I’ve worked for years to take the emotions out of my investment processes, with some success.  Where it gets tough is when I am in an absolute and relative drawdown, as I was for most of the second half of 2007.  Nonetheless, I stuck with my disciplines.  This week, a lot of things went right:

• Retail
• Insurance
• Trucking
• Energy
• Small cap value was the best style

Will this persist?  Who can tell…  I was ahead of the Russell 2000 Value index this week, even though my portfolio is more midcap value in nature.  I’m still wrestling with where to deploy incremental funds.  I’m 2-3 positions light at present, and I know I am already insurance-heavy, with many of my best candidates being insurers, and the rest Irish Banks.  I don’t want to get too heavy in financials… I’m overweight there now.  Ideas are welcome.  Oh, at the end of the day I did make a small purchase:

		David Merkel
		Rebalancing Buy
		1/25/2008 4:02 PM EST

Bought some Gruma, SA into the close. Tortillas and other Mexican foods are not going out of style, even if the Mexican stock markets are having difficulty of late. I’ve had a good week. Hope you did too.

Position: long GMK

The market always has a new way to make a fool out of you, so I am not relying on a change in the financial weather here.  I just keep doing what I do best.

Full disclosure: long GMK

I didn’t feel well today, but my broad market portfolio did better than me. I probably could not have picked a worse day to do my reshaping, but here are the results:

Sales:

• Aspen Holdings
• Flagstone Reinsurance
• Redwood Trust
• Mylan Labs
• Lafarge SA

Purchases:

• Reinsurance Group of America (old friend, cheap price)
• Honda Motors

Rebalancing Buys:

• Valero
• ConocoPhillips
• Vishay Intertechnology

Rebalancing Sale:

• Deerfield Capital

I’m not done. My moves today raised cash from 5% to 10%, and trimmed positions from 36 to 33. I have room for two more ideas, and am working on where to place cash. My timing of buys and sells today was good — not that that is a key competency of mine by any means.

Aside from the sale of the reinsurers, which were just cheap placeholders, the other positions were not as relatively cheap as they once were. RGA and Honda are quality companies selling at bargain prices. If I had more names like those, I would buy them all day long.

Away from my broad market portfolio, I raised my equity exposure in my mutual funds fractionally today. Time to rebalance.

PS — I can’t remember another day quite like this, where the late negative to positive move was so pronounced.

Full disclosure: long DFR RGA HMC VLO COP VSH

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.  In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.  Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.  Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.  It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.  This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.  That said, valuations are more compelling than they were, especially compared to Treasuries.  Compared to BBB corporate yields, they are still attractive.  I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

If I did not use a mechanical method for ranking replacement candidate stocks against my portfolio, I would not let so many stocks go onto my potential replacement list. Today I updated my industry model, and here it is:

Industry Groups January 2008

(If you have any difficulty downloading that, let me know. I’ve been having trouble with that.)

From that, I ran a bunch of screens, adding in some technology industries that have been hit of late. Here are the additional tickers that will be added to my candidates list: AMIE ASYT BBBY BC BELM BGFV BIG BNHN BRLC BWS CAB CBR CHRS CHUX CMRG CRH CTR CWTR DBRN DECK DFS DSPG DSW ESEA EXM EXP FHN FINL FRPT FSS GASS HGG HLYS HTCH HZO IDTI IKN IM IMOS JAS JNS KSWS KWD LF LIZ LNY LSI MIPS MRT NSIT NSTC NTY ODP OPMR OVTI OXM PERY PLAB POOL RCRC RENT ROCK RSC RT RUTH SAIA SHOO SIG SMRT SNA SNX SONC SSI TJX TOPS TUES VLTR VOXX ZQK

Now, the mechanical ranking system is supposed to be a simple way of prioritizing value stocks, and typically it does pretty well in directing my attention to the stocks that I should analyze, not necessarily the ones I should buy. That’s true of any screening method, no matter how simple or complex. You always find some companies that look really good initially, but got there because of data errors, accounting mis-characterizations, or a business situation that was vastly different when the accounting snapshot was taken.

Now, after all of this work, I’m only trading 3-4 stocks into and out of my portfolio of roughly 35 stocks. But the idea is to end up with a portfolio with better offensive and defensive characteristics, such that the relative performance will be good, and should the market turn, I will be in the industries and companies with a lot of potential to outperform.

I will admit, I don’t feel much like doing my portfolio reshaping now, even though it is a part of my management discipline, because the portfolio has been kicked around.  Not much worse than the rest of the market, though, and there are some stocks that look interesting that could be worth considerably more three years out.  As you look through my tickers list for candidates for addition, you’ll see a few commonalities:

• Energy (still)
• Industrials (still)
• Retail (now, that’s new)
• Insurers (many still cheap, particularly some stronger operators, also title names)
• Technology (different for me)
•  A few odd real estate names (not likely, but there are some places where values are protected)

So, the process begins.  Within a few days, I’ll run my industry model, and do a few screens off of it, adding a few more tickers.  Beyond that, I invite you to send me ideas as well.  Last time, ideas suggested by readers made up two of the four new names that I bought.  So, send them in, and thanks as always for reading me.

The replacement candidate tickers:   AA ABK ACIW AEO AES AIG AIT ALL APA APL ARM ARO ARW ASGN ATU ATW AVCA AVZA AZ BAC BCS BER BGP BKE BKS BRO BRY CACC CAE CAKE CALL CAMD CBL CCRT CHS CNQ CNX COF COST CQP CRI CRK CRZO CSCO CSG CSGS CSL CTLM DDS DFG DITC DLB DNR DRI DTLK DVN EAT EEP EFII EMC ENWV ESST ESV EXAR EXTR FLEX FNF FNM FRE FSII GCA GLW GPC GS GSIT GSK GW HAS HCC HCSG HD HIG HILL HMC HOC HOG HOLX HPQ IDTC INAP INFN INSP INT INTC IRE ISSI JCG JCP JEC JRT JWN KEM KFT KSS LINE LM LOOK LRW LUV LYG MAN MAS MDC MHK MHP MHS MMC MNST MTSC MTW MU MUR MVC MW MWA NOV  NSH NSR OII OMX ORI OXY PCZ PDC PDE PDII PDS PHLY PNCL PNRA POL PROS PTEN PVSW RAMR RAVN RGA RIG RNIN RNWK SCMR SGP SIMG SKS SKSWS SKX SLXP SNY SPN SSTI SSW STC STI SU SWK T TECH TECUA TEX TGI TLGD TMTA TM TNB TOT TRID TRLG TSO TWB UFS UNP URBN USG VFC VMC VNR VPHM WAG WCG WDC WHQ WLL WSM WSTL WU WWW XL XTEX XTO

PS — Though I don’t feel like doing it, I didn’t feel like doing it in the Fall of 2002 either,and some of my best picks came then.  So, discipline before feelings.

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”  Ergo, the commenters are always right, at least in terms of what they want to read about.  So, tonight I write about benchmarking.  (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.  The idea behind a benchmark is one of three things:

1. A description of the non-controllable aspects of what a manager does.  It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
2. A description of the non-controllable aspects of what an investor wants for a single asset class or style.  It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
3. A description of what an investor wants, in a total asset allocation framework.  It reflects the risk-return tradeoff of the investor.  The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.  The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.  Should he buy it?  Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.  Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.  (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.  Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.  The greater the frequency of measurement, the more index-like performance becomes.  The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.  Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.  Give them the money, and check back in five years.  (The list is illustrative, I can think of more…)

What does that mean for me, though?  The first thing is that I am not for everybody.  I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.  Over a long period of time, I believe that I will beat those benchmarks.  Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.  I think I will beat those broad benchmarks for several reasons:

• Value tends to win in the long haul.
• By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
• By not limiting picks to the US, I can find chedaper stocks that might outperform.
• By rebalancing, I pick up incremental returns.
• Industry analysis aids in finding companies that can outperform.
• Avoiding companies with accounting issues allows for fewer big losses.
• Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
• I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.  In the short-term, I live with underperformance.  Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.  Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM

I thought I did worse this quarter, but I ended up trailing the S&P 500 by less than 50 basis points. That meant that I trailed the S&P 500 for the first year in eight by somewhat less than 1%. So goes the streak.

On the bright side, it happened in a period where growth was trouncing value, and large capitalization stocks were trouncing the small.  My investing style is value-oriented, and all-cap, so I will always be smaller than the S&P.  I did better than value indexes, and better than small caps.  Is this examination of factors an excuse?  I don’t know.  The wind was at my back for the last seven years, and it is in my face now.  What I do know is that I’ve had my share of bad decisions, and I will try to rectify them in 2008.  The next reshaping is coming up soon, and I am gathering my tickers and industries.

But winning big and failing small should be good for anyone. With that, I wish you a Happy New Year.  Let’s make some serious money in 2008, DV.

Just a short post this evening because I’m tired, and not feeling that well. Here is an Excel file containing my industry ranks for year end 2007:

Year End 2007 Industry Ranks

Remember, this can be used two ways. In the short run, the “hot industries,” the ones in the red zone, can be bought if one follows a fast turnover momentum-type strategy. For those of us with lower turnover value-type strategies, we buy industries in the green zone, but insist on quality, and attempt to analyze how transient the industry troubles are likely to be. Note that I’m not looking at all industries in the green zone — areas affected by the housing and finance sectors, for example.

One more brief note, since a couple of readers e-mailed me on this. It looks like the forced sellers of National Atlantic are done. Also, the compensation decisions for the three senior executives give them some compensation if a deal goes through. I’m not smiling on this one yet, and things could still go badly wrong. Use caution here.

Full disclosure: Long NAHC

Cast your bread upon the waters,
For you will find it after many days.
2 Give a serving to seven, and also to eight,
For you do not know what evil will be on the earth.
3 If the clouds are full of rain,
They empty themselves upon the earth;
And if a tree falls to the south or the north,
In the place where the tree falls, there it shall lie.
4 He who observes the wind will not sow,
And he who regards the clouds will not reap.
5 As you do not know what is the way of the wind,^[a]
Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.
6 In the morning sow your seed,
And in the evening do not withhold your hand;
For you do not know which will prosper,
Either this or that,
Or whether both alike will be good. [Eccelesiates 11:1-6, NKJV, copyright Thomas Nelson]

The point of Ecclesiastes 11:1-6 is that the farmer in Spring, much as he might be hungry, and want to eat his seed corn, instead has to cast his seed into the muddy soil, perhaps planting 7 or 8 crops, because he doesn’t know what the future may bring. If he looks at the sky, wondering if it will rain enough, or whether the winds might ruin the crops, he will never get a crop in Summer or Fall.

That’s the way that I view investing. You always have to have something going on. You can’t leave the market entirely, because it’s really tough to tell what the market might give you. Typically, across my entire set of investments I run with about 70% equity investments, and the rest cash, bonds, and the little hovel that I live in. Private equity is a modest chunk of my equity holdings, so public equities are about 60% of what I own. Domestic public equities are about 45%.

I don’t think of that as particularly bullish or bearish. Even with public equities trading at high price-to-sales ratios, my portfolio doesn’t trade at high ratios of sales, cash flow, earnings, or book value. Together with industry selection, modest valuations provide some support against bear markets.

My tendency will be if the market moves lower from here to layer in slowly using my rebalancing discipline. That’s what I did in my worst period 6/2002-9/2002, and the stocks that I held at the end were ideally positioned for the turn in the market.

So, I never get very bullish, or bearish. I see the troubles in the markets, and I avoid most problem areas, such as in housing-related areas, but I continue to plug along, doing what I do best — trying to pick good stocks and industries (and occasionally, countries.)

Here’s my second video from TheStreet.com on the Federal Reserve.  This one is on where to invest from an equity standpoint.  There are two areas to look at.  Companies that benefit from:

• Lower borrowing rates
• Higher inflation

In the first category are healthy financials, and companies with the flexibility to borrow short-tern and buy back stock.  I highlighted insurance companies in my video, but this could apply to other financials and yield-sensitive companies, so long as they don’t face any significant fallout from housing and housing finance.

In the second category are companies that are exporters, and companies where the global prices of their products will rise in dollar terms, while their inputs stay relatively fixed.  This would include energy and most commodities.

Bonds were not a topic of discussion, but I still favor foreign, high quality and short-to-intermediate bonds for now.