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Book Review: Why Stocks Go Up and Down, Fourth Edition

Tuesday, December 3rd, 2013

Book Cover

This is a good book to help the inexperienced learn about investing.  It begins by teaching the rudiments of accounting through the adventures of a man and his company who have built a better mousetrap.

He starts the business on his own, but needs more capital.  In the process of growing, he taps bank loans, private investors, public investors, bonded debt, and preferred stock.  All of this is done with simple explanations in a step-by-step manner.

The book then explains bonds and preferred stocks.  At first I was a little skeptical, because this is supposed to be a book about stocks, and the authors made a small initial error in that section.  That was the last error they made.  I became impressed with their ability to explain corporate bonds and preferred stocks, even some arcane structures like trust preferred securities, and other types of hybrid debt.

Now, if I were trying to shorten the book, a lot of those sections would have been cut.  For those that do want to learn about bonds in the midst of a stock book, you get a free bonus.  If you don’t want to spend the time on bonds, you can skip those sections with little effect on your ability to understand the rest of the book.

Then the book turns to trickier aspects of accounting, explaining cash flow from operations, and free cash flow.  It’s all good stuff, but here is my first problem with the book: what is the most common way of giving a distorted picture of earnings?  Revenue recognition policies.  The book does not talk about revenue recognition, and the most basic idea of Generally Accepted Accounting Principles [GAAP], which is revenue gets taken into earnings proportionate to the delivery of goods and services.  With financial companies, revenues are earned proportionate to release from risk.

That brings up another point.  The book is very good for describing the analysis of an industrial company, but does little to describe how to deal with financial companies.  Financial companies are different, because most of the cash flow statement has no meaning.

Then the book moves on to valuation of common stocks, and that is where I have my biggest problem with the book.  Though they mention other means of valuing stocks, their main valuation method is earnings.  The book does not mention price-to-book as a metric, which is a considerable fault.  Price-to-book is the main way to value financials versus ROE, while price-to-sales is a very good way to measure industrials relative to relative to profit margins.

Further, it suggests that P/E multiples should remain constant as a company grows.  I’m sorry, but P/E multiples tend to shrink as a company grows.  This is because the highest margin opportunities are exploited first, and then lesser opportunities.  For the P/E to remain constant, or even expand means that new opportunities are being exploited that have higher margins.  Investors should not count on that.

These mistakes are minor, though, compared to the good that the book does for an inexperienced investor.


Already expressed.

Who would benefit from this book: This is a classic book that will aid inexperienced investors to learn the basics.  Just remember, it is only the basics, and it covers most things, but not all things. It would be an excellent book for one of your relatives or friends that think they know what they are talking about in investing, but really doesn’t know.  If you want to, you can buy it here: Why Stocks Go Up and Down.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

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

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

Two More Good Questions

Friday, November 29th, 2013

I had two more good questions in response to my piece Why I Resist Trends.  Here we go:

I think you have some idea which ones are the best by the discount to intrinsic value. If you were running a business (which you are when you are investing) and you had 10 projects with lets say a minimum return of 5% but a spread of 20% to 5% wouldn’t you first invest in the 20% return project and fund each project in descending order of return. By equally weighing aren’t you equally investing in the 5% and 20% projects? If you were a CEO shouldn’t the shareholders fire you? I know the markets have more volatility than projects due to the behavioral aspects of investing but in my view equally weighting is more important when you do not know much about your investment and less important when you do. I think you know a lot about the companies you invest in. Why not try an experiment. Either in real time or historically take a look at what would have happened overtime if you would have weighed you selections by discount from intrinsic value. I think you will be pleasantly surprised. I and John Maynard Keynes have been pleasantly surprised.

I do this in a limited way.  In the corporate bond market we have the technical term “cheap.”  We also have the more unusual technical term “stupid cheap” for bonds that are very undervalued.

When I have a stock that is “stupid cheap” I make it a double weight, if it passes margin of safety and other criteria.  On one rare occasion I had a triple weight.

But I meant what I said  in Portfolio Rule Seven — “Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best.”  I have been surprised on multiple occasions as to what would do best.  Investing is not as simple as assessing likely return.  We have to assess downside risks, and possibilities that some things might go better than the baseline scenario.

I don’t use a dividend discount model, or anything like it.  I don’t think you can get that precise with the likely return on a stock.  My investing is based on the idea of getting very good ideas, as opposed to getting the best ideas.  I don’t think one can get the best ideas on any reliable basis.  But can you find assets with a better than average chance of success?  My experience has been that I can do that.

So, I am happy running a largely (but not entirely) equal-weight portfolio.  It is an admission of humility, which tends to get rewarded in investing.  Bold approaches fail more frequently than they succeed.

By the way, though Keynes was eventually successful, he cratered a couple times.  I have never cratered on a portfolio level, because of my focus on margin of safety.

On to the next question:

What are the tests you use to check if accounting is fair?

Start with my portfolio rule 5, here’s a quick summary:

Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

  1. 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.

  2. 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.

  3. 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.

  4. 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.

Then add in my portfolio rule 6, here’s a quick summary:

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.

Portfolio rule 6 does not deal with accounting per se, but management behavior with free cash flow.  Rules 5 and 6 reveal large aspects of the management character — how conservative are they?  How honest are they?  Do they use corporate resources wisely?

On Ethics in Business and Investing

I would add in one more thing on ethics of the management team — be wary of a company that frequently plays things up to the line ethically and legally, or is always engaged in a wide number of lawsuits relative to its size.

I know, we live in a litigious society — even good companies will get sued.  But they won’t get sued so much.  I realize also that some laws and regulations are difficult to observe, and interpretations may vary.  But companies that are always in trouble with their regulator usually have a flaw in management.

A management team that plats it “fast and loose” with suppliers, labor, regulators, etc., will eventually do the same to shareholders.  Doing what is right is good for its own reasons, but for investors, it is also a protection.  A management that cheats is in a certain sense less profitable than they seems to be, and eventually that reality will manifest.

All for now, and to all my readers, I hope you had a great Thanksgiving.

With Jeremy Siegel at CFA Institute Baltimore

Saturday, October 5th, 2013

At the CFA Institute at Baltimore, we had the pleasure of having Jeremy Siegel come speak to us this past Thursday.  He was lively, engaging, and utterly convinced of his theses.  Thanks to Wisdom Tree for helping fund the endeavor.

He openly asked us to poke holes in his theories.  This article is an effort to do that.

1) Stock tends to get bought in when it is undervalued, and sold via IPOs when it is overvalued.  Thus the time-weighted rate of return exceeds the dollar-weighted rates of return by a few percent.  This dents the main premise of “Stocks for the Long Run.”  Buying and holding is not possible, because valuable stocks are lost at the troughs, giving us cash, and we are forced to buy more near peaks, of overvalued stocks.

Dollar-weighted returns are what we eat, and they don’t vary much versus time-weighted returns when considering bonds or cash.

Also, in the present day, private equity plays a larger role, and they exacerbate the degree to which stocks get IPOed dear, and acquired cheap.

2) He spent a lot of time defending the concept of the CAPE Ratio, but not its execution.  He began a long argument about how accounting rules for financials were behind the drop in earnings for the S&P 500, and that AIG, Bank of America, and Citi were to blame for all of it.

Sadly, he seems not to know financial accounting so well.  What was liberal in the early and mid-2000s was corrected 2007-2009.  In aggregate the accounting was fair across the decade.  Remember that accounting exists to try to measure change in value of net worth across short periods, and net worth at points in time.

Really, if we were trying to be exact, when a writedown occurs, we would spread it over prior periods, because prior accounting was too liberal – the incidence of the loss occurred over many years prior to the writedown.

Thus I find his argument regarding specialness of financial company accounting to be bogus – he is just searching for a way to justify valuations off of current earnings, rather than off of longer term measures.

3) The longer–term measures agree with CAPE:

  • Q-Ratio
  • Market Cap/ GDP
  • Price-to-Resources
  • Financial Stress indexes
  • Eddy-Elfenbein’s Stock Market if valued like a bond measure

All of these point to an overvalued market.  But markets can be overvalued for a while.  Why might that be in this case?

4) Because profit margins may remain high for some time.  In an era where the prices for labor and resources are cheap, should it be surprising that profit margins are high?  Those conditions will eventually change, but not soon.

With that, I would simply say that:

  • Stocks do outperform bonds and cash over the long run, but not by as much as Dr. Siegel thinks.
  • Stocks are overvalued by long-term balance sheet-oriented measures at present.
  • But stocks may stay high because profit margins are likely to stay high – there will be regression to the mean, but not now.

Finally I would note that he was one of the most graceful and generous speakers to come speak to us in some time, took a long Q&A, staying longer than he needed to, and happily signing the books he had written.  I showed him my First Edition version of his book, signed by him after speaking to the Philadelphia AAII chapter in 1995, and said, “We were much younger then.”  He smiled and said, “Yes, we were.”

I may disagree with him on some points, but he is one very bright and personable guy.

On Principles-Based Accounting for Financials

Wednesday, September 18th, 2013

I may lose some friends in the industry for writing this.  Accounting bases vary for three reasons at minimum:

  • Accurate portrayal of the change in value of the firm (GAAP, IFRS)
  • Assuring solvency of financial institutions (Statutory)
  • Making sure taxes get paid (Tax)

Here’s the problem: when assets or liabilities get complex, accounting rules have a hard time setting values for them.  This is especially difficult for anything that does not trade regularly, if at all, and anything that has unique personal characteristics.  The value of a life insurance contract varies from person to person, even if major underwriting variables are the same.

But this applies to other areas.  Living benefits for variable insurance contracts do not have a good theory behind them, because the performance of asset markets is unpredictable.

Another example: letting banks set reserves for credit losses off of internal models.  Remember the rating agencies calculating subordination levels for ABS, RMBS & CMBS?  These securities had never been through a failure cycle, so they used default rates from non-securitized lending.  But those that lend and retain the risk are more conservative than those that lend and sell the risk.

The internal models have the potential to be more accurate than accounting rules, but they have greater potential to be more liberal, as management teams lean on accountants, quants, and actuaries for a desired accounting result.

I think it is better the the accounting standards setters to spend some money, hire people with expertise, and craft better rules.  Here’s another example: I think that the pension accounting standard should not allow investment earnings and discount rate assumptions higher than 2% over the ten-year Treasury.

I am in favor of rules-based accounting for solvency purposes.  Let the regulators be conservative.  Principles based accounting might be fine for GAAP/IFRS, but it destroys comparability across companies, and makes equity analysis a lot harder.  Better to have rules-based accounting there too.

If we had God doing accounting, yes, principles-based would be better, because he knows the future perfectly.  But we don’t know the future, so we have to build in conservatism via rules.

I have two more ideas for accounting simplification.  First, tax financial companies on their GAAP income.  That aligns taxation with their priorities.  If they offer a modified GAAP income that reflects how value is delivered, tax them on that.  Income should be taxed on the true increase in value.

Second, eliminate the statutory accounting basis by using GAAP/IFRS, and boost the level of statutory capital that financial firms need to hold.  Adjust the capital levels off of the business mix, penalizing secondary guarantees.

These two proposals would radically reduce the accounting efforts that financial firms go through, while increasing taxes, and enhancing solvency.

One final note: require that those who prepare the squishy parts of financial statements have an ethics code, like CFAs and Actuaries.  That’s not perfect, but training in ethics generally makes people more conservative in accounting.

The Rules, Part XXXVIII

Thursday, May 23rd, 2013

There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

  • Chasing performance
  • Over-diversification
  • Benchmarking / Hugging the index
  • Over-trading
  • Relying too heavily on earnings growth
  • Analyzing the income statement only
  • Refusing to analyze industries
  • Buy newsy companies
  • Relying on the sell-side
  • Trusting management too much


Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.  I am against regret.  Don’t buy something after you have missed most of the move, as if future stock price movement is magically up.  Unless you can identify why the stock is underappreciated after a strong move up, don’t touch it.


Most managers hold too many stocks.  There is no way that a team of individuals can follow so many stocks.  Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.  Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.  You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.  Aim for a large active share, differing from the benchmark index.  Make some real nonconsensus investments.     Show real moxie; don’t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?  More volatility in search of better overall returns is what investors need.  If they can’t bear short-term volatility, they should not be invested in stocks.


We don’t make money when we trade.  We make money while we wait.  Ideas take time to work out, and there are frequently disappointments that will recover.  If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.  For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.  Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.  For value companies, far less so.  Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.  In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.  Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.  One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.  Macroeconomics rarely translates into useful portfolio decisions in the short run.  Even when you are right, it may take years for it to play out, as in the global financial crisis – the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely “bottoms up,” and not gaining the broader context of the industry.  As a young investor that was a fault of mine.  As a result, I fell into a wide variety of “value traps” where I didn’t see that the company was “cheap for a reason.”

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.  I think most of those companies are overanalyzed, and as such, don’t offer a lot of investment potential unless one thinks the news coverage is wrong.  I actually like owning companies that don’t attract a lot of attention.  Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.  What are the key drivers to watch?  What management teams seem to be building value the best?  This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.  Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren’t.  Who is honest, and who bluffs?  This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever – you might lose some advantage doing that, but you won’t be tricked by a slick-talking management team.  Trusting management implicitly is the big problem to avoid.  They are paid to speak favorably regarding their own firm.


This isn’t an exhaustive list.  I’m sure my readers can think of more foibles.  I can think of more, but I have to end somewhere.  My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

The Rules, Part XXXVII

Tuesday, May 21st, 2013

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”  So the saying goes for those that blindly follow momentum.  The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.  (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

  1. In 1998-2000, tech and internet stocks were the only place to be.  Even my cousins invested in them and lost their shirts.  People looked at me as an idiot as I criticized the mania.  Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
  2. In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.  This was not, “Buy what you know,” but “Buy what you assume.”
  3. In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.  A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.  Both trades went badly.  Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to  blow up, and the least levered to suffer considerable losses.
  4. 2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.  There were earlier shocks around 2002, and the late ’90s.  Those buying them in 2008 and crying foul neglected the lessons of history.  The underlying collateral possessed no significant diversification.  Put a bunch of junk debt in a trust, and guess what?  When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.  Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

  • The go-go years of the ’60s or the ’20s
  • The various times the REIT market has crashed
  • The various times that technology stocks have wiped out
  • And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.  But recently, there has been some discussion of a possible “safety bubble.”  The typical idea is that investors are paying up too much for:

  • Dividend-paying stocks
  • Low-volatility stocks
  • Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.  It is possible to have one?  Yes.  Is it likely?  No.  Are we in one now?  Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.  But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.  At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.  Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.  They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?  Tenuously, but yes.  Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.  In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market  history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.  When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.  Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.  You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.  You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.  I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.  But with stocks, I would simply say look forward.  Analyze:

  • Margin of safety
  • Valuation, absolute & relative
  • Return on equity
  • Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.  If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”  Just don’t  compromise margin of safety in the process.

Value Investing Flavors

Thursday, April 4th, 2013

I ran across this article, Value Investor or Value Pretender: Which Are You?, by who puts out The Manual of Ideas, along with Oliver Mihaljevic.  I appreciate what they do — you can learn a lot from their organization.

I told him that I was going to write this, and he said to me:

The piece was meant tongue-in-cheek but feel free to rip it apart :)

I will rip it apart, but gently, because every point he made is mostly true for value investors, but there are variations in the way that value investors operate, so you can do some of the things he says you can’t do, and still be a value investor — what matters is how you implement them.

There will be more parts to my “Education of a Risk Manager” series, and one of them will deal with all of the different managers that I met, and how much they varied in terms of what they thought were factors that mattered.

Thus, as I developed my own theories of value investing, I considered the range of opinion, and realized that there is a single model for value investing, but that it is complex enough that different parties use different approximations of the full model, and those approximations do better and worse in different environments.

Like a David Letterman-style Top 10 list, John Mihaljevic listed and described things that made you a value pretender.  Time to go through them:

Reason #10: You invest based on chart patterns

I don’t use chart patterns, but I do use momentum both positively & negatively.  There is decent evidence that investors are slow to react to new information, and so stocks with strong price momentum over 200 days tend to do better.  There is some evidence where there is lousy price momentum over a 4-year period, that things tend to mean-revert.

Granted, there is a tendency among some value investors to troll the 52-week low list.  I like doing that too, but you have to be careful, because maybe you are missing something that cleverer investors know.  The same would be true of short interest figures.  Whenever I see one of my stocks gain a high short interest ratio (shares sold short / volume, or % of mkt cap sold short), I do a review to see what I don’t know.  That’s why I am not afraid of the high level of shorting on Stancorp Financial.  This is a conservatively run firm that manages risk up front.  Even though disability claims rise when unemployment is high, they underwrite better than most of the industry.

There have been some very successful value plus momentum investors.  The balance is tricky, but blending two of the most powerful anomalies does bear fruit.

Reason #9: You assume multiple expansion in your investment theses

I never assume that, but if you are buying them “safe and cheap,” you often do get multiple expansion.  The challenge is figuring out where things are less bad then the implied opinion of the depressed valuation.

Reason #8: You try to figure out how a company will do vis-à-vis quarterly EPS estimates

I don’t do that either, but I have known some value managers that incorporate prior earnings surprise data, because past earnings surprises are correlated with future surprises.  Often, near the the turnaround point for a company’s stock, there are some earnings surprises.

Reason #7: You base your decisions on analyst recommendations

I have few arguments with this, except negatively.  Sell-side analysts are trailing indicators.  I like buying companies where the sell-side is negative, but not very negative.  With very negative opinion, there are often reasons to stay away, unless you possess specific knowledge that the sell-side analysts do not have.

Reason #6: You use P/E to Growth (PEG) as a key valuation metric

I’m sorry, but PEG works, if indeed you have the growth rate right, which is a challenge.  I do try to analyze sustainable competitive advantage for the firms that I own.  That often leads to growth.  Now I am a growth skeptic, so it takes a lot to make me pay up for growth, but occasionally I will do so, when the PEG is low enough.

Reason #5: You use EBITDA as a measure of cash flow

EBITDA is not cash flow from operations, or free cash flow, but it is a valuable figure in value investing when it divides into Enterprise Value (Value of Debt + Value of Stock – Cash).  Low ratios of Enterprise value divided by EBITDA are very effective at identifying promising investments — it indicates cheap assets, and in a time when M&A is hot, it can really pay off.

Reason #4: You would worry about your portfolio if the market closed for a year

I could live with the market closed, but there are advantages to having it open.  With any given stock, there are times in a year to increase or reduce exposure — if you have a firm idea of what the firm is worth, you can buy more during dips, and sell a little into strong rallies.  Short term (one month) stock price movements are fickle, and commonly reverse.

Reason #3: You make investment decisions based on the activity or tips of others

But Manual of Ideas tracks the 13F filings of great investors.  I get good ideas from the best investors also, but you have to do your own research.  Many bright investors chat with each other, and I had many occasions at the hedge fund that I worked for where I disagreed with a friend of the boss.  I was right more often than I was wrong.

Perhaps a better way to phrase it is “choose your idea generators wisely, but do your own research as well.”

Reason #2: Your investment process centers on the market opportunity

This is largely true, but when I know a industry or sector is in horrible shape, I often buy the strongest name in the industry, realizing that they will do well as the competition dies, and they don’t.  Also, there are times when few recognize that pricing power has shifted, and it is time to take a position on a misunderstood industry that is about to grow faster than expected.  Particularly with cyclical companies this idea can be promising.

The same applies to countries where the markets are washed out.  Don’t try to time the bottom, but when a country is cheap, buy a promising/safe company in the country after things have turned up for 100 days or so.

Reason #1: Your investment theses do not reference the stock price

At some points, I like to own companies with strong management teams relative to their industry.  I will let valuation stretch at those points, because there is more of a sustainable competitive advantage there.  You get more positive surprises, and that definitely aids total returns.

That said, a focus valuation is key to all investing.  The only thing more important is margin of safety.

Margin of Safety

There are three elements to margin of safety:

  1. Sustainable Competitive Advantage (Strong Gross Margins)
  2. Strong Balance Sheet (Conservative Accounting)
  3. Cheap Price vs Likely Value

This is different from other formulations of margin of safety, because one has to take into account factors that make it less certain that we can calculate value.  Many value managers were buying cheap financials up until September 2008, only to realize that their estimates  of value were wrong because credit losses would be far worse than expected.

Good stock analysis begins with good bond analysis.  If you wouldn’t buy a bond from the firm, you probably shouldn’t buy the stock.  Value investing is conservative, and looks for situations where there is little credit risk.


If you want to read  summary of my portfolio rules, you can find them here.  I am a firm believer in value investing, but I realize that there are many ways to approach the process.  I watch other value investors, and continue to learn.  Good value investors are lifelong learners, and generalists with broad knowledge.  It is not a narrow discipline, but one that can accommodate new knowledge.

Full disclosure: long SFG


The Education of an Investment Risk Manager, Part II

Saturday, March 30th, 2013

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.  Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.   I chose the spot with AIG, because they led me to believe I would work on the international side.  When I arrived, lo, I had a job on the domestic side.  As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.  They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.  As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.  AIG parent wanted growth in GAAP earnings.  They wanted to see a 15% ROE, which few in the life industry were attaining.  In order to do that, they entered into reinsurance treaties (before I arrived).  These would lever up the balance sheets of the subsidiary companies, without incurring debt.  Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”  I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”  He said, “What do you mean?”  I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.  I just shrugged.  I was not the creator of the treaty, and would not have done it if I had been at AIG two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).  In one sense, the treaties were structured like the trading requirements in CDOs.  If you must trade:

  • Get more income
  • Don’t give up rating
  • Don’t extend maturity
  • And a few more smaller things.

I was not there when the treaties were created.  Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.  As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.  After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.  I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.  Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.  What was worse, the liabilities underlying the treaty were structured settlements.  (Structured settlements result from a court case where someone is injured.  The defendant offers to buy from a reputable life insurer an annuity that will make the requisite payments.  Low bid wins, and if the plaintiff is badly injured, the cost goes down for payments that terminate at death.  That’s where most of the bad estimates com in.)  In those days, structured settlements were a “winner’s curse.”  If you won, it was because you mis-bid.  AIG Domestic Life Companies regularly overbid for their business (as did most of the industry).  LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.  LR decided to sue.  After I had gone on to Provident Mutual, AIG settled with LR.  Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.  That should have been enough to jolt AIG’s earnings for a quarter, but it did not.  Funny that, and it always left me a little suspicious of AIG.  (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.  I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.  It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

A Bond Deal Requiring Caution

Thursday, March 21st, 2013

Recently, a company for which I once managed bond money announced a bond offering.  An odd bond offering that I would not buy regardless of pricing.You might say, “No such thing as bad assets, only bad prices.”  Mostly I believe that, but not here.  There are some assets you should not want to take the chance on.  This is one of them.

Here is the biggest weakness: you are lending to an intermediate holding company.  When I was a bond manager, I would lend to the uppermost holding company, knowing that the stockholders did not want to hand their profitable company over to me.  I would also lend to subsidiaries that I knew a parent company would not want to lose.  But I would not lend to intermediate holding companies — owned by the parent, and owning a subsidiary not directly responsible for the debt.

I inherited such a debt in the portfolio, and it took me months to sell it at a halfway decent level.

Here is the second weakness: they will take two-thirds of the proceeds, and give it to the life insurance subsidiary in exchange for a surplus note, with similar terms compared to the note sold.  Surplus notes are weak, because state insurance departments can forbid payment of interest and principal.  The ability to repay the bond is weak.  The subsidiary borrowing does not have any significant cash flow to repay, aside from dividends from its insurance subsidiary.

Third, I do not appreciate the affiliated reinsurance.  That is just a scam, with no economic difference to the enterprise as a whole.

Fourth, I do not appreciate reinsurance recoverables larger than common equity.  There is some credit risk there… how much do you rely on your reinsurers to pay claims in full?  The operating insurance subsidiaries look like they are adequately capitalized, but with that level of reinsurance, you really can’t tell for sure.

Also, some of the reinsurance agreements are specifically targeted to eliminate pesky reserves that make Statutory (regulatory) accounting more conservative than GAAP.  That’s not all that unusual with financial reinsurance, but it does lessen future statutory cash flow, which is what is needed to service the debt.

Fifth, 25% of the offering will be paid as a dividend to the parent company, which further weakens ability to repay.

Sixth, there are related party transactions within the Harbinger Group.  Harbinger Group has been through tough times and liquidity is tight.  You only do moves like this when things are desperate. Reminds me of Southmark.  The operating insurance subsidiaries have made loans to EXCO Resources, a Harbinger subsidiary, buys asset-backed securities that other Harbinger subsidaries originate, and has a large reinsurance agreement with a Harbinger subsidiary in the Cayman Islands.  I respect most reinsurers in Bermuda.  Other foreign domiciles like Ireland, Cayman Islands, etc., are more questionable.  Regulation is more lax.

Seventh, Here are some of the points from the risk factors:

Our Reinsurers, Including Wilton Re, Could Fail To Meet Assumed Obligations, Increase Rates, Or Be Subject To Adverse Developments That Could Materially Adversely Affect Our Business, Financial Condition And Results Of Operations.

Our insurance subsidiaries cede material amounts of insurance and transfer related assets and certain liabilities to other insurance companies through reinsurance. For example, a material amount of liabilities were transferred to Wilton Re pursuant to the Wilton Transaction in 2011. See “Business—The Fidelity & Guaranty Acquisition—Wilton Transaction” below. However, notwithstanding the transfer of related assets and certain liabilities, we remain liable with respect to ceded insurance should any reinsurer fail to meet the obligations assumed. Accordingly, we bear credit risk with respect to our reinsurers, including our reinsurance arrangements with Wilton Re. The failure, insolvency, inability or unwillingness of Wilton Re or other reinsurers to pay under the terms of reinsurance agreements with us could materially adversely affect our business, financial condition and results of operations.

As noted above, reinsurance is a source of credit risk, and is a type of leverage.  Companies that use a lot of it are less strong than they seem.

Our Insurance Subsidiaries’ Ability To Grow Depends In Large Part Upon The Continued Availability Of Capital.

Our insurance subsidiaries’ long-term strategic capital requirements will depend on many factors, including their accumulated statutory earnings and the relationship between their statutory capital and surplus and various elements of required capital. To support their long-term capital requirements, we and our insurance subsidiaries may need to increase or maintain their statutory capital and surplus through financings, which could include debt, equity, financing arrangements or other surplus relief transactions. Adverse market conditions have affected and continue to affect the availability and cost of capital from external sources. We and HGI are not obligated, and may choose or be unable, to provide financing or make any capital contribution to our insurance subsidiaries. Consequently, financings, if available at all, may be available only on terms that are not favorable to us or our insurance subsidiaries. If our insurance subsidiaries cannot maintain adequate capital, they may be required to limit growth in sales of new policies, and such action could materially adversely affect our business, operations and financial condition.

There is kind of a pathology to insurance companies that rely on reinsurance for capital.  It fronts expected statutory profits from the future, reducing future statutory income, but increases capital.  It’s kind of an addiction.

We Operate In A Highly Competitive Industry, Which Could Limit Our Ability To Gain Or Maintain Our Position In The Industry And Could Materially Adversely Affect Our Business, Financial Condition And Results Of Operations.

We operate in a highly competitive industry. We encounter significant competition in all of our product lines from other insurance companies, many of which have greater financial resources and higher financial strength ratings than us and which may have a greater market share, offer a broader range of products, services or features, assume a greater level of risk, have lower operating or financing costs, or have different profitability expectations than us. Competition could result in, among other things, lower sales or higher lapses of existing products.

They are up against much stronger competition with better balance sheets.  In a crisis, they would have less flexibility, and have a harder time raising capital than most competitors.

The Issuer Is A Holding Company And Its Only Material Assets Are Its Equity Interests In FGLIC. As A Consequence, Its Ability To Satisfy Its Obligations Under The Senior Notes Will Depend On The Ability Of FGLIC To Pay Dividends To The Issuer, Which Is Restricted By Law.

The issuer is a holding company with limited business operations of its own. Its primary subsidiaries are insurance subsidiaries that own substantially all of its assets and conduct substantially all of its operations. Accordingly, the repayment of interest and principal on the senior notes by the issuer is dependent, to a significant extent, on the generation of cash flow by its subsidiaries and their ability to make such cash available to the issuer, by dividend or otherwise. The issuer’s subsidiaries may not be able to, or may not be permitted to, make distributions to enable it to make payments in respect of the senior notes. Each subsidiary is a distinct legal entity and legal and contractual restrictions may limit the issuer’s ability to obtain cash from its subsidiaries. While the indenture governing the senior notes will limit the ability of the issuer’s subsidiaries to incur consensual restrictions on their ability to pay dividends or make other intercompany payments to the issuer, these limitations are subject to certain qualifications and exceptions. If sources of funds or cash from the issuer’s subsidiaries are not adequate, we may be unable to satisfy our obligations with respect to the senior notes without financial support from the issuer’s parent, which is under no obligation to provide such support.


The issuer intends to use $195.0 million of the proceeds from the senior notes to purchase a surplus note from FGLIC. The interest rate and tenor of the surplus note will be substantially similar to those of the senior notes.

As pointed out above, owners of this bond would be lending to an empty shell from which it will be difficult to extract value if there is financial stress.

We And Our Subsidiaries May Be Able To Incur Substantially More Debt And Other Obligations.

We May Not Be Able To Generate Sufficient Cash To Service All Of Our Obligations, Including The Senior Notes, And May Be Forced To Take Other Actions To Satisfy Our Obligations, Which May Not Be Successful.

The Senior Notes Will Not Be Secured And Will Be Effectively Subordinated To Future Secured Debt To The Extent Of The Value Of The Assets Securing Such Debt.

The Issuer May Not Be Able To Repurchase The Senior Notes Upon A Change Of Control, And Holders Of The Senior Notes May Not Be Able To Determine When A Change Of Control Giving Rise To Their Right To Have The Senior Notes Repurchased Has Occurred Following A Sale Of “Substantially All” Of Our Assets.

Our Principal Shareholder’s Interests May Conflict With Yours.

Lest this post go from “too long” to “way too long,” I am summarizing off of the headings of five more risk factors.  The first three show the weakness of the position of the holders of the notes, in that you can be diluted or subordinated.   The fourth shows how the notes themselves would complicate a sale of insurance subsidiary assets.

The fifth tells you that Phil Falcone has different interests than you.  If things go well, he may do very well, while you get repaid early because of call provisions, and must reinvest.  If things go badly, recoveries on a bond like this could be very low.  When surplus notes stop paying interest and principal, they trade near zero if it looks permanent.  Remember, the Maryland Insurance Administration has every reason to be conservative about making surplus note payments if the operating insurance subsidiary is under financial stress.

Eighth, if it’s not obvious get, I eschew complexity in debt agreements.  I’m not crazy about:

  • Reserving on indexed and variable products
  • Complexity of financial operations
  • Liabilities that can run easily — I don’t have the data for that, so I don’t know how big that is, I would have to look at the Statutory books to know for sure.
  • Deferred tax assets as a part of Statutory Capital — again, I would have to look at the Statutory books to know for sure.

Ninth and Last, the covenants protecting the notes are weak, and exceptionally verbose.  I have a rule that the longer and more detailed covenants are, the less protection they usually give note owners.  It’s kind of like Proverbs 10:19, “In the multitude of words sin is not lacking, But he who restrains his lips is wise.”

For a corporate bond prospectus, this one is really long, ~320 pages, longer than some securitizations that I used to buy as a mortgage bond manager.  I assume that most of the investor interest here would be institutional, but if you give your broker some discretion over an account in which he purchases individual bonds, you might ask him to avoid this deal.  It will be a tempting bond to buy, because it will come with a fat yield in this yield-starved environment, if the deal gets completed.

As one friend of mine once said to me, “This bond deal is horrid, but it has one sweet YTNJ.”

Me: “YTNJ? Haven’t heard that one.”

Friend: “Yield to next job.”

Be like Will Rogers, the return of the money is more important than the return on the money.  Be wise, stay safe.

PS — The opinions of Moody’s & Fitch

Questions from Readers

Friday, February 15th, 2013

From a reader:

I have enjoyed reading your blog for the past few years. I started researching some insurance companies and went to some of your posts to help me get a better understanding of their financials. In one of your posts you talk about RGA trading below TBV and TBV ex AOCI. Why do you exclude AOCI from TBV?  Do insurance companies trade on ex AOCI multiples or regular BV and TBV multiples?

  • BV -> Book Value
  • TBV -> Tangible Book Value
  • RGA -> One great life reinsurer, Reinusurance Group of America.
  • AOCI -> Accumulated Other Comprehensive Income

We typically exclude AOCI from book value, because AOCI stems from one time events, or things that may revert.  That said, insurance stocks they tend to react to book value prior to any adjustments.  Maybe the answer is this: unless we think the AOCI should revert, the AOCI should be credited to the value of the firm, though ignored by its operating income.

In this low interest rate environment, many bonds trade above the prices at which they were purchased.  Unrealized Capital Gains are usually one of the biggest items in AOCI.  Sadly, only the asset values rise when rates fall, because liabilities aren’t publicly traded, and as such have no price to mark to market.  With life companies, because of the longer tail of obligations, and the capitalizing of deferred acquisition costs (DAC, which is a discounted measure) the unrealized capital gains are applied to reduce the DAC.  DAC, though intangible, is a hard intangible, because there are are cash flows behind it, and if those cash flows are insufficient to repay the DAC asset, the asset gets written down.

Most insurance analysts as a result exclude AOCI from book value for valuation purposes; they think it will disappear when rates rise.  Now that said, I have read research that indicates that insurance stocks track unadjusted book value more than BV less AOCI.  If true, I think that works better for short-tail insurers, because discounting of liabilities does not have so much impact.

I look at it all and kind of shrug.  After that, I do some digging to analyze whether some components of AOCI might be more permanent than otherwise considered.

Insurance stocks mostly trade in line with their book value.  I have been around long enough to see the average multiple move in the range of 0.5x to 2.0x.  Be aware of where we are in the range, and whether pricing power is rising of falling.

From another reader:

I stumbled upon your blog post regarding generating ideas. I too use google alerts to fill the inbox. Unfortunately, I have been unhappy with the results so far. I have attached my alerts (with some culling of personal ones), which can be generated from the bottom of the manage alerts page. 

 I was hoping that you would do likewise and send me your fruitful query strings. 

It would be greatly appreciated.

My Googlebots use the following phrases:


  • CEO resigned
  • CEO “Steps down”
  • CEO fired

Now, creating good Googlebots takes time and effort, trial and error.  I typically create them for a specific task, and when that task is complete, I retire them.  My biggest success with Googlebots occurred in 2005, when they detected the peak in the housing market.  I had about 10 Googlebots working to pick up market chatter.  In October 2005, they went through a dramatic change, where the chatter was confused, and the speed of the closing for housing sales dropped dramatically.  After that, the chatter was subdued.  I posted my result at RealMoney’s Columnist Conversation sometime in October, and told my boss that though credit conditions were still loose, the wind was now at our back on housing prices.  We were “too early” bears on housing, and I was the one skeptic in the shop on the timing of that.

That’s all for now.


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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