June 2014 – Page 4 – The Aleph Blog

On Value Traps

Posted on 6 June 20146 June 2014 by David Merkel

One thing that floors me regarding my readers, is who reads me. ?I have many professional readers who read me regularly, and I thank you for doing so. ?Tonight’s piece stems from an e-mail from one of my professional readers:

Hi David,

Big compliments for your blog, it?s probably the best on the net and one of the very few I am reading these days. I really like your overall approach to investing and I am using some of your methods myself with success in my ZZZ?Fund (ZZZ on Bloomberg) like having an even-weighted portfolio of 30-40 stocks with regular rebalancing or focusing on the strongest players in weak industries (southern European banks anyone?).

Now my question for you that might interest all reader is how you handle potential value traps like Staples that spring on you in slow motion. I think you had that one in your portfolio some time ago, but the specific case doesn?t matter that much. For full disclosure, I am holding Staples in my fund at the moment.

The typical pattern is something like this: You find a stock that has some growth issues, but is attractively valued with a 10% FCF/EV yield, which implies no growth or a slow decline forever. Then there?s a profit warning, the profit or FCF estimate goes down by 10%, but the stock price drops even more by 15% or so. And again and again? or not. It?s especially tricky in cases like Staples where it is not so obvious that their business model is becoming obsolete compared to, for example, Nokia or Blackberry/RIM a few years ago.

In my experience, that?s one of the situations where I tend to lose the most money. How do you handle them? Sell at the first profit warning, reasoning that the investment case got fundamentally altered even though the stock dropped even more? Or keep it and wait for a confirmation of the negative trend? For how long?

Out of experience, I probably should sell Staples asap and have another look in year or so. But the value guy in me can?t sell much hated stocks with high FCF yields and some potential for a fundamental turnaround.

I used to own Staples, but I think their lunch is getting eaten by Amazon. ?I sold somewhere in the $16s. ?Retailers are tough, in my opinion. ?They are so cyclical and faddish.

There are many reasons that a stock can be a value trap. ?Let me try to list them:

The accounting is liberal, with revenue recognition policies that let more revenue accrue than will be realized. ?Or, the assets aren’t worth as much as the book value posits. ?This is particularly common with financials.
Many value traps are lower quality companies. ?They may seem cheap, but there is a lot of debt, and will they earn enough to refinance the debt?
Some companies waste their free cash flow buying back stock, or acquiring companies that do not add to value. ?When valuations are high, issue special dividends rather than buying back stock. ?Your?shareholders have better opportunities for the money.
They are up against stronger competition. ?Try to understand the industry as a whole, and see whether the?company’s?profits are likely to come under pressure.
The high dividend has attracted a lot of yield investors who push the price up, but the yield is not sustainable.
And there are likely more reasons…

I’ve lost significant money in a few stocks in my life, but only once in the last 10 years. ?It was a highly levered mortgage REIT that did it “the right way” as I saw it, and was opportunistic with debt assets. ?I lost 90%+ of my money on that one, one of my worst losses ever. ?Had I paid greater attention to the amount of leverage, particularly heading into the crisis in 2008, I would not have lost so much.

As a friend of mine once said, “There are lousy companies, but to really see the price fall, it has to have significant debt.” ?I tend to buy higher quality companies. ?That’s not a panacea, but it tends to prevent large losses. ?Avoid overly indebted companies relative to the??industry.

Analyze the accounting. ?How much of income is coming from accruals? ?How often do they deliver negative earnings surprises? ?How is cash flow from operations versus earnings? ?Is book value growing a lot more slowly than earnings less dividends would indicate?

Is this a stock held by those sucking on dividends? ?Is the dividend sustainable? ?Think of the ’70s where dividend-paying stocks got whacked when they reduced their dividends.

Analyze the competition. ?It is rarely a good idea to buy the stock of a weak company in a competitive industry, regardless of the valuation. ? Better to buy the more expensive competitor.

Finally, stock buybacks and acquisitions are not always good. ?Many stocks, like IBM, tread water because of the buyback. ?The stock price is too high, and remains too high because of the buyback. ?There is no good solution to this for IBM management, aside from new avenues of profitable organic growth, and those solutions are rare. ?Thus I avoid IBM.

My methods aren’t perfect, but they are pretty good. ?I stumbled into a lot more value traps when I was younger, but not so much anymore. ?Live and learn.

Investment Management: A Science to Teach or an Art to Learn?

Posted on 5 June 2014 by David Merkel

Imagine for a moment that you move to a new country that you have never been to before. ?When you get there, they give you a map of the country. ?But as you use the map, you find that it does not accurately represent the country at all. ?You never get to the place you want to go.

So, you complain to some of your new friends about the map, and they acknowledge the shortcomings of the map, but they say it is correct in theory, and is better than having no map at all.

This is economics and finance today, and there are changes that need to be made. ?They would rather have a wrong map than admit that their theories are bogus.

Today I read?Investment?Management: A Science?to Teach or an Art to?Learn?? I think its 99 pages are well worth reading, and if half or more of the observations get implemented by the CFA Institute, the Society of Actuaries, and Departments of Business, Finance, and Economics, the entire industry will be better off.

It is better to have an accurate uncertainty, than an inaccurate certainty. ?We are better of professing ignorance of what we don’t know, than being certain about things where we are wrong.

Investing is an art to learn. ?There is little science here. ?Stocks and other investments do not behave like modern portfolio theory would dictate. ?There is not one central risk factor that accounts for most of investing. ?There are many risk factors, and the credit cycle. ?The credit cycle is dominant, because as debts build, there is a boom in the favored asset classes. ?Then, as debts become unsustainable, there are crashes where the previously favored asset class returns to reasonable pricing or less.

We have to absorb the idea that most people are not rational, they merely imitate. ?”If my friends are doing it, it must be a ?good idea,” is the thought of many. As such, crises are easy to understand, because people imitate “the success” of others, not realizing that an asset?bought at a lower price might be good, but the same asset bought at a higher price might be bad.

We also have to grasp that physics is the wrong model for finance, and ecology offers us a better model — actors pursuing scarce resources in order to survive/thrive. ?In physics, it is simple. ?Human actions don’t matter; what humans care about does not affect physics. ?It does affect economics.

Beta vs Credit

Beta is not risk. ?Risk is more akin to the likelihood of bankruptcy, and the severity thereof. ?Crises happen when a lot of companies and individuals face the threat of bankruptcy. ?In some ways, we need to retrain all investors to think like bond managers — examining balance sheets, cash flow statements, and avoid companies that have higher probability of bankruptcy.

What do we Need to Change?

We need to end the idea?that markets natively are in?equilibrium. ?Indeed markets may weakly tend toward equilibrium, but the shocks to the system are far greater than the equilibrium tendency. ?Markets may tend toward equilibrium, but they are almost never in equilibrium.

We must teach students that the beauty of markets is that they function in disequilibrium. ?That is their glory. ?We should not expect perfection of markets in the short-run, but in the long-run many imperfections get eliminated where the government is not interfering.

We need to teach that crises are normal, and not accidents. ?They happen because a class of assets gets overbid, and often because of debt incurred to buy the assets.

We need to teach economic history to students, so that they grasp the wide array of what can happen in markets. ?What? ?That can’t happen today because the Fed watches over us? ?No way.? The same problems will recur in different forms.

The most important thing to teach new students about statistics is how they can be manipulated. ?Teaching them advanced statistics is overkill, because the markets are more random than that.

Quibbles

We don’t need to teach more macroeconomics to investors, because the theoretical foundations are shaky. ?I agree that we need to teach more qualitative reasoning to students. ?Maybe there should be some practical tests, where they work in a startup, and have to reason broadly, because there is no one to break it down to a simple level for the newcomer.

Beyond that,on page 98, if you don’t know how to value a derivative contract, you will not be able to trade it properly. ?As a former mortgage bond manager, it helped me a lot to understand the math. ?I could make better bids than most could.

Summary

The main idea here is to develop qualitative reasoning, and neglect quantitative reasoning when there is no reason to think it is impartial.

I write this as a mathematician who mostly understands where math fairly represents the world, and where it does not.

On Overstated Book Titles

Posted on 4 June 2014 by David Merkel

I have a problem with book titles. ?They are often inflated far beyond what the book actually states or proves. ? I have a few in my hands now, and it burns me, because the books in and of themselves are good, but they don’t reflect the title. ?The title makes grandiose claims, and then there is not enough in the book to back them up.

I will review in the next few days, The Secret Club That Runs The World. ?Great book with a lousy title. ?Sensationalistic, and I bet the marketers at the publisher created the title. ?Why do I think this?

I have a lot of respect for Larry Swedroe, but I trashed what was a good book in my review of?Think, Act, and Invest Like Warren Buffett. ?Honestly, I wish I had approached Larry first, before posting my review, because the title was not his idea, but that of the publisher. ?The original title “Playing the Winner’s Game” would have gotten a five-star review from me.

And yet, I am coming to realize that publishers, manipulate people through titles. ?Make them sensational. ?Make them offer a solution to?an impossible problem through a title, and the book does not deliver. ?Really it stinks.

But here’s my specific problem: when I write a negative review (usually 3-star) of a good book that overstates in its title, I tend to get a large number of negative votes at Amazon.

To use a term from Cramer, book publishers are in the OPUD game [Over-promise, Under-deliver]. ?That works for a while, but eventually it dulls people from buying books. ?Far better to borrow it from the library, even via Inter-library loan, than pay up for a book where title promises aren’t delivered.

To publishers: honesty is a basic objective of publishing; do not destroy your franchise by creating deceptive book titles.

To the public: look at the books before you buy them, and do not buy books that overstate what they actually deliver.

Buy Stocks When Credit Spreads are High, Sell When They are Low

Posted on 3 June 2014 by David Merkel

Credit spreads and implied volatility are cousins. ?When there is complacency, both are low. ?When there is panic, both are high. ?For those of us with strong balance sheets, when do we buy? ?We buy during panic. when we can get quality assets at bargain prices. ?When things are euphoric, we sell, or at least reduce exposure, increase quality, etc.

That’s why I don’t have much sympathy for articles talking about Great Moderation 2.0. ?Ask yourself, “How did the Great Moderation work out? ?Was taking a lot of risk then a good idea?

There were many that chased past returns 2005-7 that got hosed 2008-9. ?So when I see articles like?Trends Point to Growth & Stability, I shake my head and say, “Driving by looking through the rear-view mirror.”

I feel the same about this article,?Investors Rewarded for Trek Into Little Known Markets. ?Anytime a lot of new money spills into any new asset class, returns are high and implied volatility falls. ?That tells us little about the future.

When implied volatility and credit spreads are low, that tells us that people are very certain about the future, and they are relying on things remaining stable. ?It doesn’t tell us when the bear market will come, but it does tell us that gains are limited before the bear market.

I can’t tell you when things will break, or how badly they will break. ?I can tell you that stocks are producing earnings gains by levering up more, and not through organic growth. ?In the short run, it pays to issue debt to buy back stock, but the additional debt eventually exacts its price — when the cycle turns, and the price of liquidity rises, the debts will still be there, and interest costs to refinance them will be considerably higher. ?Or, equity might have to be issued at an unfavorable moment.

One practical tip — the area with the greatest percentage amount of credit growth is usually the one that performs the worst when the cycle turns — candidates for that include E&P firms engaged in fracking, student loans, US Government debt, and more. ?If anyone can think of additional areas, please mention them in the comments.

I’m not running away. ?I’m just trimming here and there, and investing in safer companies that seem to have good accounting. ?All for now.