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Book Review: Treasure Islands

Tuesday, April 1st, 2014

9780230341722

Tax havens exist to lower taxes and regulations on corporations and wealthy individuals.  But doing this involves significant complicated legal and accounting work.  The average person could not benefit because the fixed costs are high.  You need to have a lot of assets to benefit from tax havens.

So why do the wealthy governments of the world tolerate tax havens?  Why don’t they “use NATO to blockade these places, and tell them to end their tax-avoidance-facilitation policies, or else.”  Sadly, the wealthy have disproportionate power over politicians, and the majority of politicians are wealthy.  They like the system as it is.  You can make the tax code as progressive as you like; you will not end up taxing the intelligent wealthy much more.

This book confronts transfer pricing, where profits get shifted to low-tax countries by clever accountants.  Very difficult to police.

The is an amusing section in the middle of the book about the City of London Corporation, which has unique rights in the UK.  It is the home of most financial activity n London, and is mostly unaccountable to the UK.

In general, I believe that taxation should be the same regardless of the structure of the entity being taxed, its location, etc.  To that end, I think that corporations should be taxed on their global income as expressed to its owners.  Or, don’t tax corporations, but make all taxation like limited partnerships, and tax the individuals that own them.

There are other possible solutions.  There can be limits on corporate structure.  Israel limits subsidiaries such that the depth from the holding company cannot exceed two.  There could be consolidation and/or non-recognition of  subsidiaries in tax havens.

Additional Resources

Longreads article

Book website (those reading at Amazon, come to Aleph Blog to get links)

Quibbles

The book makes its last chapter about how tax havens helped cause the financial crisis, but it makes a very weak case.  Individuals and Banks overlevered themselves as asset prices rose, creating a bubble — not much different than the 1920s.  Tax havens played little role, even if they aided securitization in a few ways.

The book argues for capital controls, but those controls often create incentives for greater corruption.

My main problem with the book is that it does not offer any workable solutions to the problems.  My secondary problem is that the problem is not so much with the tax havens, which we could easily marginalize, but with the politicians, who do not do the hard work of seeing that taxation takes place, regardless of the corporate form or location.

Who would benefit from this book: You have to be willing to endure complex arguments to benefit from this book.  If you want to, you can buy it here: Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens.

Full disclosure: I borrowed it at my library.

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.

As Light As Hydrogen

Wednesday, March 19th, 2014

Okay let’s roll the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 3/18/13DeclineAnnualizedSplits
GTXO

5/27/2008

2.45

0.040

-98.4%

-50.8%

BONZ

10/22/2009

0.35

0.001

-99.7%

-73.0%

BONU

10/22/2009

0.89

0.001

-99.9%

-79.1%

UTOG

3/30/2011

1.55

0.000

-100.0%

-95.1%

OBJE

4/29/2011

116.00

0.167

-99.9%

-89.7%

1:40

LSTG

10/5/2011

1.12

0.010

-99.1%

-85.7%

AERN

10/5/2011

0.0770

0.0001

-99.9%

-93.4%

IRYS

3/15/2012

0.261

0.000

-100.0%

-100.0%

Dead
RCGP

3/22/2012

1.47

0.300

-79.6%

-55.1%

STVF

3/28/2012

3.24

0.420

-87.0%

-64.5%

CRCL

5/1/2012

2.22

0.026

-98.8%

-90.6%

ORYN

5/30/2012

0.93

0.110

-88.2%

-69.5%

BRFH

5/30/2012

1.16

0.515

-55.6%

-36.3%

LUXR

6/12/2012

1.59

0.009

-99.4%

-94.7%

IMSC

7/9/2012

1.5

0.900

-40.0%

-26.1%

DIDG

7/18/2012

0.65

0.042

-93.5%

-80.7%

GRPH

11/30/2012

0.8715

0.085

-90.3%

-83.5%

IMNG

12/4/2012

0.76

0.045

-94.1%

-88.9%

ECAU

1/24/2013

1.42

0.240

-83.1%

-78.8%

DPHS

6/3/2013

0.59

0.010

-98.3%

-99.4%

POLR

6/10/2013

5.75

0.070

-98.8%

-99.7%

NORX

6/11/2013

0.91

0.210

-76.9%

-85.2%

ARTH

7/11/2013

1.24

0.360

-71.0%

-83.6%

NAMG

7/25/2013

0.85

0.164

-80.7%

-92.2%

MDDD

12/9/2013

0.79

0.320

-59.5%

-96.4%

TGRO

12/30/2013

1.2

0.220

-81.7%

-100.0%

VEND

2/4/2014

4.34

4.900

12.9%

187.3%

3/18/2014

Median

-93.5%

-85.2%

Tonight’s loser-in-waiting is HydroPhi Technologies [HPTG].  This one can’t even get basic science right.  It claims to be able to split water into hydrogen and oxygen, and then recombine them to create energy.  Circular processes in general lose energy, otherwise we would have perpetual motion machines.

And behind the vapid analysis is an uber-loser.  His analyses never pan out over one year.  A clever speculator might make money occasionally, but not regularly, because the stocks he pumps are like this one.  Little revenues, negative earnings, negative net worth.  This is a recipe for disaster.

Think about it — if you had a miracle energy technology, would you merge your company with a failed internet advertising company “BigClix?”  I would think not.  You would keep your company private and enjoy the significant profits.

As it is, there are no profits, so where is this great energy technology?  This is a scam, and laws should be revised to allow prosecution of those who write such promotional garbage as we have seen.  It is no good to have the 4-point type disclaimers telling some of the truth, while the big type says “Buy, buy BUYYY!!!”  Also, as far as the web version of this promotion goes, the promoters pour in half a million.  As it says in the 4-point type:

Third Party Advertiser IMPORTANT NOTICE: Esquire Media Services Inc (EMS) has managed up to a $500,000 USD advertising production budget as of January 21, 2014 in an effort to build industry and investor awareness for HydroPhi Technology Group Inc (ticker symbol: HPTG). 

It’s easy to affect the price of a company that has bad fundamentals.  It’s overvalued to start; it will only be more overvalued at the crest of the promotion.  If you attract a bunch of people to the pump-and-dump who want to play the momentum, some may think they will be clever enough to scalp a quick profit along with the insiders.  Some of them win, and others lose.  Others believe the advertising, and stay to lose a ton.

Seth Klarman recently said, “It might not look like it now, but markets don’t exist simply to enrich people.”  This needs to be remembered by all.  Markets are for trading, and trading is a negative-sum game.  Those who buy & hold valuable businesses for a span — that is a positive-sum game, because the underlying asset is appreciating.

To close: don’t buy promoted stocks.  Never.  Those who are paid directly or indirectly to encourage you to buy are at best sub-agents for the seller — they aren’t on your side.  In buying promoted stocks, it’s like going to Vegas, minus the fun.  You will lose.  You will lose a lot.   The house edge is fixed — it’s only a question of how much you will lose.

Avoid promoted stocks.  As I often say: “Don’t buy what someone else wants to sell you, buy what you have researched and know has value.”

On the “770″ Account

Thursday, March 6th, 2014

A letter from a reader:

Dave,

My Mom asked me about 770 accounts (apparently, she wants to open one). I’ve reserched [sic] them, but can’t quite figure out if it’s legit or not. So much, what I’ve found is that it is really some kind of insurance policy, it’s tax free, and it’s not openly advertized [sic].

Do you know anything about these accounts? Are they safe? Are they worth it?

Dear Friend,

We are talking about permanent life insurance here.  I’ve written about this at least once before.  The types of policies they talk about maximize the savings element inherent in permanent life insurance, and minimize the death benefit.  Monies in the insurance policy accrue tax free, and at death they escape estate taxes.  What could be better?

Well, permanent insurance is laden with fees, and agents love to sell it if they can, because the commissions are huge.  Mortality charges are significant as well.  As I often say with this kind of product, insurers love to create complex products because average people can’t tell whether they are getting a good deal or not.  (Hint: usually, you are not getting a good deal.)

Life insurance is a very expensive way to manage assets, between the agents and the operating costs of the company.  At present, insurance company assets yield more than market rates, which gives a subsidy to customers, but the day will come, like the late 70s — early 80s, where it was very much the reverse.

Aside from scamming the tax man, and providing protection to loved ones at your death, life insurance is a lousy vehicle for building wealth.  If you have built wealth already, it is an excellent way to preserve it for your heirs.  But it won’t make you rich, and all of those advertising such accounts and those like them, make huge commissions off of permanent life policies if they are the agent.  They make out far better than you will.

Are they safe?  Yes, life insurance is safe.  Are they worth it?  No.  Not that I am bullish on the stock market now, but under most conditions, the stock market outperforms the returns that insurance companies before expenses, much less after expenses.

This can make a lot of sense if you are rich already, but it will never make you rich.  Having reviewed many of the advertisements for these products, they use a Madoff-like technique that tells you that you are being let in on a secret way of wealth.  It’s all garbage, because permanent life insurance has been around for over 100 years.

Hey, let me tell you a secret.  Did you know that insurance stocks  have outperformed most other industry groups over the last 40-50 years?  Buffett will tell you, insurance is a great business.  Now, maybe I can give this a cryptic name, like a 321 fund, and tell people that owning the 321 fund is a way to wealth.  (Psst… the same is true of the stocks of money managers… they do much better than mutual funds.)

Sadly, you would likely do better with my 321 fund, the the 77o account, especially if it is held within a tax-deferred account.

Be wary of any pitch that is too good to be true.  Don’t buy what someone wants to sell you.  Buy what you have researched and want to buy.  Oh, and buy the 321 fund — really, buy it. ;)  (I feel ashamed.)

Final Note

THERE ARE NO SECRETS IN MONEY MANAGEMENT!  THERE ARE NO SECRETS IN MONEY MANAGEMENT!  THERE ARE NO SECRETS IN MONEY MANAGEMENT!

There is no secret club.  There are no secret formulas. There are a lot of clever lawyers, accountants, and actuaries that the wealthy employ, but for average people, the high fixed costs won’t make it work.

If you want to be wealthy, you have to run your own firm, run it well, providing value to many.  Don’t listen to those who say they have an easy way to wealth.  They are lying, and are looking to make money off of you.  Those who give you free advice are using you in some way.  (Wait, what does that make me to be? Sigh.)

Signing off, your servant David, who does this for his own reasons…

Book Review: “The Up Side of Down”

Friday, February 14th, 2014

Failure. We’ve all experienced it. Can we benefit from it?  The answer is maybe, depending on the costs of failure.

If the costs of failure are high, e.g., repaying debts for the rest of life, people will avoid taking risks.  As a result, society will stagnate, because few take risks.

But if the costs of failure are low, people will take more chances, start more businesses, try experiments that might prove something bold.  That is one great thing about America; the penalties for failure are low.  Some have said we are the land of unlimited second chances.  After resigning from the presidency, Richard Nixon became an influential voice on foreign policy.

Megan McArdle uses her own life and many other societal problems to illustrate how a proper use of failure  can benefit individuals and society as a whole.  Failure is how we learn.  As some have said, “The wise learn from the failures of others, normal people learn from their own failures, but the stupid don’t learn.”

I enjoyed this book a great deal, but I want to point out a few of the chapters that particularly struck me.

In Chapter 8, she described the various ways that ideologues described the causes of the financial crisis.  The Left and the Right chose their own monologues to explain the economic failure that occurred.  The truth was far more banal, as average people bought into a housing mania, with financial institutions more than willing to facilitate it, levered as they were.  When the bull market ended, many people found themselves with too much debt relative to the value of their houses.

Chapter 9 was the one from which I learned the most, as it described a probation method used in Hawaii, that I would describe as the judicial equivalent of spanking.  When one on probation violates a term of probation, he gets sent to a rather grim prison for a short period of time.  Like spanking, it is short, and sharp.  Those on probation get tested randomly and regularly.  Most quickly get the idea that they need to change their lives.  The recidivism rate on this program is low.  Small failures get punished.  Resistance to the system means permanent jail.  No failures means freedom.

But what I really appreciated in the book was the willingness of the author to expose her own life failures — jobs, caring for her mother’s health, bad relationships, etc.  She learned from her mistakes, and ended up with a husband who loves her, a good job, and a home in DC, where there is not much debt on the property.  Well done.

My own life has had its share of failures, and they have all taught me something.  The question to you, reader, is what have you learned from your failures?  Memorialize failures, so that you can avoid them and their cousins in the future.  In that sense you can fail well.

There is not a bad chapter in this book.  I recommend it highly, and you will learn a lot.  I learned a lot.

Quibbles

None.

Who would benefit from this book: Anyone could benefit from this great book.  If you want to, you can buy it here: The Up Side of Down: Why Failing Well Is the Key to Success.

Full disclosure: The PR people offered me a book, and I accepted it.  I am glad that I did.

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.

 

Serve Client Needs, or Die

Wednesday, January 15th, 2014

Another letter from a reader:

Hi David:

Happy new year!

I’ve been reading the blog for about six months now and can’t thank you enough.  I have found so many of the post to be extremely thought provoking and helpful.  I also appreciate your openness about your faith.  As a young Christian man in the finance world I find it very encouraging.

I’m contacting you to ask a few questions but before I do that, let me give you some context.  This past April I started in sales on the fixed income trading desk at XXXXXXX.  My desk in particular is more “middle market” focused and has a strong tax exempt muni bias.  Although there is an effort to grow our mortgage business, most of our taxable business would be considered more “retail”.  That said, I have spent my last 10 months or so traveling YYYYYYY visiting with all sorts of institutional investors trying develop relationships that will eventually result in a trading relationship.  I’ve met with anywhere from small community banks, to a larger insurance company, and even sat down with a few portfolio managers at a state pension fund.

What I’ve learned from this experience is that one, we don’t have much of a “call” into some of these folks.  One example is the pension fund.  They really aren’t gonna care on any of our exempt positions and we dont bring any large taxable deals for there to be a great fit.  Ive also learned that there are many internal hurdles I am going to have to endure in order to develop a sustainable network of individuals to call on. (Account assignment, crm software, trader skill

All this considered, I’m wondering if you have any words of wisdom for a young aspiring fixed income sales person?  Any dos and dont’s from the coverage you’ve had over they years?  What can I do to set myself apart from my competition?

I realize you probably get inundated with emails so no rush on my end.  Just thought I’d reach out. 

Dear Friend,

I get a lot of emails, but I am not inundated.  Let me give you the perspective of a former corporate bond manager.  I divided my coverage into three groups: those who produced value every day, those who could help me occasionally, and those who could help me rarely, if at all.  I was not like those at the company that acquired my firm.  I would do business with anyone, so long as they offered value.

Yes, that is more difficult to deal with than limiting coverage, but I was aiming to do the best for my client.

You are in a difficult spot.  Your company needs to align itself with the market; it needs to seek a niche where it can add value for clients in a way that fits their tax status, yield needs and liabilities.  Look for niche areas where intelligent investors could provide adequate yields with safety.  I had several brokers that specialized in niches, and I used them to a high degree.

This would require a research effort from your firm that would reveal values to clients and potential clients.  But with most business efforts, client needs come first.  Re-orient the business to serve client needs, or die.

As for you, individually study your clients and potential clients to see what they need.  See if your firm can deliver that.  If it can’t, you may have to find another firm.  Big clients won’t deal with anything but the main office of the big firms, unless the regional coverage is particularly clever.  Medium and small clients are often happy to work with a local or regional firm, or the regional office of one of the big firms.

As coverage, you can be:

  • Prompt
  • Attentive
  • Knowledgeable about how to help your clients (if you can within your firm)
  • Empathetic, Friendly
  • Honest (that goes a long way)
  • Reliable
  • The guy who knows how to find the other side of a trade.

That last one is important: I’ve known coverage that could pry illiquid, hard-to-find bonds out of the hands of parties who don’t know what they are worth.  That’s a valuable skill, but difficult to do, except with insurance companies and mutual funds, which have to report their holdings at the security level by CUSIP.

But if your firm can’t deliver what your clients need, you will likely just be a nice guy on the phone who eats up the time of clients.  I knew a number of those, and I never got much business done with them.  You would be better off with another firm, if you can make the jump.

Protect Your Older Family & Friends

Thursday, December 26th, 2013

This article was spurred by this article in the Wall Street Journal: Financial Scammers Increasingly Target Elderly Americans.  The elderly are indeed a target because of three reasons:

Seniors are targets, and not just by those who are regarded as fraudsters.  I had an older friend who was approached by the sales professionals of a major bank to manage her $3 million portfolio, which was already well-managed.  They made all manner of promises of what they would do for her, in exchange for a fee on assets — 3%/year.

At that level of expense, there are a lot of things that could benefit the Senior in question, but the nice-looking, unctuous people from the bank sell an expensive mirage.  I’ve never seen a bank that was genuinely good at asset management, and certainly not to the degree of charging a 3% fee.

Every elderly person needs a younger skeptical friend who is sharp enough to be able sense when a deal is sketchy, and the elderly person needs to have the discipline to run things by their younger friend.

As I so often say, “Don’t buy what someone wants to sell you.  Buy what you have researched for yourself.”  The elderly should develop a hatred of marketers.  Hang up on anyone who is offering something that is “too good to be true” because it almost always is too good to be true.

To those who Lead Churches

I am an elder in my Reformed Presbyterian congregation.  I have served my denomination on the boards of its college, denominational trustees, finance committee, and pension board.  In my congregation, we watch out for our elderly members.  We make their requests a priority.  If they need financial advice, I give it to them for free.  God rewards those who aid widows.

I encourage Church leaders who have enough financial sense to be able to know when something financial “feels funny” to gather their elderly congregants, and tell them to call you if they are tempted by slick-talking salesmen to make them part with money.

To those who Love Elderly Family or Friends

Take the time to tell them to be careful, and that you are available to help them whenever someone calls them out of the blue, where that party will benefit from money from the senior, no matter what it is.  This isn’t as tough as telling them to give up the car keys (been through that once).  But they do need to be sensitized to two things:

  • There are people out there who want to cheat them, and
  • You love them, and will help them in any situation like that.

We’re supposed to take care of and honor elderly people anyway.  Societies that don’t do that tend to fail.  So look out for your elderly friends to the degree consonant with your relationship to them.

Three Dimensions, and Printed, but not Real

Tuesday, December 10th, 2013

Okay, let’s run the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 12/9/13DeclineAnnualizedSplits
GTXO

5/27/2008

2.45

0.014

-99.4%

-60.9%

 
BONZ

10/22/2009

0.35

0.001

-99.6%

-74.2%

 
BONU

10/22/2009

0.89

0.001

-99.9%

-79.4%

 
UTOG

3/30/2011

1.55

0.001

-99.9%

-93.0%

 
OBJE

4/29/2011

116.00

0.350

-99.7%

-89.1%

1:40

LSTG

10/5/2011

1.12

0.015

-98.7%

-86.2%

 
AERN

10/5/2011

0.0770

0.0001

-99.9%

-95.3%

 
IRYS

3/15/2012

0.261

0.000

-100.0%

-100.0%

Dead
RCGP

3/22/2012

1.47

0.300

-79.6%

-60.4%

 
STVF

3/28/2012

3.24

0.490

-84.9%

-67.1%

 
CRCL

5/1/2012

2.22

0.028

-98.8%

-93.5%

 
ORYN

5/30/2012

0.93

0.038

-95.9%

-87.6%

 
BRFH

5/30/2012

1.16

0.420

-63.8%

-48.6%

 
LUXR

6/12/2012

1.59

0.015

-99.1%

-95.6%

 
IMSC

7/9/2012

1.5

0.800

-46.7%

-35.8%

 
DIDG

7/18/2012

0.65

0.049

-92.5%

-84.4%

 
GRPH

11/30/2012

0.8715

0.053

-93.9%

-93.5%

 
IMNG

12/4/2012

0.76

0.063

-91.7%

-91.4%

 
ECAU

1/24/2013

1.42

0.330

-76.8%

-81.2%

 
DPHS

6/3/2013

0.59

0.007

-98.8%

-100.0%

 
POLR

6/10/2013

5.75

0.090

-98.4%

-100.0%

 
NORX

6/11/2013

0.91

0.160

-82.4%

-97.0%

 
ARTH

7/11/2013

1.24

0.182

-85.3%

-99.0%

 
NAMG

7/25/2013

0.85

0.785

-7.6%

-19.1%

 

12/9/2013

Median

-97.2%

-88.4%

Market regularities are heartening.  It’s astounding how regular the losses are from promoted stocks.

On to tonight’s loser-in-waiting, Makism 3D Corp [MDDD].  This is another company with no revenues, has never earned a dime, etc.  It used to be a company that supposedly was trying to improve cellular telephony, but never earned a dime doing so.  So they bought a UK company that was supposedly working on 3D printing, and surrendered the company to them.

It would be incredibly surprising that a company of three people would be able to overthrow the 3D leaders — DDD and SSYS.  They have invested a lot of time, money, and effort to improve 3D printing, and a startup can beat them with less than a million bucks, and less than a year, with a young undifferentiated staff?  I don’t think so.  Or, as an old-style pinball machine might say, “TILT!”

I don’t buy it, and you should not either.  As with all promoted stock scams, the hard part is identifying who benefits.  My guess is affiliates of the guy who wrote the glowing reportThe company has disclaimed ay responsibility.

In any case, avoid promoted stocks.  Do your own research, and buy stocks that you find attractive.  Don’t buy anything that another is trying to pitch you.

Two zeroes merge, and should we expect a positive result?  I think not.

 

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.

Few Things Are Impossible

Thursday, October 10th, 2013

Buffett supposedly once said something like, “We’re paid to think about things that can’t happen.”  What would be examples of this?

  • The Housing Bust, and the ensuing funk with banks.
  • Hurricane Katrina, and the flood that it helped create.
  • The Tohoku Earthquake, with the surprising damage to the nuclear reactor
  • Four hurricanes hitting Florida in 2004.
  • The Fall of the Soviet Union
  • The Murderous effect of forced collectivization in the Ukraine, China, Cambodia, and other places.
  • The rise of Hitler
  • Chernobyl
  • Long US interest rates would fall below 5%.

This will be a short piece, but what I want to stress is that things that pundits say can’t happen sometimes do happen.  The application is that it is not impossible that the US Government defaults for political reasons.  Brinksmanship is a tough and heady thing, and it is possible for all parties to miscalculate and be intransigent.  Pride brings out the worst in mankind.

I’m not saying a default will happen, or that it is more likely to happen than not.  I am only saying the probability is non-zero, like rolling boxcars or snake-eyes at the craps table.  Thus credit default swaps [CDS] on a US default have risen considerably, because a few are hedging the possibility.

Personally, I think it would be interesting to see what would happen in a default, because we don’t have a lot of data points there, even for a short default.  That said, vain curiosity of mine should not be satisfied to the harm of many, so would prefer that the GOP and Dems would agree to a short-term extension of the debt ceiling combined with spending reductions.

But nothing is impossible among men.  Pride has often driven the otherwise sane to take courses of action that harm their enemies more, even as their friends are harmed also.

The Bible says, “An eye for an eye, and a tooth for a tooth.”  People look upon it as cruel, but it was meant as a limit.  You can’t force suffering at a greater level than you were harmed, and the threat of equal suffering would lead offenders to negotiate a monetary settlement to protect their eyes and teeth.

But when men will not restrain themselves, and seek to gain revenge, all manner of bad consequences occur.   There is something to having limits on political processes.  There is something to having manners in society.  There is something to having personal self-control.

We have lost a lot as a society as the Greatest Generation has handed power over to the Baby Boomers.  We agree far less on what society ought to pursue, and what is right and wrong.

That is why the fights in DC are so bare-knuckled.  Gerrymandered districts send ideologues to Congress, which have very different views on policy and ethics.

Back to the main point — when the two or three sides of the debate have widely different views should it be surprising that it is possible that we may end up with a stalemate leading to a temporary default?  A permanent default is another matter — I don’t think the politicians are that stupid, at least not yet.

Quiet Companies Are Better

Thursday, September 26th, 2013

I appreciate the companies in my portfolio that don’t say much.  They just do their work, and don’t advertise it.

There is a bias among promotional companies, that one must promote the company in every press release.  I disagree.

Just be honest.  If you don’t have anything significant to say, don’t say it.  Spend your time on growing the business, rather than advertising accomplishments.

Truth: I would prefer that companies simply issue a 10-Q or 10-K, and do not hold a conference call for analysts.  Just give us the data, and let us analyze it.

Let the analysts do their work, and don’t answer their phone calls.  Create a genuine level playing field where no one gets to talk with management unless everyone is invited to listen.

I realize this is radical, but I am trying to be genuinely fair, which does not happen often on Wall Street.

Disclaimer


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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