Search Results for “portfolio rule”

“Smart Beta” and Portfolio Rule Seven

Posted on 24 June 2014 by David Merkel

I’m not an advocate for smart beta. ?There are several reasons for that:

I don’t pay attention to beta in the stocks that I buy; it is not stable.
The ability to choose the right brand of enhanced indexing in the short-run is difficult to easily achieve.
I’m a value investor, a bottom-up stock picker that doesn’t care much about what the index does in the short-run. ?I aim for safety, and cheapness.

But today I read an interesting piece called?Slugging It Out in the Equity Arena. ?It talks about an issue I have been writing about for a long time — the difference between what a buy-and-hold investor receives and what the average investor receives. ?The average investor chases performance, and loses 2%+ per year in total returns as a result. ?As the market relative to the index is a zero-sum game, who wins then?

The authors argue smart beta wins. They say:

To us, the smart beta moniker refers to rules-based investment strategies that use non-price-related weighting methods to construct and maintain a portfolio of stocks.^1?The research literature shows that smart beta strategies earn long-term returns around 2% higher than market capitalization-weighted indices. Moreover, smart beta strategies do not require any insight into the weighting mechanism. One can build a smart beta strategy with any stock ranking methodology that is not related to prices, from a strategy as na?ve and transaction-intensive as equal weighting to a more efficient approach such as weighting on the basis of fundamental economic scale. For example, a low volatility portfolio and its inverse, a high volatility portfolio, both outperform the market by roughly 2%?as long as they are systematically rebalanced.²??It is not the weighting method but the rebalancing operation that creates most of smart beta?s excess return. Acting in a countercyclical or contrarian fashion, smart beta strategies buy stocks that have fallen in price and sell stocks that have risen.

When I read that, I said to myself, “That is a more intense version of my portfolio rule seven:

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 learned this rule from three good managers — one growth, one core, one value. ?They were all fairly rigorous in their quantitative analyses, but they all agreed, a 20% filter on target weight added ~2%/year to performance on average. ?But unlike the current “smart beta” discussion, I have been using this idea for the last 15-20 years.

The mostly equal-weighting also induces a smallcap and value tilt, which is an additional aid to performance. ?Since I concentrate by industry, the 30-40 stocks?requirement does not lead to over-diversification, as a great deal of my returns comes from choosing the right industries.

In one sense, portfolio rule seven is an acknowledgement of mental limitations, and is an exercise in humility. ?So things have been great? ?They will eventually not be so. ?As prices go up, so does fundamental risk. ?Take a little off the table. ?Raise a bit of cash.

Things have been bad? ?Look at the fundamentals. ?How badly have they deteriorated? This can take three paths:

a) Fundamentals?have deteriorated badly, or I made an initial error in judgment. ?I would not own it now, even at the current price there are much better stocks to be owned. ?Sell the position.

b) Fundamentals are the same, a little better, or haven’t deteriorated much. ?Rebalance to target weight.

c) Fundamentals are better and people are just running scared from a class of companies — not only rebalance, but make it a double-weight. ?I only do this in crises, for high-quality misunderstood companies like RGA and NWLI in the last financial crisis. ?Some of that is my insurance knowledge, but I have done it with companies in other industries.

For fundamental investors, who think like businessmen, there is value in resisting trends. ?Having an orderly way to do it is wise. ?Don’t slavishly follow me, but ask whether this fits your management style. ?This fits me, and my full set of rules. ?Modify it as you need, it is not as if there is one optimal answer.

I’ll close with an excerpt from the first article that I cited, which was its summary:

KEY POINTS

1.?????Smart beta strategies are countercyclical, periodically rebalancing out of winning stocks and into losers. They may underperform for extended periods but they ultimately tend to prevail.

2.?????Investors? procyclical behavior, selling recent losers and buying recent winners, pays for the estimated 2% per year in long-term value added by smart beta strategies.

3.?????Smart beta investing can be reasonably expected to have an edge as long as investors persist in following trends and chasing performance.

Are you willing to take the long-term view, meaning more than 3 years? ?These ideas will work. ?Focus on longer-term value, and do your analytical work. ?And if you outsource your investing, be willing to allocate more to stocks during bad times. ?To avoid really ugly scenarios, wait until the 200-day moving average has broken to the upside, of look at the 13Fs of value managers.

Do that and prosper. ?Resisting trends intelligently can make money.

The Portfolio Rules Work Together

Posted on 30 October 2010 by David Merkel

Here are the eight rules with links to my recent pieces:

For the most part these are rules that would only serve a value investor.? They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which? rules 7 and 8 spell out.? The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors.? Value traps are companies that are cheap, but cheap for a reason.? How do you avoid value traps?

Try to have industry factors working for you (Rule 1)
Look for companies that still have some room to grow (Rule 4)
Avoid companies that are aggressive in their reporting of income (Rule 5)
Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together.? They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

=–==-=-=-=-=-=-=-=-=-=-=-=-=-=-

This is the end of the “Portfolio Rules” series.? From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.

Portfolio Rule Eight

Posted on 29 October 2010 by David Merkel

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.

Many investors are undisciplined when they make decisions to add stocks to their portfolios.? They see what they think is a neat idea, and they add it to their portfolios.

Don’t think that it is that much better in institutional investing.? Often Chief Investment Officers, and portfolio managers react to news cycle, and demand action from their analysts when the analysts are behind the curve.? That is not a time to ask for action.? Once an event has happened, it’s too late.? Ignore it, and move on.

You might say to me, “But wait!? There is new information here the changes our opinion about everything!? We have to make portfolio changes here!”? Okay, take a deep breath and ask yourself the following question, ?At current prices, which have reacted to the change in the news, what advantages do you have relative to all of your competitors who have all seen the same news??

Most the time, after an event has taken place, there is little advantage to investing in securities that are affected by the event.? The objective of an investor is to get ahead of the curve.? Far better to ask, “What is not being noticed by the market here?”? That’s what I do when I do my industry studies.? I try to get away from the short term news flow, and ask ?Where will things be three years from now?”

Yeah, that’s tough to do.? But why play games where we chase our tail by trying to gain an advantage off of current news flow?? That is a loser’s game.

That is why I deliberately try to slow things down when I am making changes to the portfolio.? I take action in changing the portfolio 3 to 4 times a year and when I make changes, I tend to trade three or four stocks.? An approach like this gives me roughly a 30% per year turnover rate.

Ganging up decisions like this forces decisions to be more dispassionate, and not subject to news flow.? It forces me to look at valuation metrics, momentum, industry factors, and sentiment factors.? By the time I am done, I will have identified a group of companies in my current portfolio that are not as good for future performance as a group of new companies that I have identified.

Where do those new companies come from?? Often they come from my industry studies.? I will go through those industries and look for attractive names.? I will then add them to the list of candidates.? Sometimes they come from my reading.? I will read an article and say, “That’s a good company.? Add it to the list.”? At other times I’ve seen article that runs a screen that I think is interesting; I will add those names to the list also.? And, if I’m really scraping the bottom of the barrel, I will run a variation of Ben Graham’s screen that combines price-to-earnings and price-to-book, and add in the names that look interesting.

When I do the grand comparison, I take all the names that are in the portfolio already and compare them against the replacement candidates.? I rank them on a wide variety of valuation factors, some sentiment factors, and momentum.? Before I start the process, I look at all the factors and ask how important they are in the current environment.? What is scarce?? What is common?? I give more weight to what is scarce and less weight to what is common.? If there is significant momentum in any factor, I ask how long momentum has been there, and whether it is getting tired, or showing signs of blowing off.? Most of the time, if there is momentum in a factor, I will give it more weight.? But if it is getting long in the tooth, I will drop the weight of that factor.? If the momentum is crazy, I will drop the weight of that factor.? Normal momentum is a positive.? Failing or crazy momentum is negative.

Once I have my factor ranks, and I have weights for my factors, I can then calculate grand ranks.? Then I sort the entire portfolio and replacement candidates on the grand ranks, and I look for the median stock currently in my portfolio.? I look below that stock for companies in my portfolio to trade away.? I look above that stock for candidates to add to my portfolio.

Now comes the hard part.? I look at the financials of each of the replacement candidates.? In most cases I end up finding that there is something wrong with the company and that is why it is so cheap.? But usually I find three or four names that are cheap for no good reason.? I buy them, and sell away companies that are relatively rich in my portfolio.

That does not guarantee that I have best portfolio in the world, but it does mean that I have a better portfolio, most likely, than I had before.? And, if you can to improve your portfolio quarter after quarter, your portfolio will deliver good results.

And so far, that is what my portfolio rules have done for me.? I’m done with the eight rules, but I will close this series of posts on how the eight rules work together.

PS ? I always wanted to complete a series when I was writing for RealMoney.com, where I would explain all of my eight rules.? Now I have done so.? And, you have gotten it for free.? Such a deal.

Portfolio Rule Seven

Posted on 28 October 2010 by David Merkel

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.

Let me begin with the last part of the rule.? I’ve gotten different reactions over the years from holding 30-something names my portfolio.? From some friends who run concentrated hedge funds they say, “Why so diversified?”? From those that run mutual funds they say, “Why so concentrated?”

Since I concentrate industries, owning 30 to 40 names my portfolio is relatively undiversified, compared to an index fund.? My view is that industry performance is the main driver of stock performance.? I also think that owning industries in proportion to the index is a recipe for mediocre performance.? If you don’t break free from the industry weights of the index, you will never achieve index beating performance.

Now, some may criticize the idea that I don’t know what my best ideas are.? Good, go ahead and criticize.? My experience has been that ideas that I thought were marginal often did quite well and ideas that were highly promising sometimes did marginally.? On the whole I think there was some rough positive correlation between how well I thought it would do, and how it actually did, but not enough to make me change this rule.

I do occasionally make a name for my portfolio a double-weight, or once even a triple-weight, but those are rare.? To have a high weight in my portfolio means that it must be exceptionally cheap, and be exceptionally safe.? In other words, it must be very, very, misunderstood.

At present I have 34 names my portfolio.? Ordinarily I like to have 35.? But, I don’t change the number rapidly.? I have a greater tendency to raise the number when the market is cheap, and I add equity exposure.? That said, during the bear market from 2000 to 2002, I decreased the number of names as the selloff got worse, concentrating into the names that got hit the hardest that still deserved to be invested in.? As the market began to rise, I added to the number of names that I invested in.

Keeping the number of names relatively fixed in the short run helps to facilitate swap transactions.? Swap transactions are a more intelligent way of managing an equity portfolio, because people are reasonably good at doing binary decisions, and not at doing decisions that have a lot of degrees of freedom.

I can’t tell you at any given point in time that I have the best set of stocks in the world.? But, it is relatively easy for me to look at the stocks that I am buying versus the stocks that I am selling, and conclude that I am coming up with a better portfolio as a result.? More on that when I discuss portfolio eight.

=-=–==-=–=-=-=-=-=-=-==-=–==-

Now, on to rebalancing.? I have gotten some criticism over the years, arguing that my rebalancing discipline leads me to pump money into losers that lose yet more.? Part of the misunderstanding is that when a stock falls by 20%, it doesn’t trigger an automatic buy, but an automatic review.? If my review comes the conclusion that the stock is fundamentally okay, then I rebalance up to the target weight.? I don’t double the position; that would be lunacy.? I only add to bring it up to target weight.? This is a moderate and disciplined way to buy weakness.

If my review finds that I made a fundamental mistake, I sell the position out.? Now, all that said, my worst losses typically came from cases where I rebalanced down and rebalanced down, and never caught the fundamental error.? Hey, I’m human.? But I can say that my gains more than paid for my losses.? Also, most of the companies that hurt me had balance sheets that were less strong then I thought.

When I was on the other side of the table, choosing investment managers, I ran across three managers with excellent track records that used this strategy.? They felt that it added on 1-3%/year.? Surprisingly, one was a growth manager, one was a core manager, and one was a value manager.

My sense is this: markets oscillate, and performance by industry and company oscillates.? This simple strategy catches some of those oscillations, buy low and selling high.

It also helps portfolio management from a psychological standpoint, because you realize that by realizing gains partially, and buying lower selectively, you don?t care so much about day-to-day fluctuations.? Rather, you realize that on average, fluctuations are working for you, and so, you focus on fundamentals, not the noise.

At least, that is what I have experienced.? And that is why I rebalance.

Portfolio Rule Six

Posted on 23 October 201024 October 2010 by David Merkel

I am more optimistic over how my asset management practice will start.? Thanks to all who have expressed interest.? Depending on how the state of Maryland replies to my filings, I will be able to get started sometime in November, December or January.? At present I am interviewing custodians who be clearing brokers.

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Cash flow is the lifeblood of business.? In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

I want to avoid companies that do big scale acquisitions.? Large acquisitions tend to waste money.
I also want to avoid companies that do acquisitions that are totally unrelated to their existing business.? Those also waste money.
I want to avoid companies that buy back stock at all costs.? They waste money by paying more for the stock than the company is worth.
This was common in the 50s and 60s but not common today, but who can tell what the future will hold?? I want to avoid companies that pay dividends that they cannot support.

Intelligent companies pay a reasonable fraction of the earnings as dividends.? They only buy back stock when their stock is cheap.? They don’t buy their stock back when their stock is sort of cheap.? They only buy it back when it is cheap.

And as for mergers and acquisitions, intelligent companies don’t do large-scale acquisitions.? Instead, they do little infill acquisitions.? They do acquisitions that give them a new technology to extend their business.? They do acquisitions that give them new markets distribute their products or services through.? In general, they do acquisitions that allow them to grow more effectively organically.

Organic growth is what it’s all about.? Anyone can do a stupid acquisition, and give the appearance of growth, but real organic growth is hard to find; it is the acid test of determining what is a good management and what isn’t.

That brings another point to mind.? Unlike many investors, I don’t mind if intelligent managements hang onto cash.? Cash is valuable in the hands of the bright men.? It gives them flexibility during times of economic stress.? Giving intelligent management teams additional flexibility is a good thing.

When you hear the phrase “transformational merger,” hang onto your wallet.? Most big mergers do not achieve the goals that they were designed to achieve.? And as I said before, the best management teams are not looking to grow rapidly through mergers and acquisitions.? Rather, they do little acquisitions to facilitate organic growth.

That’s all for this rule.? If you want more information on this topic, you can review this set of five articles that I wrote for RealMoney.com, that are freely available on the web.

Portfolio Rule Five

Posted on 16 October 201017 October 2010 by David Merkel

News: I’m planning to submit my paperwork to Maryland on Monday for registering my investment advisory.? Aside from that, I am giving a talk on the Efficient Markets Hypothesis in New York City on Wednesday to the Society of Actuaries.? Onto tonight’s topic:

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Maybe I should rephrase that to be “avoid companies that abuse their accounting, overstating earnings,” because it is perfectly possible to overreport earnings, while staying within the boundaries of GAAP accounting.? Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

For nonfinancials, review the difference between cash flow from operations and earnings.? Companies where cash flow from operations does not grow and? earnings grows are red flags.? Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.? The latter portion of that rule can be applied to financials.
For nonfinancials, review net operating accruals.? Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.??? The values of assets on the balance sheet are squishier than most believe.? The accruals there are not entirely trustworthy in general.
Review taxable income versus GAAP income.? Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.? b) management is clever in manipulating GAAP earnings.? It is the job of the analyst to figure out which it is.
Review my article “Cram and Jam.”? Does management show greater earnings than the increase in book value plus dividends?? Bad sign, usually.? Also, does management buy back stock aggressively — again, that’s a bad sign.

The idea is to see how honest and focused on the long term the management team is.? Management teams that cut corners in financial reporting will cut corners elsewhere, and deliver negative surprises to you.? That’s what I aim to avoid.

Portfolio Rule Four

Posted on 9 October 201010 October 2010 by David Merkel

I find myself in a different mindset, as I labor to start Aleph Investments, LLC.? I find myself both optimistic and fearful.? Optimistic, because this is what I’ve wanted to do for a long time, and I see the pieces coming together.? Fearful, well? I’m intellectually honest enough to know that even though I’ve done well over the last 10 years that may have no bearing over the next 10 years.? My greatest fear is that I start this business and I don’t do well for those who invest with me.

In the last week I’ve received confirmation from the state of Maryland that my LLC has been approved.? I have gotten my employer identification number from the IRS, and filed form 2553 to elect taxation as an S Corporation.? I have also begun filing with the state of Maryland and FINRA to register my investment advisory.

My next main task, while I am waiting for the state of Maryland to approve my filing, is to choose a clearing broker will be the custodian of funds for my clients.? I have five possible custodians that are willing to work with startup registered investment advisors.? This week I will send out some sort of RFQ to the five.

Beyond that, it’s time to get accounting and tax software for my firm, business cards, and help from someone who can help me in compliance matters, given that I would like to keep this blog not shut it down.? This blog is my greatest marketing asset, and yet my greatest compliance challenge.? Almost anything that an investment advisor might write on the web is regarded as advertising, even comments at someone else’s blog.? Part of the problem is that the rules regarding communications on the Internet for investment advisors are fuzzy to nonexistent.? If yhou have ideas, e-mail me.

To my readers: I want to keep this blog going.? Writing this blog allows me to do several things:

My first purpose was to give back to the general community.? If you have been given a gift, you should do some pro bono work.
Yes, to some degree, it does make me better known.? That is a help in attracting clients, but that wasn’t my first goal in starting this blog.
I like writing.? I like writing about economics, business and investments.? I enjoy being a bit of an iconoclast on economics.? I think business and investments are one of the greatest games in the world, and I like writing about it.? Even more, I enjoy playing the game.

So, I don’t want to lose the blog.? That said, if I can’t find a good compliance solution, I will sacrifice the blog for the good of the business.? My guess is that the odds are low that I will have to sacrifice the blog, so don’t worry.

Anyway, that’s what I’m up to.? If you want to talk to me about any of this, just e-mail me.

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

With that, here’s portfolio rule number four:

Purchase companies appropriately sized to serve their market niches.

A short rule, a simple rule ? what could be better?? The basic idea here is to purchase companies that have room to grow, or have some sustainable competitive advantage that allows them to prosper in the market niche that they occupy.

Sustainable competitive advantage is an important concept.? If you read the works of Warren Buffett, he talks about a concept that he calls “a moat.”? The idea is, what does a company uniquely have that would be difficult for competitors to reverse engineer?? Granted, almost anything can be reverse engineered with enough money to do so, but that’s the game.? Is it worth a competitor?s time to spend that much money?? Will the business still be as profitable even if they do reverse engineer you?

Let me give you a more plebeian example.? The restaurant chain Applebee’s had a strategy of setting up restaurants in small towns.? They looked for places that did not have a dominant restaurant, and where the town was big enough to support one restaurant, but not two.? The size of the town was Applebee’s “moat.”

In investing, what you don’t want is a company so big in its niche that it cannot grow, unless the pricing of the equity is such that it resembles a junk-bond yield.? Also, you don’t want a small company that can’t compete against larger rivals.

Ideally, you want to find a management team that understands its competitive advantage and maximizes it.? I have found that many times in the last 20 years, and when that happens, it is a thing of beauty.

This rule is a little more squishy than the others.? There is a decent amount of qualitative judgment that must go into analyzing the competitive structure of the industry the company is in.? That doesn’t make the rule invalid.? Rather, I think that the average investor, unlike Peter Lynch, has the capacity to analyze industry trends and come to a correct decision on trends in pricing power.

Anyway, that’s rule number four, which can be otherwise summarized as pay attention to sustainable competitive advantage.

PS — for a set of articles I wrote three years ago on this topic that were a hit, please visit this page.

Portfolio Rule Three

Posted on 2 October 20103 October 2010 by David Merkel

One side benefit of deciding to start up Aleph Investments, LLC, is that it is forcing me to write out articles on my rules.? When I was writing for RealMoney.com, I wrote a number of articles about my eight rules, but I only wrote about four out of the eight rules.

Before I write about rule number three this evening, I would like to bring you up to date on what I am doing with Aleph Investments, LLC.? This past week I incorporated the business, and in this coming week.? I will be registering as an investment advisor.? I will be managing equity money, on both a long only and hedged basis.? I have yet to choose a custodian and clearing broker, but I am working on this.? Given the state that I am domiciled in, Maryland, there may be delays but I suspect I’ll be up and running by late November or early December.

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

Let me give you a little history of how the eight rules came to be.? In 2000, I had an e-mail discussion with Kenneth Fisher.? I explained to him what I had been doing with small-cap value, and how I had done well with it in the 90s.? He told me to forget everything that I’ve learned, especially the CFA syllabus, and look for the things that I can do better than anyone else.? We exchanged about five or so e-mails; I appreciate the time he spent on me.

So I sat back and thought about what investments had worked best for me in the past.? I noticed that when I got the call right on cyclical industries, the results were spectacular.? I also noticed that I lost most when investing in companies that didn’t have good balance sheets, no matter how “cheap” they were in terms of valuation.

I came to the conclusion that size and value/growth were not the major determinants of my investing success. ?Instead, industry selection played a large role in what went right and wrong with my investment decisions.? So, I decided to formalize that.? I would rotate industries with a value bias.? But that would have other impacts on how I invested.? One of those impacts is rule number three.

I formalized the first seven of the rules in 2002, when the strategy was two years old and seemingly performing quite well.? I began doing what rule number eight states sometime in 2004, and reluctantly added it to the seven rules sometime in 2006.

With that, on to rule number three:

Stick with higher quality companies for a given industry.

There are three simple reasons for why rule number three works:

First, companies with lower debt levels within a given industry tend to be more profitable than companies with higher debt levels that industry, contrary to what the Modigliani-Miller theorems state.
Second, many investors, both retail and professional, have a bias toward what we might call “lottery ticket stocks.”? Many people swing for the fences in the stocks that they buy and accept high risks in order to achieve a high return.? On average, this strategy does not work.? In general, buying high beta, high volatility stocks is a recipe for disaster and buying low beta, low volatility stocks tends to earn money better than the market averages.
Third, if you are rotating industries, there are two ways to do it.? These two ways are not mutually exclusive, you can have part of your portfolio in one strategy and part of your portfolio in the other.? Method one is to look for trends that are clearly going on, but that the market has not fully discounted.? In this case, one can buy companies with excellent or good balance sheets because the trend will carry you along.? Method two is to look for industries that are sick but not dead.? In that case, you only select companies with excellent balance sheets.? This is how it works: if the industry remains sick, weaker competitors will be destroyed, capacity will exit, and pricing power will return to the survivors.? If the industry?s pricing power suddenly improves, then all of the companies industry will do well.? The one with the excellent balance sheet will outperform the market as a whole.? That the ones with poor balance sheets do even better is not a concern.? The idea is to avoid losing money; don’t take the risk by buying the “lottery ticket stock.”

For what it is worth, this same idea not only works with stocks but it works with bonds as well.? If you read the book Finding Alpha, the author has an extensive discussion on why high quality bonds outperform low-quality bonds over the long haul.? In general, corporate bond investors underestimate the costs of default risk.? BBB bonds do best, followed by AAA bonds, and then other investment grade bonds.? After that, the lower the rating of the bond the worse they do.

The same is true of stocks, which is why it pays to look at where the market is in its liquidity cycle.? In November of 2008 through March of 2009, it made a lot of sense to buy junk bonds, and I did so for my church building fund.? Though I didn’t say it at the time and did not act on it, it was also in hindsight the right time to buy junk stocks.? Oh well, that’s water under the bridge.? I tend not to take the risk of buying junk stocks because I don’t want to lose money.? I did well enough by adding to more cyclical names that had strong balance sheets.

Two notes before I close: first, industries tend to have preferred habitats.? In other words, typically the difference between the company with the best balance sheet the industry and the company with the worst balance sheet industry is not all that great.? Why is that?? If you’re in the same industry, typically you have similar levels of fixed costs versus variable costs, and you face the same levels of variability in sales.? These two factors together will lead an industry to a preferred level of financial leverage.? But even though the difference might not be that much between the company with the best balance sheet and the worst balance sheet within the industry, when pricing power is weak that small difference is significant.

Second, I am a proponent of “good enough” investing.? What I am saying here is that it is very difficult to achieve optimal results, and that if you try too hard to achieve optimal results, it is likely that you will do worse than good enough results.? The demands of perfection kill.? Size your goals to what is humanly possible.? My methods allow me to sleep at night.? My methods allow me to step away from my computer, and spend time analyzing what really might matter.? I can go visit clients and not worry that something is going to blow up on me.

This is not laziness on my part.? It is my view that most investors can do well enough in investing at low to moderate levels of risk.? But at high levels of risk, you have to get too many things right too much of the time in order to succeed.

That’s all for now.? Back next week when I write about rule number four.

Portfolio Rule Two

Posted on 25 September 201026 September 2010 by David Merkel

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

=-=-=?==?=-==?==-=-=-=-=-=-=-

If you have read me for a while, you have heard of my eight rules of stock investing.? Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.? I thought it was a good idea, so this is the second of what is likely to be eight episodes.? Here?s portfolio rule two:

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

The first principle of value investing is having an adequate margin of safety.? Make sure that your downside is clipped, if things go wrong.? But that’s not today’s topic, I will cover it later in this series.

The second principle of value investing is buying the investment cheap to its intrinsic value.? That is an easy phrase to utter, but complicated to implement.? There is no one single simple metric that serves as a guideline for evaluating cheapness as a value investor.

Ideally, one would create an integrated free cash flow and cost of capital model, one like Michael Mauboussin did in his book Expectations Investing.? That is the correct general model to use; the only problem is that it is impossible for individuals or even small investment shops to implement.

So, when evaluating companies, rather than using a complex model for free cash flow and cost of capital, it makes more sense given limited time, to look at the most critical partial sensitivities of the true model.? What do I mean there?

I go back to what the best boss I ever had sent me regarding modeling: “80 to 90% of the valuable model can be encapsulated in the top 2-3 factors of the model.? What that implies to me regarding analysis of valuation is that simple ratios do still have punch.? But the challenge is selecting the ratios that are the most appropriate for companies in a given industry.

Here is the most basic thing I have learned so far about what valuation ratios to use: with financial companies use price-to-book, and with all other companies use price-to-sales.? How did I come up with this insight?? I spent a lot of time using one of Bloomberg’s functions [GE] and I found the tightest correlation of price movement to each of those variables.

But the intuition that I have received from that is not the end of the story.? Let’s stop for a moment and think about what various valuation ratios mean.

The classic ratio is the price to earnings multiple.? It makes a lot of intuitive sense because we want to know how much we are earning per dollar spent on the stock.? Earnings, and its cousin operating earnings, are the lowest figures on the income statement.? They are also the most manipulated numbers on the income statement.? But there are other ratios on the income statement, less manipulated, that exist higher up on the income statement, or over on the cash flow statement.

Operating income/earnings is a means of trying to look at the profitability the business before interest, taxes and nonrecurring elements.? Many analysts think that this is a better measure of earnings on a continuing basis than ordinary earnings, because it eliminates a lot of noise.? But you can go higher up on the income statement and move to price to sales.? Particularly in an environment like this where sales growth is so scarce, the price to sales ratio plays a larger role.? Exactly how cheap can a stock get on price to sales ratio basis?? Where would its valuation be stretched?

Away from that, on the cash flow statement, we have EBITDA, cash from operations and free cash flow.? EBITDA is earnings before interest, taxation, depreciation and amortization.? Cash from operations is simple to understand.? How much cash is the business generating?? So long as that does not involve the buildup of additional liabilities, or need for additional capital expenditure, that can be a useful figure for analysis.? The same is true of EBITDA.? Free cash flow goes further and subtracts maintenance capital expenditure.

Operating earnings and free cash flow are proxies for trying to understand what the income generating capacity of the business is on a normalized basis.

But then there are balance sheet measures like price-to-book and price to tangible book.? The idea is to ask how much assets are allocable to the equity investors.? In financial companies, where the cash flow statement is pretty meaningless, attempting to estimate the value of the firm, using book or tangible book has some power.? Why?? Because financial firms are in the business of shepherding scarce capital in order to produce returns.? Since capital is typically a constraint for earnings price-to-book is a useful measure for analyzing the valuation of the financial company.

The same is largely true of sales for industrial companies, sales are relatively hard to fake.? Now don’t get me wrong here, sales have been faked in many companies.? It helps to study revenue recognition policies, and it also helps to consider the buildup in accruals for accounts receivable.? Yes, sales can be faked, but cash from sales is very hard to fake.

One more metric worthy of consideration is enterprise value to EBITDA.? This metric is useful during times when there are a lot of mergers and acquisitions going on.? This metric measures in a crude way the amount of free cash flow that the assets of the business throw off.? It is the way many acquirers would look at a business.

Another way to think of it is, is the business more valuable in the hands of the current management, or the hands of new management?? If it is more valuable in the hands of new management, enterprise value to EBITDA is the better metric.? If the current management makes it more valuable, then price to sales is the better measure.

Now there are two more ideas that must be considered here: cost of capital, and reversion to mean.? In one sense we want to look at earnings, or free cash flow in excess of the cost capital employed.? The way I handled this is not to estimate the cost of capital but to look at the credit ratings, leverage on the balance sheet, volatility of the stock price, and volatility of earnings in order to get a feel for the riskiness of the company.

Mean-reversion is involved in value investing, in the sense that return on equity for firms tends to mean-revert over time.? What that implies is that it makes sense to pay attention to valuation, because firms in bad shape often clean up their act and get better, and firms in exceptionally good shape find their excess earnings competed away by other firms.? And that’s why value investing tends to work: companies with cheap valuations improve, and multiples expand.? Companies with high multiples tend to contract, because it is difficult to maintain superior growth over the long haul.

Portfolio Rule One

Posted on 18 September 201019 September 2010 by David Merkel

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

=-=-=–==–=-==–==-=-=-=-=-=-=-

If you have read me for a while, you have heard of my eight rules of stock investing.? Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.? I thought it was a good idea, so this is the first of what is likely to be eight episodes.? Here’s portfolio rule one:

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

I always get a little look of surprise the first time that I mention my main idea to consultants or other equity managers. I sometimes say, “Some managers are top down, others are bottom up — I am middle out.”? The idea is that I don’t rely on a view of the economy to drive my investing, nor do I just look for cheap stocks, wherever I might find them.? Instead, I look for industries that are hated, either absolutely or relatively.

In my view, paying attention to industry fundamentals is always superior to viewing the economy as a whole, because:

The industry cycles as compared to the overall economic cycle are not exact comparisons, both with respect to timing and amount.
Among other reasons, demand outside the US can be decidedly different than demand inside the US.
New entrants and company failures and acquisitions can affect the industry economics more than the general economy.
Major innovations like the Internet can turn stable cash flow generators like newspapers and parts of the telephone industry into permanent losers.

If I were allowed to turn back the clock, and teach those who allocate equity assets how it really works, I would have told them to ignore value and growth, large and small.? I would replace those with industries.? Industries tend toward value and growth, large and small, but the aggregation hides a lot of valuable information.? But the consultant community is a sucker for simple explanations that explain little of a more complex reality.

Think about it, ideally, when to you want to buy shares in an industry?? When the hatred is thick.? Valuations are crushed to the degree that they can’t go much lower.? And at such a point, the risk lover buys the dodgiest company in the industry — high fixed costs, bad balance sheet.? Clever, but what if the recovery takes too long, and it goes broke?? Such a strategy makes a short-term bet.? Those with a longer time horizon, and reasonable expectations, buy the high quality company.? If the downturn prolongs, more competitors will fail, and they will pick up pricing power.? If the downturn ends quickly, and pricing power returns, the high-quality company will still do very well relative to the market as a whole, though a lower quality name that might have died under other circumstances will do much better.

The second-best place to buy are industries in the midst of improving pricing power that will persist, but many think it will not persist.? In that case, since there is only a low threat of companies going into financial stress, buying cheap companies of moderate quality will result in very good gains.? The risk is that I am wrong in my estimate of continuing pricing power, but if I am wrong, the cheap name typically won’t do that badly, and I can trade away for the small gain, or not much of a loss.

All of this means spending time watching industry economics, looking for places that will outperform market expectations.? This isn’t always easy, but there aren’t so many players asking those questions, compared to those doing top down or bottom up investing, and so I have a better chance of profit, in my opinion.

PS — For those with access to RealMoney, some of my best articles on portfolio management are listed here.