One of the things that annoys me about the concept of the equity premium is that it is an academic creation that does not grasp the structures of the markets.  Send the academics to be bond and equity portfolio managers for a time, and maybe we would get a better theory than Modern Portfolio Theory [MPT].

Here is the first thing that is wrong with MPT — it doesn’t understand the bond market.  The best estimate of what bonds will return over time is the current yield less expected losses from defaults and optionality.  Hold a bond to its maturity, and the standard deviation of returns is low, over the full time horizon.

Thinking about bonds in the current environment, virtually nothing is earned with high-quality short-dated debt.  The yield curve is still relatively steep, as people expect the economy and lending to pick up.

Think for a moment. what is a longer asset, a corporate bond, or the stock of the same company?  The stock is the longer asset, because the cash flows of the business in question potentially stretch far longer than the maturity of the corporate debt, at least in most cases.

Also think, in a bad scenario, where insolvency is possible, who has the better claim: the equity or the unsecured debt?  The unsecured debt, of course.

Longer assets in general possess more risk and should carry higher yields to induce people to take those risks.  Inverted yield curves are exceptions.  Also in general, longer corporate bonds have higher spreads over Treasuries most of the time, than shorter corporate bonds.

The one significant advantage that equities have over corporate bonds is that of control.  Increases in earnings go to the stockholders.  Buyouts go to the stockholders.  Bondholders get paid off at best.

That said, in the losing scenario, bondholders get back 40% of par on average, while stockholders get little if anything.

I believe that the equity of a company needs to be priced to return more than the longest unsecured debt or preferred stock of the company.

Thus when I think about MPT, I think they are positing an asset-liability mismatch, comparing T-bills versus a long asset, common stocks.  The comparison should be broken down into several spreads:

  • T-bills vs T-notes/bonds of the longest maturity issued by companies like them.
  • Corporate bond yields minus Treasury yields at the same maturity.
  • The earnings yield of the stock minus the corporate bond yield.

This takes apart the seemingly simple MPT calculation, revealing the complexity within, helping to explain why beta doesn’t work.  It embeds an asset-liability mismatch.  Stocks are long term, T-bills are not.  There is no reason why their returns should be considered together, without a model of yield curve spreads, corporate spreads, and equity financing spreads.

That’s a sketch of the correct model, now who wants to try to build it out?

Debt Markets

  • Leverage Addicts Get Junk-Loan Fix With Derivatives ETF http://t.co/CWMxLXlz3v Not much different than a HY closed-end fund or a CLO $$ Jun 01, 2014
  • Bond Market Flips the Script on Risk and Reward http://t.co/3geslTXRMo Difficult for rates 2 rise when monetary velocity keeps falling. $$ Jun 01, 2014
  • Shakeout Threatens Shale Patch as Frackers Go for Broke http://t.co/pGj2CUiTxG Not healthy 4 so many 2b financing w/high amount of debt $$ Jun 01, 2014
  • Bond Market to Fed: Your 4% Rate Forecast Is Way Too High http://t.co/Ji55pmAlYZ Forward rates r much lower than wrong Fed forecasts $$ Jun 01,
  • New Fund Stars Ride Junk Bonds to the Top http://t.co/1WtqogYOZX Junk credit & HQ long duration risks have paid off, what an odd couple $$ Jun 01, 2014
  • The Hidden Risks in Your Local Housing Market http://t.co/7OcDXnTvGC As the amount of debt behind housing rises, systemic risks rise also $$ Jun 01, 2014
  • Pimco Rehires Former Senior Executive Paul McCulley http://t.co/7U71N8jO12 Wish he had stayed retired; I enjoyed him not publishing $$ Jun 01, 2014
  • And so it begins: Square is to start lending to customers http://t.co/F7xDzGTxAQ Harder than it looks 2b a lender; 2 much optimism $$ May 31, 2014
  • S&P, Moody’s Lose Bid to Block Calpers $800M Suit http://t.co/crQdAbw2v2 Ratings r advice not guarantees, sophisticated investors know it $$ May 31, 2014
  • How to Manage Bankers Voracious Risk Appetites http://t.co/yrwkZkQaHW Criminal liability, clawback of pay, & boards holding mgmt acctable $$ May 31, 2014
  • Goldman Shuns Bonds Pimco’s Gross Favors in ‘New Neutral’ http://t.co/bTPbJpi6Me Go with Goldman over Pimco; buy tails, short belly $$ $GS May 31, 2014
  • You’re All Whales in Bond Market Now With Trading Volume Slump http://t.co/ewXmldKzC5 It means that more Tsy notes r held 2maturity $$ $IEF May 30, 2014
  • Pimco Rehires Former Senior Executive Paul McCulley http://t.co/7U71N8jO12 Wish he had stayed retired; I enjoyed him not publishing $$ Jun 01, 2014
  • How to Manage Bankers Voracious Risk Appetites http://t.co/yrwkZkQaHW Criminal liability, clawback of pay, & boards holding mgmt acctable $$ May 31, 2014
  • Goldman Shuns Bonds Pimco’s Gross Favors in ‘New Neutral’ http://t.co/bTPbJpi6Me Go with Goldman over Pimco; buy tails, short belly $$ $GS May 31, 2014
  • You’re All Whales in Bond Market Now With Trading Volume Slump http://t.co/ewXmldKzC5 It means that more Tsy notes r held 2maturity $$ $IEF May 30, 2014

 

US Politics & Policy

  • Geithner’s Dubious Accounting http://t.co/8uwwJyeKHo “justifying the bailouts b/c a simplistic measure shows the govt made $$ is a stretch.” Jun 01, 2014
  • Seven States Running Out of Water http://t.co/pXpEU9Hu7K All in southern west & midwest — CA, NV, NM, KS, AZ, OK, & TX $$ Jun 01, 2014
  • State Pension Transparency Is Right Message At Right Time http://t.co/vwGqJn7ZDq Read about troubles of North Carolina Public Pensions $$ Jun 01, 2014
  • ‘Pink Slime’ Makes Comeback as Beef Prices Spike http://t.co/XmDfVz5zAB “Finely textured beef” returns to cheap hamburger; ask yr butcher $$ May 31, 2014
  • Economy Shrank, U.S. Now Says http://t.co/qm9rarCX9P They’re blaming the weather which is always a weak reason 4 the structural slowdown $$ May 30, 2014

 

Rest of the World

  • Japan Begins Purposely Dumping 100s Of Tons Of Radioactive Water From Fukushima In2 The Pacific http://t.co/TklIa4ECs2 Source fish w/care $$ Jun 01, 2014
  • Spain Sees Embers Glow in Wreckage of Property Crash http://t.co/J1KWh56u0l Prices finally gaining real money buyers $$ Jun 01, 2014
  • Escape From Tiananmen: How Secret Plan Freed Protesters http://t.co/yAmoc6MfKT Unlikely group of people risked their lives 2 aid escapees $$ Jun 01, 2014
  • Iran, Stable but Miserable http://t.co/1HNuO03Ncv @Steve_Hanke Once Govts start giving subsidies, is very difficult 2 end them $$ #bigbang May 31, 2014
  • Aging Swiss Face Pension Funding Dilemma on Immigration http://t.co/9k2X7Oeszf Demographic eclipse faces Switzerland, needs immigrants $$ May 30, 2014
  • No, China Isn’t Really Rebalancing http://t.co/HbR7rVIiOZ @WilliamPesek notes quick return of stimulus measures in China as growth flags $$ May 30, 2014

 

Market Impact

  • Bad Credit No Problem as Balance-Sheet Bombs Rally 94% http://t.co/6xLjaGnBCp A backward-looking insight, one common 2 late bull markets $$ Jun 01, 2014
  • Reynolds Aims to Oust Fidelity in Push to Gain 401(k)s http://t.co/CO9RF3YZsk 401k financial servicing is a scale game 4 Great-West Fin’l $$ Jun 01, 2014
  • Bets on Higher Food Costs Reach 11-Week Low: Commodities http://t.co/Bqi5PPkTsS Time for food costs to move up $$ Jun 01, 2014
  • Neff’s do’s and dont’s http://t.co/Sx2oExlAHb The thinking of John Neff is underrated in my opinion; this article summarizes some of it $$ Jun 01, 2014
  • Top 10 Valuation Ratios and How to Use Them http://t.co/bbdT2lMHeI Worth a read $$ Jun 01, 2014
  • Dragon King beats Black Swan: Ted Talk with Didier Sornette http://t.co/QMJNGE3N8w Listen to Sornette; black swans can be predicted $$ Jun 01, 2014
  • New Rules 2 Alter How Companies Book Revenue http://t.co/3siTlXkluz Mostly liberalizes revenues, lowers earnings conservatism, watch $$ flow Jun 01, 2014
  • Nasdaq Nears 13-Year High as Technology Becomes Loved http://t.co/0Q7VrPsnUy Note unprofitable IPOs coming 2 market eating sideline cash $$ Jun 01, 2014
  • Dennis Gartman: We Were Wrong Calling for a Correction http://t.co/IhmICbVO2M Few more capitulations & then the topping process will end $$ Jun 01, 2014
  • Managing a Portfolio I – Stop Wasting Time, Start Adding Value, Part V http://t.co/2z2bLQV7zK A very good series, very worthy of a read $$ May 31, 2014

 

Other

  • Little Children and Already Acting Mean http://t.co/4RRva4OVu1 Should only surprise if u think ppl r natually good; good must b trained $$ Jun 01, 2014
  • The Myth of the Climate Change ‘97%’ http://t.co/BCsHXfzudX I know science Ph.D.s who don’t agree, but how 2do a fair count? $$ Jun 01, 2014
  • How Many Kidneys Is an NFL Career Worth? http://t.co/EdaeHVt8zW Gives reasons to eliminate team doctors; players, get yr own doc 4 safety $$ May 31, 2014
  • Mementos of triumphs make a return to bankers’ desks http://t.co/1fetPsXSrc Deal toys made of Lucite return to Wall Street $$ $GS $MS $XLF May 30, 2014
  • My Resume http://t.co/lkMocQczJB James Altucher spills all of the beans on his business career & life. A train wreck in slow motion $$ $SPY May 30, 2014
  • Railcar Shortage in US Pushes Up Lease Rates http://t.co/bcaqp0DvwV If pipelines aren’t built, more crude will flow by rail $$ $GATX $TRN May 30, 2014

 

Wrong

  • Wrong: SEC Set to Spur Exchange Trading http://t.co/jU2JJvc3vi This may help mutual fund managers, but it won’t help small investors $$ Jun 01, 2014
  • Wishful thinking: Is Hillary Clinton Too Old for the White House? http://t.co/Fy0qYw11a6 People, particularly women live longer than b4 $$ Jun 01, 2014
  • Wrong:Annotated History Of The World’s Next Reserve Currency http://t.co/XtCSg2WQPt Only free countries w/open markets r reserve curncies $$ Jun 01, 2014
  • Fink Says Leveraged ETFs May ‘Blow Up’ Industry http://t.co/cVTubsqeiY More likely they blow themselves up, & not the all mutual funds $$ Jun 01, 2014
  • Wrong: Paper money is unfit for a world of high crime and low inflation http://t.co/XC4pAWjHf2 We need 2get currency out of govt hands $$ May 31, 2014
  • Wrong: Borrowers Show in Rush to Grab US Rate Break http://t.co/H8yJX9TCQQ Funny how everyone keeps saying rates will rise $$ FD: + $TLT May 30, 2014
  • Wrong: Make more money by dumping your investment adviser http://t.co/8hSPQqgDlr Investment advisers can prevent panic & greed $$ $TROW

 

Retweets, Replies & Comments

  • RT @ReformedBroker: Nice that we printed a new record S&P 500 high today. Too bad so few stocks are involved. Via @allstarcharts http://t.c… May 26, 2014

The following article was published at Realmoney.com in 2004.  Rates were lower then but the issues remain the same.

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

My 401(k) plan has a stable value fund that currently pays a preannounced annual rate of 5.30 percent.  The fund enters into guaranteed investment contracts (GICs) with insurance companies which invest in government and corporate bonds and mortgages.
 
I’ve heard that stable value funds can now be purchased outside of retirement plans.  Does anyone know of any fund families or brokers that offer these funds to individual investors?

— Reader Question from M. J.

 

In my career, I have run a GIC (Guaranteed Investment Contract) desk at an insurer, designed one stable value fund, and helped administer and invest for several others.  I know stable value funds, respect them, invest in them when it makes sense, but I am still a skeptic at some points.

Legal Risks Lead to Elimination of Non-401(k)-type Stable Value Funds

Last year, there was a big scandal over mutual fund pricing, and non-401(k)-type stable value funds came under the microscope because of the obvious difference between the value of the assets and the stated NAV of the funds.  The SEC made an inquiry about the accounting for the funds in December 2003.  Since then non-401(k)-type mutual funds have died a slow death.  There is one left, and they are probably going to turn the fund into a short term bond fund, as the others did.  Their reason for existence has gone away, and now they are expensive short-to-intermediate term bond funds.

Your opportunity to invest in stable value funds outside of 401(k)/defined contribution world has gone away, but given that there is over $200 billion invested in stable value funds, and not much has been written on them from a third party point of view, I’ll describe them in more detail.

Defining the Investment

So what’s a stable value fund?  It’s a short-to-intermediate term fixed income pool that has some agreements on the side to allow the assets to be accounted for at book value, so that the investment accrues at a positive rate.  It looks like a savings account to the investor, not a short-to-intermediate term bond fund.  Because it invests at longer maturities than money market funds, they deliver higher yields than money market funds, except in years worse than 1994, where yields rise rapidly and the yield curve inverts.  (Stable value funds did not exist in the 1979-1981 era; perhaps money market yields would have been higher than stable value yields would have been then.  The precursor to Stable value funds, initial participation guarantee funds, ran into trouble then.  That trouble led to the development of GICs.)

A stable value fund invests in insurance contracts, money markets, and highly rated (usually AAA) short-to-intermediate term bonds.  Insurance contracts are always valued at book value, unless in default, which we saw a little of in the early 90s.  Among major GIC writers, default has not been a problem since 1994.  (General American gave us a scare in 1999; Metlife bought them, and all payments were made.)

The bonds held in stable value funds can’t be valued at book value because accounting rules require that they be held at market.  The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value.  The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book value loss.  Typically, wrap agreements are only done on the highest rated bonds (AAA), so credit risk is not covered by most wrap agreements.  With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped.  The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate.

Since wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10%/year of assets wrapped.  The only risk a wrapper faces is that the interest rate-related losses on a bond in a rising interest rate scenario is so severe that the losses can’t be repaid out of the yield of the wrapped bond.  In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change.  There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value.  When the stable value fund has a higher market value than book value, typically it pays an above market yield.

There is a risk that in an environment where interest rates have risen sharply, that a stable value fund would have a lower market value than book value, with a below market yield.  In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields.  If that happens to a high degree, it will worsen the gap between the market value and book value of assets, which will be covered by the wrappers in the short run, but will reduce the fund’s yield as they pay the wrappers back.

It is unlikely, but possible to get a death spiral here, if more and more shareholders leave the pool and the yield sags to zero.  It hasn’t happened yet, so this is theoretical for now.  In theory, the wrappers would keep paying once the funds credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation.  There would likely be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability.  In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral are further reduced, but not eliminated.

Asset Default Risks

As an aside, for the most part, stable value funds take little credit risk, but (little known) this is not universally true.  Some of them buy corporate bonds, or other riskier structured product bonds.  Some of them take credit risk in hidden ways.  Here’s an example: there are some exotic, asset- or commercial-mortgage backed interest-only bonds that are rated AAA by the rating agencies.  The agencies rate them AAA because they can’t lose principal; they have no principal to lose.  But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened.  The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA.

If an asset in a stable value fund defaults, the fund will likely temporarily suspend withdrawals while it pursues one or two courses of action.  If the loss is small, they might buy a wrap contract for the loss, which will haircut the yield on the stable value fund for the life of the wrap contract.  If the loss is big, they will reduce the NAV, and attempt to keep the NAV stable from there.  Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn’t rely on that.

Summary

There are two main risks: asset default, and severely rising interest rates.  In exchange for those risks, what do you receive?  In most circumstances, you get a higher yield than a money market fund, with nonguaranteed stability of principal.

If you need a good yield, and stability of principal with modest risk, a stable value fund can be a good place to get it. That said, if you can live with fluctuations in the NAV over the intermediate term, it would be better to use a short-to-intermediate-term bond fund, and thus avoid the wrapper and high asset manager fees.  Stable value manager fees are typically higher than those for bond funds.  Over a five-year period (or so), your total return should be better.

Miscellaneous questions post — here goes:

Thank you very much for your blog! I am hooked since I found it and have been getting smarter by the day!

I like Safety Insurance Group, found it through your blog, noticed you were no longer long. They don’t do life insurance, just cars and houses – I know you say not to mix because they are sold and underwritten differently. They had a rough Q1 but a good 2013, seems like the winter Mass weather might have done it. They are over Book of 1 so there are other insurers that are cheaper, but they look like a good compliment to NWLI (also found through you and like very much) in the auto space, in a small (and thus dominate-able) market. 

Am I missing something about SAFT? 

Many sincere thanks David!

I like the management team at Safety Insurance.  When I met with them years ago, they impressed me as bright businessmen competing well in one of the most dysfunctional insurance markets in the US — Massachusetts.  Most major insurers did not write auto and home insurance there as a result.  But then the state of Massachusetts began to loosen up their tight regulations, and some of the bigger insurers that stayed away have entered — GEICO, MetLife, Liberty Mutual, etc.

When the market was more closed, SAFT had strategies that allowed them to profitably take market share Commerce Group [now Mapfre].  With more competition in Massachusetts, Safety’s earnings have suffered.  I can’t get excited about a short tail P&C insurer trading above book at 13-14x forecast earnings.

Maybe people are buying it for the 4%+ dividend.  I don’t use dividend yield as an investment criteria, for the most part.  I would avoid Safety Insurance.  It’s well-run, but the price of the stock is too high.  If it drops below $35, it would be a compelling buy.

Hi David,

I was interested in your comment on Normalized Operating Accruals as an indicator of accounting quality.

Why is this?

I tend to view changes in accruals as an indication of the underlying strength of a business, but would appreciate your insight on this.

Thanks

The idea behind net operating accruals is that accrual entries represent future cash flows, which are less certain than cash flows that have already happened.  Companies that report high levels of accounts receivable, inventories, etc., as a fraction of assets or earnings, tend to offer negative earnings surprises, because many of those accruals will not convert to cash as expected.

Here is how I measure Net Operating Accruals:

(Total assets – Cash  – (Total liabilities – Short-term debt – Preferred stock – Long-term debt))/Total assets (or earnings)

An apology here, because the term commonly used is “net operating accruals” and I messed up by calling it “normalized.”

Companies with conservative accounting (fewer accruals) tend to have stronger earnings than those that are more liberal in revenue recognition.

Dave, you and I are too old school. We need to move into this century. The way that most people seem to get into the investment industry has nothing to do with what you talk about. It is far easier to become a “financial advisor” that pushes annuities on the 60+ crowd. You don’t really have to learn anything about investing. All you need to know is about salesmanship. Offer a free lunch/dinner and reel them in!

I honestly think that more folks are going this route instead of the “hard way” you have outlined. . .

Maybe you can do a sarcastic post: “How to NOT be valuable, but make a lot of money in the Investment Business.”

Personally I find the annuity and non-traded REIT pushers very repulsive. At the same time, I know several of them that have done very well . . .

There are two factors at work here — yield and illiquidity.  The need for yield is driven by monetary policy.  Particularly with a sizable increase in retirees, many of whom can’t make enough “income” when interest rates are so low, they take undue risks to get “income,” not realizing the risks of capital loss that they are taking.

When I was an analyst/manager of Commercial Mortgage Backed Securities, there was a key fact one needed to understand: safe mortgages do not depend on whether the businesses leasing the properties operate well or not.  Safe mortgages have no operational risk, and thus avoid theaters, marinas, etc.  Stick to the four food groups: Multifamily, Retail, Office, and Industrial.

There will be negative events with insecure investments offering a high yield.  You may not get the return of your money, as you try to get a high return on your money.

Then there is the illiquidity — that is what allows the sponsors the ability to pay high commissions to those who sell the annuities and non-traded REITs.  Because the investors can’t leave the game, the income stream of the sponsor is very certain.  They take a portion of the anticipated income stream, and pay it in a lump sum to their agents as a commission.  And that is why the agents are so highly motivated.

Eventually, the demand for yield will be disappointed.  Uncertain yields will fail in a crisis, and reset much lower.  Income that stems from dividends, preferred dividends, MLPs, junk bonds, structured notes, etc., is not secure in the short-to-intermediate run.  It is far better to invest to grow value than to invest for income.  They can pay you a yield, sure, but if the underlying value is not growing, you will eventually get capital losses, and after that, much less yield.

Look for safety in yield investments.  If you are going to take risks in investing, take risk, but ignore the income component.  Don’t stretch for yield.

I received a survey in the mail on Trading/Investing.  I felt that if I was going to answer it, I may as well do it for my readers.  Here goes:

 

1) How long have you been trading?

I’ve been investing for my own account for 25 years.  During that time, I’ve done a lot of different things:

  • Played around with closed-end funds, and shorted overvalued companies 1989-1993
  • Value investing for myself 1993-98, with a lot of microcap value thrown in.  (Weird stuff, and very illiquid.)
  • Created multiple manager funds for group pension business 1995-1998 — got to interview many of the best managers at that time.
  • Set investment policies for a some major life insurers 1993-2003
  • For major life insurers — Mortgage bond manager 1998-2001, Corporate bond manager 2001-2003, Investment risk manager 1993-2003.
  • Small deal arbitrage for myself 1998-2000
  • Settled on my current value investing strategy, as expressed by my eight rules 2000-2014
  • Buy side analyst for a financials only hedge fund 2003-2007.  Managed the firm’s profit sharing and endowment monies using my value investing strategy.
  • Started my RIA in 2011, to offer clients my value strategy — they get a clone of what I own in my value strategy.  I am my largest client, and I eat my own cooking.

2) What style of trading / investing do you practice (technically driven, fundamental, systematic, a combination etc)?

Mostly fundamental.  Most of my trading is governed by these rules:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

I tend to resist momentum in the intermediate term.  From my era of hiring managers, those that used this technique said it added 1-3% to performance.  I think that’s about right.

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

I limit changes to the portfolio, because it takes time for investment ideas to play out.  I turn over the portfolio at a ~30% rate.  I try to be as businesslike as possible when I sell a company and buy another.  Investors can be very good at evaluating whether a company or group of companies, is better than another company or group of companies.  What is harder is asking, “Would I rather hold cash than this company?”

3) How do you feel when a trade goes against you?

Good.  I get to buy a little more at a lower price, after I check my investment thesis, which if it does not check out, I sell the whole thing.  For the few trades that do badly for a long time — 20 of them over the last 25 years, of course it hurts, but the gains far outweigh the losses, so I ignore those, except to memorialize why the failure happened, and feed that back into my investing processes.  Every time I have lost badly, it was because I violated at least one of my rules.

4) How do you feel when a trade goes for you?

I like it, but I let my rules govern my trading.  Everything is done by rules; there is almost no discretion in my trading.

5) How have these feelings changed over your trading career?  (Can you recall how you originally used to feel and elaborate on how this has changed over time?)

When I was 20-25 years younger, every move in the markets would make me excited.  By the mid-90s, I got my emotions under control.  I learned to focus on eliminating risk on the front end, so that I would have fewer problems on the back end.

6) Do you have any practices that you do away from the trading screen to help you mentally and emotionally handle trading? (e.g. meditation, yoga, running, Tai Chi, kicking the dog, hitting the bottle etc)

I pray to Jesus Christ every day, but that is not a means to handle trading.  I ask Him to guide my decisions, and that I would do my investing to glorify Him.

Because I use my rules, there is little, if any, stress over trading.  My processes are designed to take my emotion out of my infrequent buying and selling.

7) Have you always done this? 

I’ve done this for the last 14 years.  Prior to that, I was experimenting and developing my methods.

My time managing bond assets for life insurers taught me a lot about trading 1998-2003.  I traded over $10 Billion in bonds over that short window of time.  I was far more active as a bond manager, because it was simpler to ascertain when value-enhancing trades could be done.  That fed into my value investing processes, which are designed to mimic the way a bond trader would look at stocks.

8) If not, how have you learnt to deal with the feelings that come up when trading?

Look, first, it’s only money.  If you don’t take some significant losses during your life, you probably aren’t taking enough risk.

Second, investing takes time.  I hold my positions three years on average, and the longest positions have been there for 5-10 years.  A tree in my backyard won’t grow any faster if I worry about it.  The same is true of my stocks.  I review them quarterly.  Between those times, I try to muffle the nose, aside from rebalancing trades which resist the market.

9) Can you describe a time in your trading life which really rammed home the point that so much of trading comes down to psychological factors?

As a value investor, I don’t worry much about trading.  In 2000 & 2008, I did detailed studies of my trading.  In 2000, I found that many of my best trades stemmed from getting the industry right.  In 2008, I found that my top 11 gains paid for all of my losses, 2000-2008.  That was with a 70/30 win/loss ratio, and 180-190 stocks held over the period.

10) If you could give aspiring traders one piece of advice about emotionally handling the market what would it be?

If we are talking traders, it would be this: start out each morning looking at the disasters of the day, and then wait for volume to climax, and price to nadir.  Wait about 5-10 minutes, and then buy.  Close out the trade within a week, maybe at the end of that day.

That said, I would encourage traders become investors.  There is too much competition at the short time horizons of the market, and not so much over 3+ year periods.  Study the greats: Graham, Buffett, Munger, Klarman, Price, Heine, Neff, Soros, Dalio, and many others.  Learn to recognize long-term value, and wait for it to be realized.  There are no barriers of entry to trading.  Long-term value investing has natural barriers to entry, because it is work, and as such, few do it.

I don’t worry about my stock portfolio.  Because my time horizon is long, day-to-day fluctuations don’t mean much.  That makes me free to research ideas that can benefit me and my investors in the future.  That’s a great place to be.

Closing

“Richard Chignell of Embrace The Trend asked me to take part in his Pro’s Process series.  Here are the first couple of answers and for the whole thing please read it here: www.embracethetrend.com“.

71zM0CNU4QL This is an ambitious book.  It tries to draw together financial statement analysis, value investing, short-selling, technical analysis, market timing, and portfolio management into one slim book of 254 pages.

It spends the most time on financial statement analysis, going over revenue recognition, inventories, and all of the squishier areas of accounting that most industrial companies face.  It will not help you much with financial companies, they are far more complex, and deserve a book all their own.

I was surprised that the book did not suggest common summary measures of accounting quality, such as Normalized Operating Accruals.  It did feature Cash Flow from Operations less Net Income, which is almost as good.

The book focuses on the short side — how do you make money from failure?  The long side suggests maxing out on small cap value stocks, and idea which  I like, but can get overfished at times.

Think of it this way: do you want to run a portfolio that is systematically short company size, long value, short liquidity, long quality, etc?  I helped do that for 4.5 years at a hedge fund, and boy that ride was bumpy.  The market can remain insane longer than you can remain solvent.

But, to the book’s credit, it understands position sizing for short positions, which is momentum following.  Short more of things that fall.  Do not add to shorts when the prices rise.  This is a key insight of the book, and it is a reason why value managers often don’t do well in a long-short context.

My last complaint is that the book does not explain even in broad terms how they balance the various portfolio management ideas.  If you buy this book, you are on your own.  You do not  have a full roadmap to guide you.  If you were going to use this as a main strategy, you would have to fill in a lot of holes.

Now, I’m often critical of turn-the-crank books — follow my rules, and you will make money.  But I am more critical of almost turn-the-crank books — follow my rules, and you still won’t know exactly what to do.

Is this a good book?  Yes.  Read it and you will learn a lot.  Will it help you analyze stocks?  Also yes.  You can make a lot more money by avoiding stocks with a high probability of losing money.  Will it tell you exactly what to do?  No.  That is a strength and a weakness — I’m not sure any book on investing that offers a formula can be exact, and be good.  Investing is an art, not a science.  Then again, science is an art, not a science, but that’s another topic — all the great discoveries come from not following the scientific method.

So if you want to learn, this is a good book.  If you want a foolproof way to make money, sorry, this won’t do it for you, and the same for almost every other investment book.

Quibbles

There are far better books on all of the topics that they cover, and most of them have been reviewed at my blog.  Far better to read books that specialize on a single topic, than one that is a hodgepodge.

Summary

This is a good book, but average investors should not buy it as a formula, because they can’t implement it.  Average investors could benefit from the book, because it gives them a taste of a wide number of investing topics.  Just be aware that you aren’t getting a full dose of anything.  If you still want that, you can buy it here: What’s Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio.

Full disclosure: I borrowed this book via Interlibrary Loan.  It is going back tomorrow, and I will not buy a copy to replace it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

My readers are the best.  Here is another example:

undertherockstocks

David –

You may also like http://www.SECLive.com for reading filings. It’s a nice user interface and hopefully it will support additional filing search functions in the future.

There are a a lot of things to commend SECLive — setting up lists to track companies, etc., but the best feature is the ability to download tables to Excel for free.  I’m planning on doing a post on insurance reserving as a result, and you may see other articles on dollar-weighted returns as a result.  Can’t tell you how much time I have spent reformatting HTML pasted into Excel.

It is amazing what is out there for free.  Count your blessings, and if you are a fundamental investor, use some of these tools.

I love my readers.  Here is another question from a reader:

I would appreciate your advice on how to learn more about investing and how to make myself useful to people in the business as a step towards getting in.

There are two questions here:

  1. How to learn more about investing?
  2. How to make yourself more valuable to prospective employers (so that you might be hired)?

So let’s answer them:

How to learn more about investing?

There are three main answers here:

  1. Study the classics
  2. Study areas where there are current problems
  3. Read widely

When I talk about the classics, I am talking about the writings of Ben Graham, Buffett, Munger, Phil Fisher, and notable investors who have spilled their theories to the world.  Also men like Seth Klarman, Howard Marks, Ray Dalio, George Soros, Bill Gross, Jeffrey Gundlach and other clever investors who understand the markets well.

Second, if there are current problems in the market, do your research, and try to understand them well.  This may take more effort, because current problems are not well-understood, or they would have been solved already.

The correct answer is not immediately obvious.  Prior to the crisis, it is a minority view.  After the crisis, everyone knew it would happen 😉 .

Try to view the markets in a comprehensive way.  Think of the buyer and the seller, and their motives.    Look for minority opinions, and analyze them — maybe that have it right.  Most of the time, you will throw their opinions away, but in rare cases you might find something valuable.

Finally, read widely.  Try to understand the changing economy. and where value is being added where current valuations don’t reflect it.  Understand the economic world, and dedicate time to it.  I dedicated an hour par day while I was an actuary to understanding all manner of investments for ten years before I had my first job in investing at age 38.

And read economic history.  It is very valuable to understand how things worked in the past, because it offers clues to those of us in the present who don’t think “It’s Different This Time.”

How to make yourself more valuable to prospective employers (so that you might be hired)?

First, prepare yourself.  If you are not good at speaking extemporaneously, practice the things that you will say in an interview.  Think about the most likely questions, and likely variations, and have your answers ready.  Rehearse these answer in front of a mirror, and do it many times, until you have it down cold. (solid).

Second, do your research on the firm, and understand its problems.  You don’t have to have the whole answer, but if in the interview, you understand the challenges, and have some idea of how they might be addressed, you will impress those interviewing you.  You have done the homework; you are more than capable of analyzing other tough issues.

Third, be willing to question the received wisdom, and suggest solutions that are abnormal.  So long as you don’t sound like an idiot, this will do one of two things:

  1. You will come up with a clever idea that no one else has thought of, or,
  2. You will show yourself to be willing to think more broadly than most do.  Remember, it only takes one significant insight to establish a career.  Of course, more is better, but one significant insight will do a lot.

Fourth, be good with the basics.  Understand the basics of investing well.  Just as a kid should know his 100 addition, subtraction, multiplication, and division facts cold, so should investors know the basics of investing without much effort.

Fifth, give it your all.  Show dedication beyond what is required.  I’m not asking you to kill yourself, I did this while raising a family of eight children.  But whatever the situation is, give it your best, even if you have to take some of the work home.

If you do these things, you will be very valuable to the firm that you serve.  Even more, you will be valuable to many firms that might like to hire you.

So make yourself  valuable, and prosper.

 

I would carry around a 3.5″ floppy disk in my briefcase while I worked in center city Philadelphia.  The years were 1994-96, and getting data over the internet was still in its infancy.  Even Bloomberg terminals did not yet have data from EDGAR.

If I was efficient with my actuarial work, I would occasionally wave bye to my colleagues early, and walk over to the Philadelphia Public Library to use the electronic resources they had for analyzing stocks.  I would find articles on various stocks that I had interest in, and I would save them to the floppy disk for later review.  After a while, I discovered EDGAR which had the required data that companies would file with the SEC.  Now there was more data to analyze.

I’m not sure when, but eventually the SEC set up its own website for EDGAR.  And a great website it is — I probably use it twice a day at least.  But could it be better?

I sometimes say that I have the best readers in the world, and this is a case where a reader tipped me off to a website that has taken EDGAR data to a whole new level.

[Applause]

There is a lot at this site, and it is the result of a lot of open source software work.

I can’t fully do justice to all that this site does, but let me try to describe it through a series of questions.  Do you want to:

And much much more…  I found amusing the pages that showed filings plotted against stock price over time, and I decided to look at Tower Group.  My, but how the then President, Chairman & CEO, sold stock as things were falling apart in September 2013.

I will be using this site in the future.  It takes EDGAR to a new level by stratifying data in a wide number of ways, and correlates it with a variety of external data.  Very useful, and I offer my thanks to those who created it.

Market Impact 

  • Giving Yourself an Investing Makeover http://t.co/u1MmwlWiKP @jasonzweigwsj describes Guy Spier & his efforts 2b a more rational investor $$ May 24, 2014
  • The Bearish Signs Junk Buyers Reject in Stoking ’14 Rally http://t.co/xsYEJeKTnU BBs beat CCCs amid a falling Russell 2000 index $$ #odd May 23, 2014
  • Penny Stocks Like Latteno Foods Rally, Fueling Big-Dollar Dreams http://t.co/IiqCWeAyOW Fascinating 2c this amid a pullback in small caps $$ May 23, 2014
  • Buffett Too Rich for Buffett Is Sign Bargains Are Gone http://t.co/cbjQ0MDmSR I’m still finding some cheap stocks but they r unusual $$ $SPY May 23, 2014
  • For Sale: 20% Stake in Hedge Fund. Terms: Complicated. http://t.co/kDoik1H4LT “You don’t want to be wearing someone else’s underwear.” $$ May 23, 2014
  • Boomers Cash In as Bull Market Aids Exodus From Workforce http://t.co/uKRIfO4qMQ Asset illusions delude Boomers who think they r rich $$ May 23, 2014
  • Wall Street Finds New Subprime With 125% Business Loans http://t.co/USvBIvP5Vj The businesses would get better rates on Prosper $$ #dumb May 23, 2014
  • Debt Rises in Leveraged Buyouts Despite Warnings http://t.co/6T8TIpdxWc Debt makes financial systems less flexible; depend on fixed pmts $$ May 21, 2014
  • Chasing Yield, Investors Plow Into Junk Bonds http://t.co/lWFufDu7Hy Yields have never been lower 4 CCC-rated debts $$ May 21, 2014

 

Rest of the World

  • What China Property Crash? Economists See Growth Bump http://t.co/kcXGitJH1l Economists c new empty buildings & mark up GDP $$ $FXI #FTL May 23, 2014
  • Putin’s Singapore Dream Costs Crimea Banks and Burgers http://t.co/OmmtpYDB7G Singapore is not so much created by laws but by ppl culture $$ May 23, 2014
  • Russia, China Sign $400B Gas Deal After Decade of Talks http://t.co/4k8PSE5NrM The infrastructure must b created 2 make this work; not ez $$ May 23, 2014
  • Brazil World Cup Win Risks Stock Drop in Boon to Rousseff http://t.co/dPb8GVbtSZ Brazil wins, Rousseff win odds rise, stocks will fall $$ May 23, 2014
  • BlackRock Has Cut Portugal Bond Holdings Over Past Couple of Weeks http://t.co/U3CuYpUu81 Some Emerging-Market Debt > Euro-Zone Bonds $$ May 23, 2014
  • Norway Loses Reputation as Stable Investment as Firms Recoil http://t.co/fqQkiM2H3k Tax 2 highly & businesses run away $$ May 21, 2014
  • It’s a Good Time to Globalize Your Stock Portfolio http://t.co/8pqTAwFbqj Many foreign companies r trade cheaper than US stocks $$ $SPY $EFA May 21, 2014
  • UK House Prices Rise to Record High in April http://t.co/vo6gYZNlAQ B sure 2add wealthy foreigners buying in London as investment/hedge $$ May 19, 2014
  • Bank of England’s Mark Carney Highlights Housing Market’s Threat to UK Economy http://t.co/5XOwH0cIsJ 100% of all UK mtges r short-dated $$ May 19, 2014
  • Good Time To Be A Farmer In China? http://t.co/04V9YEmSQm China aggressively pushing crop insurance, & larger scale agriculture $$ $FXI $SPY May 19, 2014

Energy

  • Without Keystone XL http://t.co/qpDcgET7J3 Economic & public health costs of forgoing a new oil pipeline $$ {Sound of oil train derailing} May 24, 2014
  • Secrecy of Oil-by-Train Shipments Causes Concern Across the US http://t.co/knapJHOx1k Butane, propane & ethane should be removed b4 shpng $$ May 23, 2014
  • Oil Nations Put Out Welcome Mat for Western Companies http://t.co/cvarvyMDCt If u make the cost of drilling2high, fewer bbls get produced $$ May 19, 2014

 

US Politics & Policy

  • How Timothy Geithner failed his stress test http://t.co/qSu9V6oZvX When @rortybomb & I agree on something, that is notable $$ #housingbubble May 23, 2014
  • Meet Jessica Rosenworcel, the FCC Swing Vote http://t.co/VtIzieSnqI Marches to her own drummer, willing to cut deals 4 the greater good $$ May 23, 2014
  • How to Turn Homes Back Into Piggy Banks http://t.co/fB9PTlBwxZ Housing Personal Savings Acct & Equity Principal Tax Credit; elim mtge ded $$ May 23, 2014
  • NJ Gov. Christie under fire for cutting pension payments to state workers http://t.co/rGwAKla3aT Definite mistake; cashflows compound $$ May 23, 2014
  • BlackRock’s Fink Says Housing Structure More Unsound Now http://t.co/xeMYQmjYGG GSEs took too much default risk pre-crisis, returning $$ May 21, 2014
  • GOP’s Business Wing Sends Tea Party a Chilling Message http://t.co/W5QCHBrJrW Business fights small government GOP candidates $$ May 19, 2014
  • Why Republicans Should Take Rick Santorum Seriously http://t.co/wN7tUmnhbV Represents the middle class populist part of the GOP $$ May 19, 2014
  • California’s Drinking Problem http://t.co/GZnmdInHGY California does not have enough water for Ag, Industry, People, w/o right incentives $$ May 19, 2014

 

US Monetary Policy

  • New Faces Behind Fed Dots Seen Roiling Markets as Forecasts Move http://t.co/M2AcqPEQTX Y publish estimates if u don’t want us 2read them $$ May 23, 2014
  • Bubble States Underemployment Rates Haunt Yellen http://t.co/fRzLYozafe Monetary policy is impotent w/debt defation; Fed on wrong track $$ May 23, 2014
  • New Faces Behind Fed Dots Seen Roiling Markets as Forecasts Move http://t.co/M2AcqPEQTX Y publish estimates if u don’t want us 2read them $$ May 23, 2014
  • Yellen Adds Disadvantaged to Full-Employment Definition http://t.co/10PSrxYI9c Alas, monetary policy is weak when dealing e/employment $$ May 21, 2014
  • Fed’s Rate-Change System Up for Revamp http://t.co/srqZoDDMhK The Fed is lost. The Fed is lost. The Fed is lost. The Fed is lost… $$ $TLT May 19, 2014

 

Companies & Industries

  • Google Developing Tablet With Advanced Vision Capabilities http://t.co/ABO9NObY1h Will b interesting 2c what new apps get developed $$ $GOOG May 23, 2014
  • Planting Corn at Warp Speed Using High-Tech Tools http://t.co/tDF9EaJoy6 Astounding application of technology transforms planting seed $$ May 23, 2014
  • Golf Market Stuck in Bunker as Thousands Leave the Sport http://t.co/ju7aFEx2lp Costs 2 much $$ takes up 2 much time, but growing in Asia May 23, 2014
  • Family Dining Offers Barometer of Middle Income http://t.co/5IzzOFfS3j Ugly valuations means stocks will fall if sales don’t rise 4%/yr+ $$ May 23, 2014
  • Silicon Valley’s Laundry-App Race http://t.co/GyvIWxd5ux Long article on the efforts to turn laundry into a scalable attractive business $$ May 23, 2014

 

Personal Finance

 

  • Dueling Strategies for 401(k)s, IRAs and Your Other Retirement Funds http://t.co/DGzSDVhDZ6 Do what maxes long-term purchasing power $$ $SPY May 23, 2014
  • 40 Financial Things You Should Know by 40 http://t.co/8qqFlp1TUB 2013 article, but I thought it covered the personal financial basics $$ May 19, 2014

 

Other

  • New Study: Is No Degree Better Than A Liberal Arts Degree? http://t.co/MOYUZTngoD Depends. It helps in getting some jobs, but not all $$ May 21, 2014
  • BBC News – ‘Biggest dinosaur ever’ discovered http://t.co/Yg2qTuS27T Interesting b/c it probably was once much warmer in Patagonia $$ May 19, 2014
  • Haverford Speaker Bowen Criticizes Students Over Protests http://t.co/QXkWoAh0iE Former Princeton President calls them “immature.” Bingo! $$ May 19, 2014

 

Wrong

  • Overrated: Russia, China sign deal to bypass USD http://t.co/YNgu6bwK7H What matters is where u invest the proceeds from goods exported $$ May 23, 2014
  • Wrong: Investing: The herd isn’t always dumb http://t.co/dt0xuXKNCJ Then explain y dollar-weighted returns underperform buy & hold $$ #panic May 23, 2014
  • Wrong: Cutting Off Emergency Unemployment Benefits Hasn’t Pushed People Back to Work http://t.co/3GwlHcvq70 We run unsustainable deficits $$ May 23, 2014
  • Wrong: Ikea Economics Lure Central Bankers Seeking New Tools http://t.co/peVUXrPpKs Don’t try negative interest rates; will b a disaster $$ May 23, 2014
  • Wrong: The Retirement Apocalypse That Isn’t Coming http://t.co/ILYSCOzKTm I might buy this if we weren’t running large deficits $$ $TLT $SPY May 21, 2014

 

Retweets, Replies & Comments

  • ‘ @DGenchev I am analyzing the investors as a group, thus what % of the mkt cap is relevant. I go to EDGAR and copy XML files into Excel May 24, 2014
  • If I were doing your project, I would not have chosen any of your “governance experts.” I would have chosen a group…http://t.co/XWlYm8HaVD May 22, 2014