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On Approximate Valuation Methods

Thursday, April 17th, 2014

The growth of corporations is always constrained by something.  The trick is figuring out what the “something” is.  Tonight, I am here to simplify it for you.

Financial businesses that are regulated

We value these via book value or tangible book value.  Capital levels constrain business growth, so look at the return on equity to help modify what the proper valuation level should be.  Book value and return on equity are what govern.

Non-financial businesses that are regulated, such as utilities 

Look to the rate base that the regulators use.  Book value might be a good substitute, but look to see how companies might invest to increase their “rate base.”  Market Cap as a ratio to what the regulators allow profits on would be ideal.

Unregulated businesses that are mature

These are governed by sales per share, calculating the price-to-sales ratio.  In general, it is wise to buy these when the P/S ratios are low, and sell them when they are high.

Unregulated businesses that are not mature

This is the complex part of valuation, but in this case the PEG Ratio makes sense.  Companies that grow their earnings rapidly can justify high P/E multiples, but in general they need to grow earnings more rapidly than their P/E ratio expressed in percentage terms.

I don’t invest in many immature businesses, so this is not so relevant to me.  I look for places where businesses are neglected, and I buy, while selling businesses that are more then fully valued.


Think about compounding.   Ask what will best compound the growth of your capital.  I suspect that it will resemble what I have written here.  Focus on compounding and ignore Modern Portfolio Theory.  Compounding is real business.  MPT is fakery from men who could not build a business.

I’m Not in This for Love

Friday, April 11th, 2014

Much as I appreciate those who like what I write at this blog, I don’t write to be loved.  I don’t write to be hated, either.  I am sensitive to what people think of me, but not to the degree that it changes what I write.

I may have nonconsensus views on:

  • The Federal Reserve
  • Gold
  • Social Security & Medicare (and their cousins around the globe)
  • The current Bull Market in Stocks and Corporate Bonds
  • Long Treasuries
  • and more…..

But I write what I write to disclose the truth.  I am an active equity manager, but I encourage people to use passive investing via index funds, unless they can find a manager who can reliably obtain outperformance.

I don’t blog for economic advantage.  If I wanted to do that, I could channel a wide variety of ideas on investing that are popular, but I know are marginal at best in terms of effectiveness.

Some friends of mine have told me, “Why don’t you write about companies that you own, or companies that look attractive to you?”

I’ve been burned by doing that.  For every ten that you get right, you get the same response from every one you get wrong.  As with most of the web, the complainers dominate.  That’s why I don’t trot out many individual stock ideas.  It’s not that I don’t have them, but I only share them as a group, not as a single idea, most of the time.


I’m here to tell the truth, even if it cuts against my own short-term economic interests.  Most of the time, I adjust my portfolio so that it is ready for everything, but sometimes I delay, because I know that changes in the market usually happen slowly.

I do not write to be popular.  I write to change the consensus, unlikely as that will be.  Finance is a perverse area of life where fear and greed take over.  And with academics, they have these lame models that are fit for Vulcans (maybe) but not humans (and certainly not Ferengi).

We need new models that reflect the fear-greed cycle, and make valuation a significant input in risk assessments.

I’m not in this for love; I only want to change the way that we view investment decisions.

On Fat Tails

Wednesday, October 30th, 2013

I’m reading an investment book that is arguing for market timing.  I’m not impressed with the line of argumentation so far.  I just finished a chapter where the authors pointed out that security price movements are more volatile that the normal distribution would admit.

This is a well known result, or at least it should be well-known.  What I hope to contribute to the discussion is why the tails are fat, and skewed negatively.  There is a famous saying in investments:

Cut your losses, and let your winners run

I regard this saying as vapid, because I have had so many investments where the price action was bad initially, but ended up being incredible investments.  I have also had companies stumble after prior gains, and persevere for greater gains.  Intelligent asset management does not react to the past, but analyzes future prospects, and looks at current margin of safety.

But imagine a situation where many parties have their plans, and they are all similar.  I’ll give a few examples:

  • Institutional investors decide in 1986 to follow the momentum, but be ready to sell if the momentum breaks.  They want upside, but want to protect the downside.
  • Japan was a total momentum market up through 1989, and the reverse thereafter.  Loose monetary policy was an aspect of that, as was a loss of fear, warrant speculation, etc.
  • Those investing in hot emerging markets in the mid-90s did not recognize valuations getting stretched, and the inability of the countries to maintain stimulative policies amid falling currencies.
  • The guys at LTCM were geniuses until they weren’t.  They had no idea of the risks they were taking.  They did not have an ecological view of investing.  Essentially, they thought liquidity was free, until the jaws of the trap snapped shut, and they died.  Taking a concentrated position is a risk, because the investing typically pushes up the price.  When you are so big in a position that you are affecting the market price, that is a bad place to be for two reasons: 1) if you sell, you drive down the price for future sales, and 2) you no longer know what the fair price would be if you weren’t there.
  • Aside from that with LTCM, their brokers mimicked their trades, accentuating the boom-bust, but the brokers had risk control desks that forced them to sell out losing trades, which further hurt LTCM.
  • Think about residential mortgage bonds in 1994.  So many players thought that they had mastered the modeling of prepayment risk only to find amid a Fed tightening cycle that many wanted to limit their interest rate risk as rates skyrocketed, fueling a self-reinforcing panic.
  • Consider tech stocks 1998-2000.  Momentum ran until the sheer weight of valuations, together with insolvencies, crushed the market as a whole, and tech stocks more.  Think of European financial institutions getting forced by regulators to kick out US stocks in September 2002, putting in the bottom.  Regulators almost always act too late, and exacerbate crises, but they should do that, because worse things would happen if they didn’t.  (Later = bigger crisis, Earlier = Some Type II errors, regulating where it was not needed).
  • Finally, consider the housing/banking crisis in the US 2005-2009.  People bought homes with a lot of debt financing, and short-dated debt financing.  Banks levered up to provide the financing.  Shallow credit analysis allowed banks to take on far more risk than they imagined.  It all ended in a trail of tears, with many personal, and not enough corporate bankruptcies, with the taxpayers footing the bill.

In each of these cases, you have correlated human behavior.  The greed of investors gives way to fear.

Now if you are thinking about Modern Portfolio Theory, where market players have perfect knowledge, this doesn’t make sense.  These crises should not happen.  But they happen all too regularly, and I will explain why.

Men are not greedy as much as they are envious.  This leads to mimicking behavior when things are going well.  Those not currently playing want a piece of the action, and so they imitate.

Modern Portfolio Theory implicitly assumes that market players don’t react to the actions of other market players, but that is false.  Most market players don’t think; they mimic.

That is what leads to fat tails, because when people move as a herd, you get dramatic price moves.  Because fear is a greater motivator than envy, that is why the big downward moves are almost always greater than the big upward moves.

Add into that the credit cycle, because gains on credit-sensitive bonds are small, but losses are huge when they occur.  The distribution of outcomes has a long left tail.

The main point here is that price movements are non-normal because market players act as a group.  Their behavior is correlated  on the downside, and to a lesser extent on the upside.

Among other things, this means Modern Portfolio Theory is wrong, and needs to be severely modified, or abandoned.  It also means that we need to watch the credit cycle, and speculative activity to get a sense of how committed the hot money is to risk assets.  Hot money follows trends.  Cold money estimates likely returns over a market cycle, and invests in the best ideas when they are out of favor.

I don’t think timing the market is easy.  I do think that fundamental investors have to look at whether they have a lot of opportunities, or few, and vary their safe assets opposite to opportunities.

So beware the fat tails — we haven’t had a lot of volatility recently.  Maybe we are due.

Traveling with David

Friday, October 25th, 2013

Sometimes I over-commit my time.  That’s been the last few days.  Recently I went to visit a friend who had lost his job at a large company, to look over his severance papers, and advise him.  He is older, a “minority,” and only been with the firm 5-6 years.

Severance agreements have gotten a lot tighter since the two that I have personally experienced.  Corporations dangle some compensation to eliminate possible future legal costs.  I pointed out to my friend the most likely reasons he might sue, but added two things:

  • The company has a large number of sharp lawyers, so you had better have an open-and-shut case.
  • We’re Christians, so we don’t go to court over small matters.

But what impressed me in reading the agreement was how airtight it was — can’t sue over Federal, State, Local, or common law offenses, or anything else.  Which made me think about another thing… the connection between entrance and exit doors.

In investing, people are more wiling to invest if they can have their money back at any time.  With employment, it is the same — employers are more willing to employ if they can fire people for any reason.

Every protection for those employed makes it harder for those without work to be employed.  This also forces jobs to go underground — if advertising them publicly subjects them to regulation, then the good jobs will be filled via “word-of-mouth.”

This takes me back to the early days of the Reagan Administration.  They deregulated a lot of things, and the economy grew far more rapidly.  We could do the same now, starting with labor and healthcare.

My friend may do fine, but the things that “protected” him at his last job now hinder him in seeking another job.  Better to eliminate the protections, and let people compete based on skill and assiduousness.

Part Two

Then I was a judge in a financial analysis competition at a local college.  The analysis involved a stock that faced a large investment decision, larger than the current enterprise value of the junk-rated company.  Should the hedge fund buy, sell short, or do nothing with the stock?  The simple part of the case study was working through the intricacies of the discounted cash flow model, together with changes to the assumptions about cash flows and the weighted average cost of capital.

What I found interesting was the lack of attention to:

  • Details of the case study — did you even read it?
  • Common sense — we are sorry, but a stock can’t lose 113%.  Perhaps you would like to tell us to short the bonds?
  • Limitations of complex techniques in finance.  Yes, there’s many nifty formulas available to you, but do you understand what they really mean, and what limitations they imply?  When are they not valid?
  • What markets can and can’t do.  No, you can’t do an public issuance of junk debt at the level of current debt.  You can’t do an issuance longer than ten years.  You can’t do one that is really big without changing market pricing (and the answers from the case study had this wrong as well).  Same applies to large secondary IPOs for equity.

Now, I know these are students.  They can’t know what an experienced market professional does.  To their credit, they dug up many bits of useful data that the case study did not contemplate.  But the case study itself should have noted these things, and to that degree I fault Darden for writing up a subpar case study.

The main thing I would say again to the students is to ignore the academic models with their false certainty, and try to understand the qualitative aspects of the business, out of which the quantitative modeling will grow.

When we were done, each of the judges gave comments to the students.  I started off with, “Sorry for being such a hard-nose.”  I got a decent laugh from the students, and then explained to them what I have said to you.

Part Three

That evening I went to a talk by CareFirst on the PPACA/Obamacare.  It was a genuinely useful 20-minute presentation, with one annoying thing: all of the pictures in the slide deck were of healthy smiling people.  If you are healthy, you will pay more, unless you are really poor.  A realistic presentation would have had people that are stoic, sad, or crying, if they are healthy and not poor.

The best part of what CareFirst gave me was premium rates for PPACA.  The lowest level plan would increase my premiums by 50%, and would increase the areas in which I would have to pay.  More expensive in every way.

It is only an affordable care act to those who were previously uninsurable; to those who were insurable it is a tax on your health and income.  In 2016, we will rip it out by its roots, and have people pay for healthcare directly, with no tax deduction for employer-provided healthcare.  That will reduce healthcare spending, and shrink healthcare to a more reasonable part of the economy.

If you want healthcare to be affordable, get the government out of it in entire.

Part Four

Dr. Kathryn Crecelius spoke to the Baltimore CFA Society on Thursday.  She is the Chief Investment Officer of my alma mater, The Johns Hopkins University.  She talked to us about endowment investing.  Very common sense stuff, very well said, and much like you would hear from me.  I found myself nodding through the whole talk.  It was all very much like my last piece on endowment investing.  I learned a lot, which makes me happy, because I always like to learn.

My travels are done for a while.  I like that too, because being home is a happy place.


A New Look at Endowment Investing

Saturday, October 5th, 2013

I’ve written at least two significant pieces on endowment investing:

Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project.  This was partially in response to Matthew Klein’s excellent article, Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.

The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions.  If you are interested, it is worth a read.  The remainder of this piece expresses ways that I think their views could be sharpened.  Here goes:

1) Don’t Think in Terms of Time Horizon, but Time Horizons

2008-9 proved that liquidity matters.  The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.

Choose a length of time over which you think you have a full market cycle, with a boom and a bust.  I like 10 years, but that might be too long for many.   As I said in Managing Illiquid Assets:

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

I include all risk assets in illiquid assets here.  The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell.  There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.

2) Look to the Underlying Drivers of Value

Hedge funds aren’t magic.  They are just limited partnerships that invest.  Look through the LPs to the actual investments.  It is those actual investments that will drive value, not the form in which they are held.  Get as granular as you can.  Ask: what is the margin of safety in these endeavors?  What is the likely return under bad and moderate conditions?

3) Ignore Correlations

It is far more important to focus on margin of safety than to look at diversification benefits.  Correlation coefficients on returns are not generally stable.  Do not assume any correlation benefits from risky investments.  Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.

4) On Leverage & Insurance

Unless they are mispriced, borrowing money or getting insurance does not add value.  Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.

Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).

5) Mark-to-Market Losses Might Matter

Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.

6) Insource Assets

The best firms I have worked for built up internal expertise, rather than outsource everything.  The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced.  As you gain experience, insource more.

7) Thematic Investing is Usually Growth Investing

Avoid looking at themes.  Unless you are the first on the scene, themes are expensive.  Rather, look at margin of safety.  Look for businesses where you can’t lose much, and you might get good gains.

8) Look to the Underlying Value of the Business, or Asset Class

Cash flows are what matter.  Look at he likely internal rate of return on all of your investments, and the worst case scenario.  Buy cheap assets with a margin of safety, and don’t look further than that.  Buying safe assets cheap overcomes all diversification advantages.

Those are my differences on what was otherwise a good paper.  I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.

Advice to Two Readers

Saturday, August 3rd, 2013

I get a lot of requests for advice.  Here are two of them.


 I really appreciate you discussing your trading/haggling strategies in the Education of a Corporate Bond Manager.  It’s definitely given me new ideas and helped me get better pricing in my purchases the last couple of years.  I still refer to them every few months or so.

I have a question about changing jobs in the fixed income industry – I work in a treasury division, managing my company’s cash and short-term investments.  I’ve done well, but we use yield-based benchmarks, as part of the portfolio is used to immunize short term liabilities.  When I interview with asset management shops, they want previous total return portfolio management experience.    

Do you know any particular types of firms or sub-industries that use yield-based benchmarks?  Does managing to a yield benchmark stunt my learning growth compared to a total return mandate?


Yield-based benchmarks exist when:

  • The liability structure being invested against is short (We could need this cash at any moment for business use!)
  • The liability structure is long, but well-defined, such as a bank or insurer that wants predictable income versus their liabilities, and so the game becomes maximize spread net of default costs, subject to matching asset and liability durations (and maybe partial durations if the liability stream is long).

You are doing the first of these.  Truth, what you are doing could be measured on a total return basis, but it wouldn’t make a lot of difference.

The second one applies to banks and insurers, and can be done on either basis as well.  The difficulty comes with trying to calculate the total return of the liabilities.   If that it too hard to do, they create a bond benchmark that they think represents when they think the liabilities may pay out.  If the liabilities possess some degree of optionality, like that of residential mortgage prepayment, the benchmark could include bond options (long or short).

The yield on the bond benchmark is easy to calculate, as is the total return.   Thus relative performance can be calculated either way.  I had to do this for an insurance client once who insisted that our performance was poor when we had returned more than 0.70% year more than single-A corporate, which was quite good.

Thus, one place you could try working is for is an insurer, bank, or other financial intermediary.  But what of those that manage funds for retail.  What then?

Aside from unconstrained funds, even a mutual fund has a liability to invest against – the expectations of the client.  In that sense, most mutual fund managers aren’t doing full total return either – they have to stay within a certain range for interest rate sensitivity. They also could be evaluated on the basis of yield realized versus that of a generic portfolio meeting their interest rate sensitivity targets.  More commonly, they would be ranked against their competitors on a total return basis.

In closing, it you don’t want to manage money for a bank or insurer, you’ll have to try to wedge your way into work in a total return environment – taking a junior level position, and showing competence.  Believe me, most firms would love to promote from inside, if possible.



Dear Mr. David Merkel,

I really appreciate your hard work you are putting in your site and I am an avid reader of it. I would like to seek your advice regarding a decision I am facing. My goal is become a value investor and establish my own asset management firm to manage my own money and other people’s money. Right now, I have the opportunity to pursue partnership in my family business and be able to run it along with my father. I am 23 years old, and I am a freshman student at the _+_+_+_+_.  If I am to be a partner in my family business, I have to drop out from the university and travel to +_+_+_+_+_+_+_, where the business is. I am still a freshman student because when I was 19 years old, I dropped out to establish my own business in the same industry as my family in +_+_+_+_+_. I had an experience running a business and I had the opportunity to sell my business after two years of operation to my cousins, and, thankfully, it was a profitable venture.

My family business is somehow facing sales shrinkage and cash flow problem due to low capital (my family made terrible mistakes in managing it) and economic downturn. They are specialty contractors and manufacturers of fenestration products (windows, doors, kitchens, curtain walls, and rolling shutters). If I am to work with them, I can be able to help them in reorganizing the company. It might be risky for me, but if everything worked out well enough, I will have earnings that I believe is better than being an employee.

I am facing a decision that I need to make. You might not be able to advice me, but whatever advice you give me, I appreciate it. If my goal is to manage my own money and other people’s money by establishing my own asset management firm, is it helpful to have a university degree or the experience of having ran a business? Shall I drop out and pursue my family business opportunity? If I am to continue studying, I will incur student loan debt which I won’t prefer. But, alas, I will do it if it need be to accomplish my goal. Thank you a lot.

You have my sympathies on two fronts:

1) Choosing between family obligations and personal goals is never easy.  I have had to face that in deciding what jobs I could take while raising my family.  I was recruited for a managing director position in an investment bank in the mid-90s, but passed it up because I could not peel away that much time from my family and church.  It took a lot of time for me to become an institutional investor as a result.  I became an investment actuary at the age of 31, started working in an investment department at age 37, started work at a hedge fund at age 42, and started my own firm at age 49.  By 49, I had more than enough assets to care for my family if my business failed, at least to put the kids through college.   After that, I could be stretched.

2) Good operational businessmen can be very good investors.  There are synergies between the ability to operate a business, and the ability to make good investment decisions.  Don’t think that building another business is a waste of your time.  It will sharpen you in ways that most institutional investors never grasp.  I benefited a great deal from building profitable business within insurance companies, and it sharpened my knowledge on how to invest.

Now, all that said, if you take time out to rebuild your family’s business, don’t neglect your education.  Read good books on value investing, and study those who have been great.  I’m not saying that college is useless, but I am saying that much of the knowledge that academics teach on economics is deficient.  In some ways, it is better to be a clever businessman than an academically trained man.  The latter will not gain much insight into how to invest.  The businessman has a better chance.

Perhaps a good compromise would be to study for the CFA credential in your spare time.  I did that.  Along with that, invest some of your money in ideas that you think are worthy.  I did that from 1992-2003, before I began investing in stocks professionally, and I did very well.

You need to find out whether you have significant insights versus the rest of the markets.  Academic learning will not help that.  Operational business experience *might* help that.

Don’t give up your goal of managing your own value investing firm, but realize that there are many paths to getting there, and the most important thing is trying to develop insight into the markets that others don’t have.  Typically, academic study does not develop that.

I hope things work out for you.  Let me know how you do.



On Stock Splits

Saturday, May 25th, 2013

Mark Hulbert had a recent piece in the Wall Street Journal called How to Use Stock Splits to Build a Winning Portfolio.  I find it curious, because 31 years ago I wrote my Master’s Thesis called, “Predicting Stock Splits: An Exercise in Market Efficiency.”  As far as I know, aside from the unbound copy sitting next to me, the only other copy is in some obscure part of the Johns Hopkins Library System.  If a number of people are really curious about this, I could try OCR and see if that would adequately read the typewritten text.

But anyway, I find it amusing that some are still trying to use stock splits to try to make money.  Quoting from Hulbert’s piece:

But try telling that to Neil Macneale, editor of an investment-advisory service called “2 for 1,” whose model portfolio contains only those stocks that have recently split their shares, holding them for 30 months. Over the past decade, according to the Hulbert Financial Digest, that portfolio has produced a 14% annualized return, far outpacing the 8% gain of the Standard & Poor’s 500-stock index, including dividends.

Mr. Macneale’s track record isn’t a fluke. Several studies have found that the average stock undergoing a split outperforms the overall market by a significant margin over the three years following the company’s announcement of that split. Indeed, Mr. Macneale said in an interview, he got the idea for his advisory service in the 1990s from one of the first such studies, conducted by David Ikenberry, now dean of the Leeds School of Business at the University of Colorado, Boulder.

Research on stock splits goes back to the ’30s.  In the ’50s & ’60s before MPT got into full swing, a few researchers began trying analyze why there were abnormal rises in stock prices two months before a stock split.  Could it be that other factors affecting future value were somehow associated with stock splits?  Many factors pointed toward that, notably prior price increases, prior earnings increases, and increases in the dividend associated with the stock split.  Little did they know that they were anticipating momentum investing.

The consensus by the end of the ’70s was that there was no excess return after the stock split announcement, and few ways if any to capture the pre-announcement excess returns.  If in the present stock splits are providing excess returns for 2.5 years afterward, well, this is something new.

One of the leading stock-split theories—supported by the work of professors Alon Kalay of Columbia University and Mathias Kronlund of the University of Illinois, Urbana-Champaign—is that companies implicitly have a target range for where they would like their shares to trade.

If a firm’s shares are trading well above that range, and management believes that this high price is more than temporary, it is likely to initiate a split in order to bring its share price back to within that range.

This isn’t a new theory — it goes back to the ’50s, if not earlier.  One of the oldest theories was that it improved liquidity, but back in a time of fixed tick sizes, where everything traded in eighths, and higher commissions, that made little sense to a number of economists.  Splits made trading costs rise in aggregate for the same amount of dollar volume traded.

In the present though, there are many venues for execution of trades, commissions are much smaller, and negotiable.  Perhaps today more shares at lower prices does add liquidity, and the way to test might compare the bid-ask spread and sizes pre- and post-split.

The professors late last year completed a study of all U.S. stocks that split their shares by a factor of at least 1.25-to-1 between January 1988 and December 2007. They say the evidence their study uncovered suggests that splits are an “indication of sustained strong earnings going forward.” It therefore shouldn’t be a big surprise that split stocks outperform other high-price stocks that don’t undertake a split.

What this might mean is that stocks that split are examples of price and/or earnings momentum.  A management team splits the stock as a signal that corporate profit growth has been good, and will continue to be so.  If not, the management team runs the risk that if the stock price falls, it looks bad to a management to have a low stock price.  There are some investors who won’t buy stocks below $10, $5, etc.  Why run the risk of lowering your stock price if you think the odds are decent that the price will fall from there?  Low stock prices affect the confidence of many.

Investors looking to profit from the stock-split phenomenon should shun stocks that have undergone a reverse split and focus instead on those that have split their shares. You will have to invest in such stocks directly because there is no mutual fund or exchange-traded fund that bases its stock selection on stock splits.

Fortunately, constructing a portfolio of such stocks needn’t be particularly time-consuming.

For example, there is no need to guess in advance which companies are likely to split their shares—which in any case would be difficult, if not impossible, to do. There even appears to be no need to buy a company’s stock immediately after it announces a split, since research shows that it is likely to outperform the overall market for up to three years following that announcement.

Still, Mr. Macneale recommends that investors be choosy when deciding which post-split stocks to purchase. He cites several studies suggesting that the post-split stocks that perform the best tend to be those that, at the time of their splits, are trading at relatively low price/earnings or price/book ratios. Both are commonly used measures of a stock’s valuation, with lower readings indicating greater value.

I’m going to have to find the papers that say that post-split stocks outperform for the next 30 months.  Doesn’t sound right — a result like that would have been found from the research pre-1980, and no one suggested that; in fact, the evidence contradicted that consistently.

Note that the investment manager in question uses cheap valuation to filter opportunities.  That the stock has split usually indicates strong price momentum.  Value plus momentum is usually a winner, so why should we be surprised that stock splits often do well?

But I know of three papers that focused on predicting stock splits — two in 1973, and mine in 1982.  It’s not that hard.  Most of it is price momentum, and with a balanced set of stocks that would and would not split, the models predict 70% of the companies that would split.

What’s better, is that the formulas to predict stock splits pick good stocks in their own right — they end up being value and momentum, and maybe a few other factors.  I remember my thesis adviser being surprised at how good my models were at picking stocks.

This brings me to my conclusion: stock splits are a momentum effect, but it is larger when companies are still have a cheap valuation.  Perhaps splits have no effect on stock performance — it is all momentum and valuation.  To me, that is the most likely conclusion, and my thesis anticipated quantitative money management by 10+ years.

In one sense it is a pity I didn’t do anything with it, but if I hadn’t become an actuary, I would never have gained many other insights into the ways that the market works.  I’m happy with the way things worked out.

At the Towson University Investment Group’s International Market Summit, Part 5

Sunday, April 21st, 2013

I left one small question for last; I gave a partial answer to this one at the conference.  I think I was the only one that said much on it.  Here it is:

Where does academic theory fail in finance and in economics?

Little questions, big answers.  How do you eat an elephant?  One bite at a time.  Let’s start with math in economics:

1) We have to reduce the complex math in economics — I think we are trying to apply math where it is not valid.  As such, the true strength of ability to explain what is going on decreases, while economic becomes an odd “inside game” for a funny group of mathematicians trying to make sense of an idealized world that bears little resemblance to our own world.

2) The next piece is on maximizing utility or profits.  Maximizing takes work, assuming one can even do it.  Work is a negative, so people conserve on that.  Most of us know this: we look for a solution that is “good enough,” and do it.  That means we don’t maximize utility, and the pretty equations don’t represent reality.

What’s worse is that men care more about relative results than absolute results.  We would rather be kings over an impoverished realm rather than middle class in a wealthy country.  We are worse than greedy; we are envious.

It’s even worse for firms.  There you have agency problems where the management often has its own goals that do not maximize profits, or their net present value, but maximize the benefits they receive.  Boards are frequently a cover for management, rather than advocates for the shareholders.

Regardless, since firms don’t maximize, the elegant math does not work. Putting it simply, if you want to understand economics better, don’t listen to economists — become a businessman.  An ordinary businessman knows more about how the world works than a neoclassical economist.

3) One of the beauties of a capitalist economy is its dynamism.  It adapts to changing needs and desires.  The variation is considerable; as an example, go through your supermarket and try to count the total number of different tomato products.  Or  look at the amazing degree of variety in a major tools catalog.  Or go to Costco, Walmart, Home Depot, Ikea, and look at the incredible variety that exists under one roof.

But that level of variety cannot be mathematically accommodated by economics.  They have to aggregate the complexity into categories, and a lot of the reality is lost in the process.  That is why I distrust  many economic aggregates, such as inflation, GDP, etc.  Politicians find “economists” to suit their political ends, and they come up with complex reasoning for why measured inflation is higher than it should be, inequality is rising, etc.  You can find an economic advocate for almost anything.


4) Because of the aggregation problem, the link between microeconomics and macroeconomics is made weak, especially since utility cannot be compared across any two people, and yet the economists mumble, and implicitly do it anyway.

5) At least with microeconomics, we can agree that demand falls as prices rise, and supply rises as prices rise.  But with macroeconomics, there is little agreement as to whether a given policy aids real growth or not.  Modern neoclassical economics is to me a bunch of sorcerer’s apprentices playing around with very large and crude tools that they think can affect the economy, only to find the results are not what they expect.  Somewhere, economists got the naive idea that they could eliminate the boom-bust cycle, only to find that by eliminating minor busts, they set up the conditions for growth in indebtedness, leading to a huge bust.  Far better to be McChesney Martin, or Volcker, who let recessions do their work, than slaves of the government who did not — Burns, Miller, Greenspan or Bernanke.

Take inflation as an example.  Does printing more money, or creating more credit boost asset prices, product & services prices, both, or neither?  The answer to this is not clear.  The Fed has taken many actions over the past 30 years, using a model that assumes tight relationships between short interest rates and inflation/ labor unemployment.  The evidence for these relationships are not evident, except at the extremes.

6) The idea that running deficits to “stimulate” the economy is questionable.  Debts have to be paid back, repudiated or inflated away, any one of which would make business and consumers less confident.  Further, the way the the money is spent makes a great deal of difference.  Much government spending inhibits or does not help economic growth; think of the complexity of the tax code — a recipe for wasted time, and unneeded social enginerring.  Some government spending does aid economic growth, where it lowers the costs of consumption or production — critical infrastructure projects, etc.  But those are rare.  If it were really needed, lower level governments or private industry would do it.

The thing is, most of the deficit spending has not been useful; there’s no economic reason to run such large deficits.  If we were rebuilding all of our aging infrastructure, that would be one thing, but the crazy quilt of tax breaks and subsidies affects behavior, but does not compound and aid growth.

7) We need to admit that culture is not a neutral matter.  Some cultures will have faster economic growth, and others will be slower.  There is no universal culture, no generic economic man.  Some cultures are more enterprising than others.  That has a big impact on growth quite apart from resources, population, education, etc.

8 ) Whether the money is tied to gold or fiat, banking must be tightly regulated.  Solvency of all financial institutions should be tightly regulated.  With financials risks arise when the is too much leverage, and too much leverage that is layered.  Things should be structured such that there is no possibility of dominoes knocking over other dominoes.

  • Limit leverage
  • Increase liquidity of assets vs liabilities
  • Forbid lending to/investing in other financials
  • Derivatives should be regulated as insurance, insurable interest must exist, which means that bona fide hedgers must initiate all transactions.

On Finance

9) The first thing to realize is that a mean-variance model for investments is loopy.  First, we can’t estimate the mean or the variance, much less the covariance terms.  There is also good evidence that variances are infinite, or close to it.  Thus the concept of an efficient frontier is bogus.  Far better to try to estimate crudely the likely forward returns on a cash flow basis, the way a businessman would, and weakly factor in the uncertainty of the forecasts.

10) Thus, beta is not risk, and volatility is not risk.  At least at present, until the low volatility funds get too big, there seems to be an anomaly where low volatility equity investing beats high volatility equity investing.  This is consistent with my theory that the relationship of risk and return is non-linear.  Taking no risk brings no return; taking moderate risk brings decent return; taking high risks brings low returns.  There is a sweet spot of prudent risk-taking that brings the best returns on average.

11) Multiple-player game theory indicates that to win, you assemble a coalition with more than 50% of all of the power, and you get disproportionate benefits.  Think about the poor buyer of a home in 2006, going into the closing with the deck staked against him.  Or think about forced arbitration of disputes on Wall Street, where the investors rarely win.

Complexity is not the friend of most ordinary economic actors.  Avoid it where you can.

12) Capital structure does matter; it is not irrelevant like Modigliani and Miller said.  Companies with low leverage tend to return more than companies with high leverage.  There are real costs to being in distress or near distress.

13) Markets can have non-linear feedback loops, like in October 1987, or the “Flash Crash.”  Markets are not inherently stable, and that is a good thing.  Instability shakes out weak players that are relying on a shaky funding base, leaving behind stronger players who understand risk.  It is not wise to try to eliminate the possibility of disasters occurring.  When you do that, pressures build up, and something worse occurs.  Better to let the market be free, and let stupid speculators get burned, so long as they aren’t regulated financial companies.

Ethics matters

14) Economics would be more valuable if it focused what is right, rather than what is “efficient.”  I know there will be differences of opinion here, but a discipline that focused on explicit and implicit fraud could be far more valuable than men who don’t have good models for:

  • Inflation
  • Asset Allocation
  • GDP
  • Unemployment
  • and more

Imagine applying all of that intelligence to fair dealing in economic relationships, rather than vainly trying to stimulate the economy, and accomplishing nothing good.  It would be like the CFA Institute applied to the economy as a whole.

What I Would & Would Not Teach College Students About Finance

Saturday, February 23rd, 2013

Most of Friday I spent as judge at the Global Investment Research Challenge for Washington, DC and Baltimore.  I really like working with students.  They are so earnest, and they work so hard.

Last year, the company was Under Armour, which was tough because it was a growth company.  Very difficult to value.  This year, the company was Marriott, which I think is even harder to value because of its asset-light strategy.   Further, they have bought back so much stock that not only is the company’s tangible book value negative, but the unadjusted book value is negative too.

But for what it is worth, the students this year had similar views about the target company, and the range of target prices was small versus what I saw with Under Armour.

But when I listen to the students, I sometimes cringe, because I’ve studied statistics to a far higher degree.  Now, when I judge, I don’t take my views into account, because I know I am in the minority, and the students don’t know that they are getting bad methods for analysis.  Let them listen to their professors, who don’t have a clue as to how the economy really works, and express what they have learned.

But if I had control over what Finance students were taught, I would do the following:

1) I would reduce the math content for finance students and increase the qualitative understanding of markets.  No more MPT.

2) I would increase the level of understanding on how to relate with people, because that makes a big difference in negotiating trades.

3) I would want them to work in a simple business, like a hot-dog cart, or mowing lawns, so that they could begin to get an idea of how tough it is to earn a profit.  My best boss in my life grew up watching his parents’ delicatessen, and it shaped his view of how to make a profit.  I didn’t have that as a kid, but I did have two parents who pointed out to me that life wasn’t easy.  The profits of my Dad’s business were by no means certain, and evaporated in the early 80s.  My Mom reinvested much of my Dad’s earnings into her stock portfolio, far exceeding what most investors achieve, but with periods that would make you wonder.  I partly paid for some of my college education by encouraging my Mom to buy a company that she previously sold that several years later went private for a handsome price.

4) I would revise the concept of the cost of capital to make it credit-centric.  All the efforts to calculate the cost of equity capital from equity market correlations are bogus.  They don’t make any economic sense.  In most cases, the cost of equity should not exceed the yield on an average CCC bond.

5)  I would tell them that changes in inflation and real GDP don’t have as large of an impact on corporate profits as is commonly thought, both positively and negatively.  I would tell them to focus on the stock, and drop the complex model.  Few in the investment business work off a complex model, and if you need one, you can buy Value Line, which I like, which tries to use a single macroeconomic model for 1700 popular stocks.  (and I get the model for FREE, because my county library subscribes to the WHOLE ENCHILADA, and I can ride on their back.  Morningstar too.)  I’m generous with my insights, but I rarely pay for services, because I know that they can be obtained cheaply, most of the time.


I would teach students to think on a higher level.  Not this causes that, but this influences that, and a lot of other effects occur as a result.  This is similar to Howard Marks’ concept of “second level thinking.”

By the way, I would do the same thing for the SOA and CFA syllabuses.  Modern Portfolio Theory is garbage, and needs to be abandoned.  We understood the markets better prior to MPT,

I would teach students that markets are not neutral, and that there are people out there trying to deceive you.  I’ve had more than my share of charlatans that I have had to oppose.

In place of randomness, and statistics that imply randomness, I would teach about margin of safety, and tell them, “Do your hard work.  Analyze likely profitability.  Analyze free cash flow.  Analyze the likelihood that you are correct; make sure the price at which you are buying includes a significant margin of safety.”

I would tell them to analyze free cash flow.  Today, with the company Marriott, that was the only thing that mattered.  One team hit the nail on the head. The rest did not.  The team that hit the nail on the head is going to Toronto to compete in the North American competition.  Should they win, they go to the final round, I know not where.


Anyway, that is a start.  As with Buffett, who always thinks of what is the best way to earn and compound earnings, it is far better to analyze successful businesses than to analyze what academics think about business.  After all, what, academic has created a successful business?  Few, if any.

On the Virtue of Hard Questions for Young Analysts

Friday, October 26th, 2012

Yesterday I represented the Baltimore CFA Society at the kickoff meeting for the 2013 CFA Institute Research Challenge.  As is the norm, the Washington, DC CFA Society (which is 2.5x larger than us) and Baltimore choose a local company for the students to analyze.  Last year, it was Under Armour [UA].  This year, it is Marriott [MAR].

One quick aside.  Last year, the more bearish you were on Under Armour, the better a team scored.  But guess what?  Under Armour rose 15% in the last 7+ months — the team that finished last had the result that was the best, and the winner did the worst.  I know many of my readers don’t like Jim Cramer, but one thing that he said shines through here: “The bear case always sounds more intelligent.”  The same is true in academic competitions.  That’s one reason it is good to have a mix of temperaments in an investment firm.  Personally, I believe that bulls and bears do better together than separately — they need to round each other out.

Personally, I would prefer to analyze a growth stock like Under Armour, to the “asset light” hotelier Marriott.  That said, Marriott’s  Investor Relations team was out in force for the six (maybe seven) colleges who showed up, and gave what I thought were credible answers to the students who asked them questions.  Near the end of the presentation, the senior Investor Relations person walked them through each line of the income statement — I thought that was a nice touch, but wondered what Marriott used as an internal measure of profitability.

(Note to any students reading me: take a look at what Moody’s, S&P, and Fitch use as their metrics on Marriott.  The rating agencies are not dumb, and they get more data than stock analysts do. They are inside the wall.  They get material nonpublic information, and disclose the portion of it that is relevant to bond investors.  At the presentation, the Marriott IR folks stressed repeatedly that they want to maintain an investment grade credit rating.  That is a large constraint on what Marriott does, and should be considered in any good analysis.)

This will be an interesting competition, and five months from now, it will be fun to be a judge in the local version of the Investment Challenge.


Two weeks ago, I was a judge in a competition among finance students for four colleges that met a McDaniel College.  I was the only judge that did not graduate from McDaniel, which was formerly Western Maryland College, named after the Western Maryland Railroad which funded the school in its early years.

The question at hand was whether the Texas Rangers should have acquired A-Rod in 2000.  This is a tough question, because it is a binary decision, and it faces the winner’s curse.  So, you hired A-Rod.  How badly did you overpay to get him?

I don’t think I am overstating the problem.  Anytime there are multiple bidders for a unique asset, the winning buyer tends to overpay.

The case study (from Harvard) had its own issues.  It overestimated how fast average player salaries would grow, and the econometrics behind the estimation of wins as a function of player salaries was decidedly poor.  More than the Harvard Business School case study would admit, it was a lousy decision to hire A-Rod.  Add in the social effect on other players when A-Rod is paid a huge amount relative to them, and even if he is a nice guy, you wonder if you are truly valuable to the franchise.

But when you are a judge in such a competition, your mind works this way: the first team sets the tone, and has an advantage until a team eclipses them.  Then that team sets the tone.

The judges were pretty neutral on whether A-Rod should be hired or not.  The vote depended more on the process they undertook.  How much research did they do?  How do they back up their assertions?  Did they believe the data in the case study blindly?


Face it, the business world is unclear/dirty, and those that analyze it have to take account of what they don’t know, and make the best decision that they can.  This is the virtue of hard questions for young security analysts, and why we hold such competitions.

Toss them a hard problem.  Make them think outside the box.  Life is tough, and investment decisions are often unclear.  This is life.

Investment competitions are a far better way to train students than the raw academics.  Modern Portfolio Theory is garbage.  Most academic approaches to investing don’t work.  But try to understand a business like Marriott.  They make money off of selling their name.  They make money managing hotels.  How can they be sure to make money as they do so?  Those are the tough questions to analyze.

It’s a good thing to make young analysts face a hard question.  Whether they win or lose, they had to work hard, plan, compromise with team members, and come to a decision that would face criticism.  When we invest money, we don’t get criticism vocally, but we do see the gains and losses.  Thus the investment competitions are a very good way to prepare students for the eventual gains and losses they will face when they are making business decisions on their own.




David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.

Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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