There are some books that were important to forming the way I think about economic problems, but if I write about it, I feel that I can’t do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books. Michael Pettis was a managing director at Bear Stearns, and an adjunct professor at Columbia University when he wrote it.

The book was written in 1999-2000, and published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of “crack the whip” effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don’t have to look far. Today, Michael Pettis is a professor at Peking University’s Guanghua School of Management. He is studying China from the inside, and writes about it at his blog (I read it every day, and will add it to my blogroll the next time I update it), China financial markets. Among his most interesting recent posts:

China’s latest batch of numbers aren’t good

Chinese pro-cyclicality makes predictions so difficult

More on why high share prices don’t mean Chinese banks are in good shape

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face.  When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea.  If you want to learn how international finance affects developing economies, buy his book.

Full disclosure: if you buy the book through the link above, I will receive a pittance.

A few readers asked me if I would review some books dealing with accounting issues. I’m happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.

Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:

1. Recording revenue too soon.
2. Recording bogus revenues.
3. Boosting income with one-time gains.
4. Shifting current expenses to a later period.
5. Failing to record or disclose all liabilities.
6. Shifting current income to a later period.
7. Shifting future expenses to the current period.

There are several common factors at play here.

• Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
• Watch revenue recognition policies closely. It is the largest area of financial misstatement.  (1-2)
• Look for assets and liabilities that aren’t on the balance sheet, and avoid companies with hidden liabilities. (5)
• When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow.  (6,7)

The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of  the accounting troubles that occurred.  Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings.  I wouldn’t say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet.  Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two.  To do three, it takes fraud.

Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings.  That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not.  For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.

The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it.  For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies.  Financial companies are more complex (they are all accruals — the cash flow statement is not very useful), and can’t easily be analyzed for earnings quality from looking at the financial statements alone.

Full disclosure: I get a pittance from each book sold through the link listed above.

I must confess that I had merely heard of Dick Davis, but did not know much about him until reading his book. I enjoyed his book, and think it is useful to new investors, and investors that have been unsuccessful in actively managing their own portfolios. I have read the whole book; this is not a review that comes from bullet points suggested by the publisher or author (sent to me and others, I have ignored them). I do have a minor criticism of the book; more on that later.

The first thing to appreciate about the book is its structure. After learning about the long career of the author, the book begins with a small amount of basic ideas per chapter, moves to progressively larger numbers of ideas per chapter that are less basic, and then returns the way it came, ending with progressively fewer ideas per chapter, but more basic ones.

The second thing to appreciate is the humility of Mr. Davis. His first answer to most investment questions is “I don’t know,” followed by reasons for and against the proposed course of action, after which he would indicate an opinion if he has one, and then say that he could be wrong, and that it would be good to do further study.

What does the book emphasize?

• Passive investing (ETFs and index funds)
• Careful selection of active managers.
• Imitating those carefully selected active managers if one decides to invest in common stocks directly.
• Avoiding too much trading, because the average investor tends to panic at bottoms, and get greedy at tops. Buying and selling have to be properly timed, because the average investor tends to do worse than the buy-and-hold investor.
• Be careful with costs on mutual funds. Most aren’t worthy of the fees, and with bond funds, cost advantages are the most durable.
• Invest for the long haul, realizing there will be bumps along the way, and keep enough excess liquidity on hand.
• There is no one right person or opinion. Things shift in the market, and trends often last longer than expected.
• Be wary of news flow; get a thick skin toward the multitude of opinions presented.
• Asset allocation is the key discipline to risk control; diversify broadly by asset class, country, style, etc.
• You can’t win every time, but you can tilt the odds in your favor.
• Use stop losses to limit losses. (I disagree. Use loss points to review your thesis, and if it is wrong, sell. Get a second opinion also. Otherwise, buy more.)
• Rising dividends beat high dividends
• Many strategies can work in the market; it’s more a question of when and how you apply them.
• Macro forecasting rarely works.
• Buying and holding the equity market tends to work over the long run, so have a core investment in the equity markets.
• Humility is a core character attribute of good investors. (Be more like Charles Kirk, and less like Jim Cramer… he spends several pages on this.)

Beyond that, Mr. Davis gives lists of good investment books, good investment blogs (I‘m not on his list, so it goes), quotations, and active managers. I thought his favorite active managers to be a very good list for those looking for active mutual funds. The investment books were generally classics, though some are too new to tell. As for the blogs, well, we are here today and gone tomorrow. We are only as good as the last few things we publish, so good financial blogging is not something that a book can capture. We vary too much.

Now for my one criticism. The book has one long chapter on index fund portfolios that takes up 20% of the book, and gives 28 models (with sub-models) for “set it and forget it portfolios.” There are a couple of problems here: first, there are too many strategies here, and many don’t differ enough to deserve separate inclusion. Second, it would be better to spend more time on the factors behind why someone might choose one approach rather then another. What goes into creating a good asset allocation? How much should I have in bonds? Foreign bonds? Foreign equities? Cash? Obscure asset classes? I’m not asking for detailed math, but rules of thumb for average investors to follow, so that they could find a passive strategy that is among those strategies that would be more likely to meet their needs.

But with that one cavil, I can recommend this book to investors, particularly those that have not done well with active management. This book won’t teach you what to do, as much as how to think and discipline yourself. Most investors should limit their options in investing because their emotions and abilities aren’t suited to the violence of the markets.

For investors that do well with active management, you don’t need this book, but you might like it for the stories that he tells, or as a gift for relatives who need to follow a more passive style of investment management.

Full disclosure: I get a modest amount of money if you buy the book through the link above.

I am a fan of value investing in all of its different variations, and so when I run across a book on the topic, particularly from a skilled practitioner, I buy it. I’ll do more book reviews on value investing, but one of the first that I wanted to do was Value Investing, by Marty Whitman.

So, I start looking around for my copy, and I can’t find it. Arrrgh, I can guess what happened. I lent it out, I can’t remember who I lent it to, but the borrower never gave it back to me. Annoyed at myself, I do notice a book that was just as good, The Aggressive Conservative Investor, by Marty Whitman and Martin Shubik. Even better, it is back in print, after being out of print for 20+ years.

So, what’s so great about the book? (Most of this applies to both books.) Marty Whitman has a strong “What can go wrong” approach. He realizes that he, and most other investors, will be outside passive minority investors. We only ride on the bus. The inside active control investors drive the bus, and if we are going to make money with reasonable safety, we have to understand the motives of those that control the companies. They benefit somewhat disproportionately from control. They receive wages and benefits that other shareholders do not receive, can gain cheap outside financing, and limit tax exposures, in addition to other benefits.

Like me, Whitman doesn’t care much for modern portfolio theory. More notable for a value investor, he has a few criticisms for the traditional “Graham-and-Dodd” type of value investing.

• Typically, it works best for “going concern” situations, and not situations where activism could be necessary to unlock value. (Though, Graham did do things like that in his career; he just didn’t try to teach amateurs about it.)
• He doesn’t always stick to high quality companies, if enough information can be obtained about the target. Information allows for more risk to be taken.

There are four things that he insists on in equity investments:

1. Strong financial position
2. Honest management that is creditor-aware and shareholder-oriented
3. Adequate disclosure of information relevant to the success of the company
4. The stock can be bought for less than the net asset value (adjusted book value) of the firm.

If you have these items in place, you won’t lose much, and if the management team makes value enhancing decisions, one can make a lot of money on the stock.

Whitman places a lot of stress on reading through the documents filed with the SEC. They may not be perfect, but managements know that they need to provide adequate disclosure of material information, or they could be sued. A lot gets revealed in SEC filings, and not every investor sees that.

He also places great stress on understanding the limitations of the accounting, whether under GAAP, Tax, or any other basis. Comparing the various accounting bases can sometimes illuminate the true financial well-being of a company. (Note: this is what killed me on Scottish Re. I should have questioned the GAAP profitability, when they never paid taxes.) He lists the underlying assumptions behind GAAP accounting, and explains how they can distort the estimation of economic value. Honestly, it is worse today in some ways than when he wrote the First Edition in 1979. GAAP accounting is more flexible, and less comparable across companies today.

Marty Whitman looks for situations where resources in a company can be used in a better manner, creating value in the process.

• Is the company too conservatively financed? Perhaps borrowing money to buy back stock, or issuing a special dividend could unlock value.
• Are there divisions that are undermanaged, or would fit better in another company?
• Are management incentives properly aligned with shareholders?
• Would the company be better off going private?
• Is government regulation a help or a hindrance? (Barriers to entry)
• Analyzing corporate structures for where the value is.

Beyond that, he explains how to calculate net asset values, as distinct from book values. He describes the problems with earnings as a value metric. He explains the value of dividends and other distributions. He also explains when it can make sense to own companies that are losing money. (Underlying values are growing in a way that the tax accounting basis does not catch.)

It’s a good book. Together with Value Investing, it gives you a full picture of how Marty Whitman thinks about value investing. He is one of the leading value investors of our time, but he has spent more time than most on the underlying theory. For those who want to think more deeply about value investing, Marty Whitman is a highly recommended read. For those wanting still more, read his shareholder letters here.

Full disclosure: if you use the links on this page to buyread books, I receive a small amount of money.

PS — Twelve years ago, I wrote Marty Whitman, begging to be one of his analysts. Though I didn’t get a response, I still admire him and his staff greatly.

In principle, I make a pittance off of any book sales from clicking on the links in any review that I write.  But I will write about books that are “out of print” as well (no money there); whether in print or out of print, my goal is to serve readers by bringing important investment ideas to their attention.

Presently, I am reading Money of the Mind, by James Grant, but I have also read The Trouble With Prosperity, which is important to understanding our present circumstances.  Both analyze monetary and other economic policies in the past, with an eye toward what it implies for us today.

In The Trouble With Prosperity,  Grant’s main theme is what happens when monetary policy is perverted from trying to preserve purchasing power, to trying to assure a perpetual prosperity.  He wrote this in 1996, when the US was recovering from the severe Fed tightening in 1994, which resulted from lax monetary policy 1991-1993, where the Fed funds rate was stuck at 3%.

As with most things, James Grant is right in direction, but early.  Back in 1996, he could not envision a 1% Fed funds rate, much less the mysterious hypothetical helicopters of Chairman Bernanke.  Capitalist economies are quite resilient, and can survive considerable mismanagement.  Today we are far closer to what he worried about eleven years ago.

A central bank trying to assure continued prosperity will always be biased toward inflation.  How the inflation manifests is a function of demographics.  With a younger population, goods inflation will be stronger (buy more, save less), and asset inflation for an older generation (buy less, save more).  At the same time, such a central bank will be biased against major losses in financial institutions.

The trouble is, the likelihood of the Federal Reserve rescuing troubled financial institutions raises the odds that the institutions will get into trouble.  It skews the payoff to financial executives, and makes them more willing to take risk, because the institution will not be under threat if they fail.

In The Trouble With Prosperity, Grant walks us through:

• The puzzle of the markets in 1958, given the rise in interest rates and inflation
• A tall building that characterized the troubles of the Depression.
• The Japanese real estate and stock bubbles, and their deflation (still early in 1996)
• The S&L crisis in the early 90s
• Willingness to sponsor speculative ventures in the early 1990s, with a focus on gambling.

My opinion: low Fed funds rates foster speculation in healthy assets.  Lever them up more, because we can.  Ignore risk, and focus on the income one can generate today.  Of course, the eventual risk is that the US ends up in a liquidity trap similar to the which the Japanese have been in for the last 17 years.  Of course, the US economy is more flexible than that, but the risks are still significant.

Don’t view soft FOMC policy as a panacea.  Eventually we will have goods inflation as a result.  For now, the market is rejoicing in an accommodative Fed.  Enjoy it while it lasts, buy inflation is coming.

This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

1. Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
2. Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
3. Value and Momentum both work as strategies. They work best together.
4. He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

1. Low P/B
2. Low P/E
3. Net Insider Buying
4. Significant Declines in the Stock Price (anti-momentum)
5. Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.

Jeremy Siegel

Full disclosure: I get a small commission from any book sales through these links.

Fifteen years ago, my mom gave me a book that would change my life: The Intelligent Investor, by Benjamin Graham. Prior to that time, I was primarily investing in mutual funds, and did not have a coherent investment philosophy. The Intelligent Investor provided me with that philosophy.

What are the main lessons of this book?

1. Don’t overinvest in equities. Markets wash out occasionally, and it’s good to have some bonds around.
2. Don’t underinvest in equities. Bonds can only do so much for you, and it is good to deploy capital into equities when they are out of favor.
3. Stocks provide modest compensation against inflation risks.
4. Avoid callable bonds. Avoid preferred stocks.
5. Be conservative in bond investing. Read the prospectus carefully. Often a bond is less safe than one would expect, and occasionally, it offers more value than one would expect.
6. Purchase bargain issues on a net asset value basis when you can find them, but be careful of quality issues.
7. Volatility of stock prices can be your friend if you understand the underlying value of a well-financed corporation.
8. Having a longer-term investment horizon is valuable, because one can take advantage of short-term fluctuations in price.
9. Growth is worth paying up for, but be disciplined. Don’t overpay.
10. Be wary of mutual funds.
11. Be wary of experts.
12. Pay attention to the balance sheet; don’t invest in companies that are inadequately financed.
13. Review average earnings of cyclical companies.
14. Buy them safe and cheap. Don’t overpay for growth and trendiness.
15. Avoid highly acquisitive companies.
16. Watch cash flow, and question unusual accounting treatments.
17. Be careful with unseasoned (new) companies.
18. Strong dividend policies, in companies that can support the dividends, are an indicator of value.
19. Aim for a margin of safety in all investing.

That’s my quick synopsis of the book. Though I am not a strict Graham-and-Dodd investor (who is?), I apply the basic principles to most of what I do. This is still a relevant book today because the principles are timeless. If you want the updated version with writing from Jason Zweig, that’s fine. You gain in current relevance, and lose a little in nuance. Graham was a very bright guy. I give Zweig credit for trying, but aside from Buffett or Munger, who would really be adequate to revise The Intelligent Investor? I don’t think I would be adequate to the task….
Classic:

As Revised by Jason Zweig:

Russell Bailyn is a Wealth manager who wrote a basic book on finances, but gave it a twist to emphasize what resources were available on the web, and at financial blogs specifically. He covers a wide number of areas in a basic way, sometimes giving answers where “one size fits all,” or almost all, and sometimes explaining to readers what the right questions are when answers are situation-dependent.

Some of the areas he covers are:

• Banking, budgeting and credit.
• Financial planning and tax-deferred savings/investment
• Investment types
• Life insurance and annuities
• Retirement and portfolio management

The book isn’t long at 220 pages, so as you might imagine, this book is wide, but not deep. I would recommend this book for people who are getting started in managing their finances, and want to take a more active hand there. Alternatively, it could benefit those who want to hire a financial planner, because they would better learn how to choose a planner, and better evaluate the advice that their planner gives them.

Because I am aware of most of the areas in the book, this is a book that I skimmed. That said, as I looked at critical ideas in the book, I found that I largely agreed with his ideas. As a trivia note, Alephblog and I get featured on page 177, in the chapter on portfolio management. If I had to featured in any chapter, I’m glad it was that one, because managing risk through proper portfolio management is near and dear to my heart.