A reader sent me the following question:

Hi David, this is shall be link to your impossible dream part 2 question.

You mention in the article date May13 that we are probably at #4 part of cycle (looking back great called) Where are we in the part of the cycle? ( I would assume we are in #5) if that is the cast..why you added large 5 of your cash in this sell off? (for trading or for investing) Hope I am not asking too much since I am not a client, only long time reader whom respect your opinion.

Here’s the article he was referencing.  There is a tension between my equity management and the switching strategy I proposed in the first Impossible Dream question.  If we are in a market where we should be allocating asset to safe areas, why am I buying more equities here?

It’s a question of time horizon.  The switch model tells you what will do well for the next month.  I am playing for longer horizons.  That’s why I have my seventh portfolio rule:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

My best purchases occur in bear markets.  I buy things that are safe but way out of favor, and they rocket back when the market finally turns.  That adds a lot to my alpha, which is more than the advantage of switching, historically.  That’s why I average down in bear markets, if the thesis behind the investments is still valid.

As for what phase we are in, I would say 5 or 6. Cycles aren’t neat.  In this case, we don’t have a lot of defaults, but we do have a lot of negative momentum in equities. In four months we have moved from top momentum, top valuation, to bottom momentum middling valu1ation.  That is pretty deep in the don’t buy stocks region, but it often offers the best opportunities to long only investors, if one is buying for three years, rather than one-to-six months.

So I continue to buy equities that are attractive, even in a market where bonds might be favored in the short run.  As for my clients, it is a question of investment horizon.  Short-term: bond strategy.  Long-term: equity strategy.

In general, I aim for the long term.

Many fundamental investors have been shaped by Peter Lynch.  Invest from the bottom up.  Analyze companies, not the economy. Time spent on analyzing the economy is wasted time.

This book takes the opposite approach.  If you understand the economy, and think you know how GDP growth and inflation will go, you have a better chance of choosing the right industries and outperforming.

Like my methods of investing, he looks to understand where we are in the business cycle.  After that, look for good companies that exploit the tailwind.

I became familiar with the main author in the mid-2000s, when he worked for ISI Group.  I appreciated his approach to the markets, which was similar to mine, as the bubble grew, and he and I warned about it.

Think of it this way.  If you had been reading the main author in mid-2006, and had listened to him, how much better off would you be now?  Considerably better off and I offer many warnings over at RealMoney.com before the crisis emerged.

The book will help you understand the sectors and factors in the market that affect returns, and what elements lead those returns.

Beyond that the book expresses skepticism over many of the current economic policies of the US and other governments amid the overindebtedness of much of the world.

At the end, rather than saying, “This is what you should do,” the book asks what your views are, and says if you believe in “such and so” as an economic future, this is what you ought to do.

I liked the book a lot.  I think it is of value to most fundamental investors.

Quibbles

None

Who would benefit from this book: Most fundamental investors could benefit from this book.  If you want to, you can buy it here: The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground.

Full disclosure: The publisher sent me a copy of the book for free.

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.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and to a lesser extent Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word about reinsurance: I suspect this year will have yet more property catastrophes, particularly from hurricanes.  A lot of flexible capital has rolled into Bermuda over the last few months, so I would be disinclined to play too heavily there until late in the year.  There’s too many financial players that think there is easy money to be made in reinsurance after the recent spate of catastrophes, but that added capital is eliminating any hard pricing environment that might have emerged.  Maybe if they take losses later this year, capital won’t flow so freely for a while… I can dream.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

That’s why I’m not digging through any red zone stocks this time.  I don’t see the value, especially if we have a slowdown globally, and/or in the US.  I don’t trust this economy.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I like technology names here, some utilities, and healthcare-related names, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech, though I can never find companies that I can understand.

Even in a double dip, phone calls will still be made, and the internet will still be accessed.

I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

That’s why I’m not digging through any red zone stocks this time.  I don’t see the value, especially if we have a slowdown globally, and/or in the US.  I don’t trust this economy.

Every 100 posts, I take a step back, and think about where we have been.  My, I have been a busy bee.  And I have blogged more than usual over the last three months.

In the recent past, I have completed my “Flavors of Insurance” series.  I also wrote a series on investment modeling.  And I wrote a complete series on my eight portfolio rules.  I have created a book review database that I will continually update.  And in this time I have given two talks, one to the Society of Actuaries at their Annual Meeting, and one to the CFA Society of Denver, together with the Leeds School of Business at the University of Colorado.  Add to that my two award winning articles that I mentioned yesterday.  And this is in the midst of this, I have written more than ever.

Now as an aside, do you know who I am happy for?  Trader Mark.  I am glad that he has gotten enough subscriptions that he can start his mutual fund after the SEC okays it..  He seems to be a bright guy, and I wish him all the best.  He has more than $10 million of commitments.  Good for him, and I hope it grows from there.

As for me, by the end of January 2011, I have no idea how much I might be managing, it could be as small as $3 million, or over$10 million.  Many people have indicated interest, but the test is how many commit.  I won’t be disappointed if I hit the low end of the range, but I would not be surprised if I hit the top of the range, or exceed it.

What I am Doing

Because of many questions from readers, I want to give a brief description of what I am doing.  There is some confusion over what I do, because I have been a bond manager, and a lot of my investing is informed by conditions in the bond market.  I follow a lot of markets, because they are related, and knowledge of the whole sharpens understanding of particular markets.

But I invest in stocks.  Mostly stocks in the US, with a value orientation.  I rotate industries, as I have often written about.  I run a concentrated portfolio of 30-40 stocks.  I adapt to market environments.  Markets are very difficult to time, but if you are in stocks that have a margin of safety, a cheap valuation, and the industry is experiencing an increase in pricing power, it is hard not to earn good returns over time.  The rest is summarized in my eight rules.

The ideal here is to give investors a clone of my portfolio through separately managed accounts.  Each account has its own portfolio, which can then be be managed for tax purposes, unlike a mutual fund.

I am offering taxable accounts, IRAs, and other tax-deferred accounts.  I am not afraid of being called a fiduciary under ERISA standards, because I manage all money to those standards.

I am also offering market-neutral management of assets for taxable accounts, at no more cost than long only.  And, my fees are not high — 1% on assets between $100,000 (minimum size) and $1,000,000, 0.5% on assets over $1,000,000.

As it stands, next week I am going to start inviting those that have already contacted me to open an account at Interactive Brokers, and will send them a package of other materials via e-mail to complete the deal.  After that, I manage their money on a discretionary basis, mirroring my own trades.  I get the same execution levels as my clients.  We all trade together.  I will eat my own cooking, and at minimum 50% of my liquid assets will be invested in my strategies. At present, it is 80%+.

Aside from that, I have minimized the cost of trading by using Interactive Brokers.  Particularly for smaller accounts, it is the best solution.  Using Interactive Brokers means investors get cheap trades, while I pay fees to access market data.  Those costs get paid by investors through higher commissions in many other situations.  I bear those costs here, and I do not take soft dollars.

I start my investment management practice in early January.  I am really encouraged by this, and look forward to serving my clients.

What Remains

These are the few things I need to get done before I start:

1. Compliance Strategy, Including Web Compliance Strategy, CFA Document Retention
2. Procedures for suitability – CFA notes on such to guide
3. Investment Policy Statement

I have the data together for most of these, though I have a question for those that manage equity money for clients through separate accounts.  What do you do on suitability?

What I need to get done will get done next week, and I will start taking client assets in 2011.  I thought of doing this in 1996 and 2003, but did not do it because I did not have enough assets of my own to buffer me if it did not work.  Now I can do it, and last for many years.

Those who inquire of me can see my 10-year track record.  I’ve done well, but that does not mean that I will do well in the future.  But I will do my best for clients.

The Blog

There are some that worry that I will stop blogging.  That is not my plan.  If I could write at RealMoney while working for a hedge fund, I can blog under the same rules with separate accounts.

But some things will change.  I will delete my portfolio at Stockpickr.  Only clients will know my full portfolio.

I don’t have any public stock positions other than what is in my portfolio.

Aside from the market-neutral accounts, there are no derivatives.  And I will let client know whether I am market neutral or long only, or a percentage thereof, before I do it.  Right now I am long only.

I will not write as much about portfolio management, at least on a detailed basis.  I will provide more detailed information on portfolio management issues to clients.

Thanks

One thing I have strongly believed since starting my blog — my readers have alternative uses of their time.  I thank them for taking time to read me.  I am humbled by the large reception I have received over the  years, and thank those that take their precious time to read me.

Soli Deo Gloria

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I like technology names here, some utilities, and healthcare-related names, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, phone calls will still be made, and the internet will still be accessed.

I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

This report I will continue to publish after my firm commences operations at the start of 2011.  But I will delete my portfolios at Stockpickr.com, and will only report trades after all of my clients have their orders filled.  More to come on all of that.

Here are the eight rules with links to my recent pieces:

1. Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.
2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.
3. Stick with higher quality companies for a given industry.
4. Purchase companies appropriately sized to serve their market niches.
5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
6. Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
8. Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

For the most part these are rules that would only serve a value investor.  They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which  rules 7 and 8 spell out.  The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors.  Value traps are companies that are cheap, but cheap for a reason.  How do you avoid value traps?

• Try to have industry factors working for you (Rule 1)
• Look for companies that still have some room to grow (Rule 4)
• Avoid companies that are aggressive in their reporting of income (Rule 5)
• Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together.  They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

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This is the end of the “Portfolio Rules” series.  From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Let me begin with the last part of the rule.  I’ve gotten different reactions over the years from holding 30-something names my portfolio.  From some friends who run concentrated hedge funds they say, “Why so diversified?”  From those that run mutual funds they say, “Why so concentrated?”

Since I concentrate industries, owning 30 to 40 names my portfolio is relatively undiversified, compared to an index fund.  My view is that industry performance is the main driver of stock performance.  I also think that owning industries in proportion to the index is a recipe for mediocre performance.  If you don’t break free from the industry weights of the index, you will never achieve index beating performance.

Now, some may criticize the idea that I don’t know what my best ideas are.  Good, go ahead and criticize.  My experience has been that ideas that I thought were marginal often did quite well and ideas that were highly promising sometimes did marginally.  On the whole I think there was some rough positive correlation between how well I thought it would do, and how it actually did, but not enough to make me change this rule.

I do occasionally make a name for my portfolio a double-weight, or once even a triple-weight, but those are rare.  To have a high weight in my portfolio means that it must be exceptionally cheap, and be exceptionally safe.  In other words, it must be very, very, misunderstood.

At present I have 34 names my portfolio.  Ordinarily I like to have 35.  But, I don’t change the number rapidly.  I have a greater tendency to raise the number when the market is cheap, and I add equity exposure.  That said, during the bear market from 2000 to 2002, I decreased the number of names as the selloff got worse, concentrating into the names that got hit the hardest that still deserved to be invested in.  As the market began to rise, I added to the number of names that I invested in.

Keeping the number of names relatively fixed in the short run helps to facilitate swap transactions.  Swap transactions are a more intelligent way of managing an equity portfolio, because people are reasonably good at doing binary decisions, and not at doing decisions that have a lot of degrees of freedom.

I can’t tell you at any given point in time that I have the best set of stocks in the world.  But, it is relatively easy for me to look at the stocks that I am buying versus the stocks that I am selling, and conclude that I am coming up with a better portfolio as a result.  More on that when I discuss portfolio eight.

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Now, on to rebalancing.  I have gotten some criticism over the years, arguing that my rebalancing discipline leads me to pump money into losers that lose yet more.  Part of the misunderstanding is that when a stock falls by 20%, it doesn’t trigger an automatic buy, but an automatic review.  If my review comes the conclusion that the stock is fundamentally okay, then I rebalance up to the target weight.  I don’t double the position; that would be lunacy.  I only add to bring it up to target weight.  This is a moderate and disciplined way to buy weakness.

If my review finds that I made a fundamental mistake, I sell the position out.  Now, all that said, my worst losses typically came from cases where I rebalanced down and rebalanced down, and never caught the fundamental error.  Hey, I’m human.  But I can say that my gains more than paid for my losses.  Also, most of the companies that hurt me had balance sheets that were less strong then I thought.

When I was on the other side of the table, choosing investment managers, I ran across three managers with excellent track records that used this strategy.  They felt that it added on 1-3%/year.  Surprisingly, one was a growth manager, one was a core manager, and one was a value manager.

My sense is this: markets oscillate, and performance by industry and company oscillates.  This simple strategy catches some of those oscillations, buy low and selling high.

It also helps portfolio management from a psychological standpoint, because you realize that by realizing gains partially, and buying lower selectively, you don’t care so much about day-to-day fluctuations.  Rather, you realize that on average, fluctuations are working for you, and so, you focus on fundamentals, not the noise.

At least, that is what I have experienced.  And that is why I rebalance.

I find myself in a different mindset, as I labor to start Aleph Investments, LLC.  I find myself both optimistic and fearful.  Optimistic, because this is what I’ve wanted to do for a long time, and I see the pieces coming together.  Fearful, well… I’m intellectually honest enough to know that even though I’ve done well over the last 10 years that may have no bearing over the next 10 years.  My greatest fear is that I start this business and I don’t do well for those who invest with me.

In the last week I’ve received confirmation from the state of Maryland that my LLC has been approved.  I have gotten my employer identification number from the IRS, and filed form 2553 to elect taxation as an S Corporation.  I have also begun filing with the state of Maryland and FINRA to register my investment advisory.

My next main task, while I am waiting for the state of Maryland to approve my filing, is to choose a clearing broker will be the custodian of funds for my clients.  I have five possible custodians that are willing to work with startup registered investment advisors.  This week I will send out some sort of RFQ to the five.

Beyond that, it’s time to get accounting and tax software for my firm, business cards, and help from someone who can help me in compliance matters, given that I would like to keep this blog not shut it down.  This blog is my greatest marketing asset, and yet my greatest compliance challenge.  Almost anything that an investment advisor might write on the web is regarded as advertising, even comments at someone else’s blog.  Part of the problem is that the rules regarding communications on the Internet for investment advisors are fuzzy to nonexistent.  If yhou have ideas, e-mail me.

To my readers: I want to keep this blog going.  Writing this blog allows me to do several things:

• My first purpose was to give back to the general community.  If you have been given a gift, you should do some pro bono work.
• Yes, to some degree, it does make me better known.  That is a help in attracting clients, but that wasn’t my first goal in starting this blog.
• I like writing.  I like writing about economics, business and investments.  I enjoy being a bit of an iconoclast on economics.  I think business and investments are one of the greatest games in the world, and I like writing about it.  Even more, I enjoy playing the game.

So, I don’t want to lose the blog.  That said, if I can’t find a good compliance solution, I will sacrifice the blog for the good of the business.  My guess is that the odds are low that I will have to sacrifice the blog, so don’t worry.

Anyway, that’s what I’m up to.  If you want to talk to me about any of this, just e-mail me.

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With that, here’s portfolio rule number four:

Purchase companies appropriately sized to serve their market niches.

A short rule, a simple rule – what could be better?  The basic idea here is to purchase companies that have room to grow, or have some sustainable competitive advantage that allows them to prosper in the market niche that they occupy.

Sustainable competitive advantage is an important concept.  If you read the works of Warren Buffett, he talks about a concept that he calls “a moat.”  The idea is, what does a company uniquely have that would be difficult for competitors to reverse engineer?  Granted, almost anything can be reverse engineered with enough money to do so, but that’s the game.  Is it worth a competitor’s time to spend that much money?  Will the business still be as profitable even if they do reverse engineer you?

Let me give you a more plebeian example.  The restaurant chain Applebee’s had a strategy of setting up restaurants in small towns.  They looked for places that did not have a dominant restaurant, and where the town was big enough to support one restaurant, but not two.  The size of the town was Applebee’s “moat.”

In investing, what you don’t want is a company so big in its niche that it cannot grow, unless the pricing of the equity is such that it resembles a junk-bond yield.  Also, you don’t want a small company that can’t compete against larger rivals.

Ideally, you want to find a management team that understands its competitive advantage and maximizes it.  I have found that many times in the last 20 years, and when that happens, it is a thing of beauty.

This rule is a little more squishy than the others.  There is a decent amount of qualitative judgment that must go into analyzing the competitive structure of the industry the company is in.  That doesn’t make the rule invalid.  Rather, I think that the average investor, unlike Peter Lynch, has the capacity to analyze industry trends and come to a correct decision on trends in pricing power.

Anyway, that’s rule number four, which can be otherwise summarized as pay attention to sustainable competitive advantage.

PS — for a set of articles I wrote three years ago on this topic that were a hit, please visit this page.

One side benefit of deciding to start up Aleph Investments, LLC, is that it is forcing me to write out articles on my rules.  When I was writing for RealMoney.com, I wrote a number of articles about my eight rules, but I only wrote about four out of the eight rules.

Before I write about rule number three this evening, I would like to bring you up to date on what I am doing with Aleph Investments, LLC.  This past week I incorporated the business, and in this coming week.  I will be registering as an investment advisor.  I will be managing equity money, on both a long only and hedged basis.  I have yet to choose a custodian and clearing broker, but I am working on this.  Given the state that I am domiciled in, Maryland, there may be delays but I suspect I’ll be up and running by late November or early December.

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Let me give you a little history of how the eight rules came to be.  In 2000, I had an e-mail discussion with Kenneth Fisher.  I explained to him what I had been doing with small-cap value, and how I had done well with it in the 90s.  He told me to forget everything that I’ve learned, especially the CFA syllabus, and look for the things that I can do better than anyone else.  We exchanged about five or so e-mails; I appreciate the time he spent on me.

So I sat back and thought about what investments had worked best for me in the past.  I noticed that when I got the call right on cyclical industries, the results were spectacular.  I also noticed that I lost most when investing in companies that didn’t have good balance sheets, no matter how “cheap” they were in terms of valuation.

I came to the conclusion that size and value/growth were not the major determinants of my investing success.  Instead, industry selection played a large role in what went right and wrong with my investment decisions.  So, I decided to formalize that.  I would rotate industries with a value bias.  But that would have other impacts on how I invested.  One of those impacts is rule number three.

I formalized the first seven of the rules in 2002, when the strategy was two years old and seemingly performing quite well.  I began doing what rule number eight states sometime in 2004, and reluctantly added it to the seven rules sometime in 2006.

With that, on to rule number three:

Stick with higher quality companies for a given industry.

There are three simple reasons for why rule number three works:

• First, companies with lower debt levels within a given industry tend to be more profitable than companies with higher debt levels that industry, contrary to what the Modigliani-Miller theorems state.
• Second, many investors, both retail and professional, have a bias toward what we might call “lottery ticket stocks.”  Many people swing for the fences in the stocks that they buy and accept high risks in order to achieve a high return.  On average, this strategy does not work.  In general, buying high beta, high volatility stocks is a recipe for disaster and buying low beta, low volatility stocks tends to earn money better than the market averages.
• Third, if you are rotating industries, there are two ways to do it.  These two ways are not mutually exclusive, you can have part of your portfolio in one strategy and part of your portfolio in the other.  Method one is to look for trends that are clearly going on, but that the market has not fully discounted.  In this case, one can buy companies with excellent or good balance sheets because the trend will carry you along.  Method two is to look for industries that are sick but not dead.  In that case, you only select companies with excellent balance sheets.  This is how it works: if the industry remains sick, weaker competitors will be destroyed, capacity will exit, and pricing power will return to the survivors.  If the industry’s pricing power suddenly improves, then all of the companies industry will do well.  The one with the excellent balance sheet will outperform the market as a whole.  That the ones with poor balance sheets do even better is not a concern.  The idea is to avoid losing money; don’t take the risk by buying the “lottery ticket stock.”

For what it is worth, this same idea not only works with stocks but it works with bonds as well.  If you read the book Finding Alpha, the author has an extensive discussion on why high quality bonds outperform low-quality bonds over the long haul.  In general, corporate bond investors underestimate the costs of default risk.  BBB bonds do best, followed by AAA bonds, and then other investment grade bonds.  After that, the lower the rating of the bond the worse they do.

The same is true of stocks, which is why it pays to look at where the market is in its liquidity cycle.  In November of 2008 through March of 2009, it made a lot of sense to buy junk bonds, and I did so for my church building fund.  Though I didn’t say it at the time and did not act on it, it was also in hindsight the right time to buy junk stocks.  Oh well, that’s water under the bridge.  I tend not to take the risk of buying junk stocks because I don’t want to lose money.  I did well enough by adding to more cyclical names that had strong balance sheets.

Two notes before I close: first, industries tend to have preferred habitats.  In other words, typically the difference between the company with the best balance sheet the industry and the company with the worst balance sheet industry is not all that great.  Why is that?  If you’re in the same industry, typically you have similar levels of fixed costs versus variable costs, and you face the same levels of variability in sales.  These two factors together will lead an industry to a preferred level of financial leverage.  But even though the difference might not be that much between the company with the best balance sheet and the worst balance sheet within the industry, when pricing power is weak that small difference is significant.

Second, I am a proponent of “good enough” investing.  What I am saying here is that it is very difficult to achieve optimal results, and that if you try too hard to achieve optimal results, it is likely that you will do worse than good enough results.  The demands of perfection kill.  Size your goals to what is humanly possible.  My methods allow me to sleep at night.  My methods allow me to step away from my computer, and spend time analyzing what really might matter.  I can go visit clients and not worry that something is going to blow up on me.

This is not laziness on my part.  It is my view that most investors can do well enough in investing at low to moderate levels of risk.  But at high levels of risk, you have to get too many things right too much of the time in order to succeed.

That’s all for now.  Back next week when I write about rule number four.