $$ Aug 17, 2013
  • Teachers Face License Loss This almost never happens. The teachers’ unions always find a way 2 protect their own $$ Aug 17, 2013



Rest of the World


  • It Looks Like 1998 Again in China Excess capacity to export what world doesn’t need plus high financial debts $$ Aug 22, 2013
  • ‘Leftover women’ in China face tough choices in looking for love Women like2marry up, which means many won’t marry $$ Aug 21, 2013
  • Who Is Ali Khamenei? Long & nuanced article on the supreme leader of Iran – History, views, influences, & theories $$ Aug 20, 2013
  • Mexico’s Pemex Looks to Tap U.S. Shale This doesn’t look like a smart idea; most good business is incremental $$ Aug 20, 2013
  • Allies Thwart America in Egypt Israel, Saudis and UAE Support Egyptian Military Moves $$ #choosefreedomvsdemocracy Aug 20, 2013
  • Israel Boosts Ties With Egyptian Army as US Mulls Cuts Politics makes strange bedfellows $$ Aug 20, 2013
  • Al Qaeda ‘rat line’ from Syria to Iraq turns back against Assad Actions taken against US in Iraq now harm Assad $$ Aug 20, 2013
  • Bankers Supplanted by Elves as Iceland Chases Cash A place where allowing banks to fail worked well $$ Aug 20, 2013
  • Central-Bank Moves Blur the View Bodes well 4 their bonds, tough 4 the stocks of their exporters, importers ok $$ Aug 24, 2013
  • Potash Rift Seen Lasting as Asia Sales Said to Rile Uralkali Interesting article reviews potash cartel history $$ Aug 22, 2013
  • Gold Rout Seen Bottoming by Analysts as China Buys & China Gold-Mine Deals at Record $$ Aug 22, 2013
  • Regulatory Concern Grows along with Surge in Interbank Business Surge in China Interbank lending is worrisome $$ Aug 20, 2013
  • Egypt’s Former President Mubarak May Be Freed A logical outcome, 1 that shows the Army is playing “for keeps” now $$ Aug 20, 2013
  • In classified cyberwar against Iran, trail of Stuxnet leak leads to White House Will this lead 2 anything negative $$ Aug 19, 2013
  • Last of Zuma’s Main Critics Sidelined as Vavi Suspended South Africa traded one oligarchy for another $$ Aug 17, 2013
  • The Dutch, Europe’s apostles of austerity, feel the economic pain Paying the piper 4 taking on 2 much debt $$ Aug 17, 2013
  • Easy Credit Dries Up, Choking Growth in China Payoff 4 malinvestment may b arriving. Japan 1989 -> China 2013 $$ Aug 17, 2013

Market Impact


  • Market Size Complex Systems = More Glitches We can reduce glicthes if we reduce complexity & choice 4 large $$ mgrs Aug 24, 2013
  • Americans don’t know anything about interest rates & portfolios Investment returns r magic 2retail $$ @reformedbroker Aug 22, 2013
  • Hedge Funds Severely Underperforming This Year Net exposure relatively high, but heavily shorted stocks rally 33% $$ Aug 22, 2013
  • Low-volatility ETFs may not be what they used to be Any investment strategy can b overused, & returns vanish $$ Aug 21, 2013
  • Looking for value: When the child outperforms the parent Spinoffs r underanalyzed companies w/incentive 2 focus $$ Aug 21, 2013
  • Bond Trading Hampered as Buyers Retreat to Crowded Exits Overstates the degree dealer inventories affect prices $$ Aug 21, 2013
  • CLO Refinancings at $50 Billion Seen Rewarding Riskiest Issues Feels like 2006 in credit craziness $$ Aug 20, 2013
  • Repo Market Decline Raises Alarm as Regulation Strains Debt Repo market getting less liquid, that’s not so bad $$ Aug 20, 2013



Companies & Industries


  • Buyout of $AIG Unit Is On the Rocks Difficult to overstate how sensitive ILFC profits r2 cheapness of financing $$ Aug 22, 2013
  • Water + Sunshine = Fuel as Lab in California Chases Dream Dream indeed. Call me a skeptic on the science here $$ Aug 22, 2013
  • A New Spate of Deaths in the Wireless Industry Every death is tragic, but w/deaths <20/yr, that doesn’t seem high $$ Aug 22, 2013
  • Kodak Reorganization Approval Affirms Move From Cameras Unsecured creditors get 4-5% of their claims, stock gets 0 $$ Aug 21, 2013
  • Problem for Bezos: Mall Becoming Cheaper Than Amazon Who knows? Maybe $AMZN will have to earn $$ to exist. #nonprofit Aug 20, 2013
  • The busiest acquirer you haven’t heard of Many acquisitions in a short time is usually a recipe for disaster. $$ Aug 20, 2013
  • Shale Grab in U.S. Stalls as Falling Values Repel Buyers Anytime there is a boom, prices overshoot, then writeoffs $$ Aug 20, 2013
  • What Tim Cook and Apple should do with all that cash Harder than it sounds, most of the $$ trapped abroad, bond deal Aug 20, 2013
  • The 1975 Buffett memo that saved the Washington Post’s pension Buffett was always a smart guy; prescient in 1975 $$ Aug 19, 2013
  • Cisco and the Search for New Life Companies w/strong core businesses have a hard time expanding into new business $$ Aug 17, 2013
  • Rail-Truck Shipments Reveal Holiday Sales Clues Holiday sales may rise, higher volume of goods transported in 2013 $$ Aug 17, 2013
  • Fixed Indexed Annuities Merit Caution Law should give contractholders right 2 full value withdrawal if transferred $$ Aug 17, 2013
  • Oil-Pipeline Cracks Evading Robotic ‘Smart Pigs’ If cracks r along the welds, they don’t get detected easily $$ Aug 17, 2013




  • JPMorgan Sub-New Normal Growth Seen Vexing Next Fed Chief New Fed Chief will face economy traveling @ stall speed $$ Aug 23, 2013
  • Economists Need to Admit When They’re Wrong Crisis caused by a huge rise in private debt; economists missed that $$ Aug 22, 2013
  • Green Bay: More Legends Than Streets Smallest franchise city has more heroes than streets to append their names $$ Aug 22, 2013
  • Abandoned Dogs Roam Detroit in Packs as Humans Dwindle This is strangely fitting; Detroit slowly becomes 3rd world $$ Aug 21, 2013
  • Eating of Sausages “no Christian is bound to do those things which God has not decreed.” Of Calvinism old & modern $$ Aug 20, 2013
  • Seth Lipsky: Ben Bernanke’s Anger and the AIG Case Questionable legal ground4the Fed’s takeover of AIG 2b explored $$ Aug 20, 2013
  • Why An M.B.A. Isn’t Good Enough Anymore High costs, changing demographics, technological change-> reinvent the MBA $$ Aug 20, 2013
  • Broker Audits Marred by Conflicts of Interest, Watchdog Says Deficiencies >95% of brokerage audits it reviewed $$ Aug 20, 2013
  • What’s Ailing America’s Cattle? Scientists Suspect Livestock-Feed Additives Are Behind Distress $$ Be careful Aug 20, 2013
  • Student Test Scores Rose When Teachers Retired Early Teachers peak in effectiveness after 5-10 yrs of experience $$ Aug 20, 2013
  • Hybrid Bond Gamble Pays Off as Stimulus Spurs Gains Paid off for now, but these hybrids sting w/higher probability $$ Aug 17, 2013
  • John Laporte, T. Rowe Price Manager Who Beat Peers, Dies at 68 Pretty certain I met him @ Baltimore CFA, good guy $$ Aug 17, 2013
  • Are College Costs Reaching a Breaking Point? Possibly, if Federal aid drops & fewer people go to college $$ Aug 17, 2013
  • New Software Forces You to Pay Attention During Company Training Next, they’ll give you drug that makes u like it $$ Aug 17, 2013
  • Price Manipulation Includes Silver and Gold When prices r fixed by survey or transactions, games will b played $$ Aug 17, 2013
  • Francis Ouimet’s U.S. Open Victory That Changed the Game Forever Meet Francis Ouimet, the amateur who won US Open $$ Aug 17, 2013
  • A Chance to Own a Home for $1 in a City on the Ropes Get your own home in Gary, Indiana for $1 $$ Aug 17, 2013
  • How a Black Hole Really Works Scientists watch black hole at center of Milky Way eat a cloud of gas $$ Aug 17, 2013


Comments, Replies, and Retweets

  • #FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Aug 23, 2013
  • Commented on StockTwits: ILFC very different than NetJets. $BRK.B capable of buying ILFC, but Buffett won’t pay to… Aug 22, 2013
  • Thanks @dpinsen @ReformedBroker for being top engaged members in my community this week 🙂 | insight by Aug 22, 2013
  • Thanks @pelias01 @TopInvestBlogs for being top engaged members in my community this week 🙂 | insight by Aug 22, 2013
  • Thanks @howardlindzon @moneyscience for being top engaged members in my community this week 🙂 | insight by Aug 22, 2013
  • Thanks @brasil247 @JerseyDemic for being top new followers in my community this week 🙂 | insight by Aug 20, 2013
  • “Many acquisitions in a short time is usually a recipe for disaster.” — David_Merkel $$ Aug 20, 2013
  • @pdacosta FWIW, I thought the document was amateur in discussing financial risk management Open 2other thoughts $$ Aug 20, 2013
  • @buzzmerk @StevStiffler @truedat157 @pcyansee the greater Q is why the Mars Corp hasn’t sued him for trademark infringement- ruins the brand Aug 20, 2013
  • Thanks @AboveAvgOdds @Nonrelatedsense for being top engaged members in my community this week 🙂 | insight by Aug 19, 2013
  • Thanks @japhychron @The_Analyst for being top engaged members in my community this week 🙂 | insight by Aug 19, 2013
  • Thanks @GaelicTorus @AndreCimini for being top engaged members in my community this week 🙂 | insight by Aug 19, 2013
  • Thanks @ReformedBroker @dpinsen for being top engaged members in my community this week 🙂 | insight by Aug 19, 2013
  • Thanks @pelias01 @TopInvestBlogs for being top engaged members in my community this week 🙂 | insight by Aug 19, 2013
  • Thanks @howardlindzon @moneyscience for being top engaged members in my community this week 🙂 | insight by Aug 19, 2013
  • “Buffett would have made a very good actuary, and with a bonus: he can communicate complex concepts…” — Merkel $$ Aug 19, 2013


I’ve written on this topic before, but I want to take a different angle of attack on it tonight.  Before I do, I would like to give links to some of the things I have written on the topic:

Okay, enough.  I’m surprised that I have written so much on this topic.  There’s more, but I leave out the marginal stuff.

This article is partially prompted by my review of Octopus.  But it was triggered by my receipt of an e-mail today, that when I clicked on the link, led me to something like this.

Passive income is one of the ways that scammers appeal to the greed of people.  You get money, and you don’t have to work.  But passive income stems from buying or creating something that will have continual demand.  That takes effort or ingenuity at taking risk, and if you are wrong, you could lose a lot of effort and/or capital.

Passive income is easy to achieve.  What is hard is making sure that it continually rises, and that it stays at a high level relative to capital deployed.

With President Obama, his book “The Audacity of Hope” brought him a lot of passive income.  But there was risk involved; who knew that he would be elected President?  Few of us writing books will get so great an audience, and get such a long tail.  Most books are here and gone.  Same for most songs.  Same for most plays, etc.  Royalties are not as easy as they seem.

Most royalties are wasting assets.  Mines get mined out.  Wells go dry.  Things that are published stop selling as much.  In that sense they are worse than bonds, because the yields decrease over time.

So, no, passive income isn’t a solution, and may end up delivering less than conventional investments.

Developing a Defensive Mind

I have a saying:

Minds work best when they are like castles, when there is a moat, and defenders at the ready to deal with deceivers with arrows and boiling oil.

Here is my main advice: you need to be skeptical, but not cynical.  Skeptics question, but can be convinced with adequate evidence.  Cynics think the world is rigged.  Here’s their flaw — they can be tricked into scams where they think they are on the rigging side, when they are not.

Here’s my advice to aid your thinking: the world is not rigged.  There are few if any significant conspiracies that deny wealth and power to the masses.  The reality is more banal.  Some people, as a result of their training, networking, and effort do better than others.  Most people don’t put forth sustained, focused, intelligent effort that allows them to accumulate wealth.

Are there some that make money off of government connections?  Yes, but they are not the rule, and they don’t advertise for passive capital.

Passive capital is a highly competitive place to be.  Making money with money is desired by financial institutions, pension plans, endowments, etc.  If there were an easy way to do it, the big guys would have figured it out long before you.

If it seems to good to be true, it probably is

Trite, but true.  Condition your mind to dismiss schemes that cannot fail, investments that are a one way ticket to riches, etc.  Get a sense of the scammer voice, where he invites you into a secret “club.”

Look, if I had a path to easy riches, would I share it?  No.  All riches stem from hard mental or physical work, even if you inherit it.  That is why you have to distrust those who try to scam you through proffering easy riches.  There are no easy riches.

There are no secrets in investing.  Don’t let anyone tell you that they have a secret tactic.  I don’t have a secret tactic.  I do have my own methods, which draw from a lot of well known methods, and my own sense of what works in business, which also stems from well-known ideas.

Avoid anything that makes you think you are in the inner ring — the precious few, who due to connections have been able to escape the ordinary lot of men, because they are part of the club that has the secret, or government connections to a secret program.

If someone has a great opportunity, and need passive capital, they will advertise it boldly, because they want the cheapest cost of capital.  Those that limit the message to a select few are likely scamming.

Final Points

Pay attention to auditors and custodians.  They protect you, and they should be high quality, and unaffiliated with the promoter.  Avoid those that do not market broadly — what I mean here is those that don’t go through major brokers.  The more exposure an idea has the more likely it is valid.   That said, highly exposed ideas will likely produce market-like returns.  There is a trade-off here.

Also, all investing involves uncertainty.  Reject those that tell you something is a sure thing.  THERE ARE NO SURE THINGS!

Sigh.  Do I have to go to that level of emotion/energy?  I GUESS I DO! Because the scammers keep coming around and milk the unwary.

PS — I know my readers are smarter than most, but if you have friends or relatives that you think might need this, please forward it on.  Delete this last line to protect their self-esteem.


Most of us don’t focus enough.  We let important projects lag, while working on matters that are less important.

This book takes the approach that you will do best if you block out the first four hours of your workday, and work on the one task that will make all other aspects of the business work better.

Doing “a little of this, a little of that,” tends to waste time.  We are most productive when we focus.  In an internet age where we live with a huge distraction in front of us, it is all the more imperative that we take control of our time, and focus on the most valuable task.


This book is focused, and as such, you get a lot of repetition.  I’m not crazy about that from a literary point of view, but the author is trying to drive a simple point as many times as he can.

Who would benefit from this book: Anyone trying to improve their time management would benefit from this book.  If you want to, you can buy it here: The ONE Thing: The Surprisingly Simple Truth Behind Extraordinary Results.

Full disclosure: A dear friend gave me this book.

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.