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The Best of the Aleph Blog, Part 25

Tuesday, July 29th, 2014

In my view, these were my best posts written between February and April 2013:

Wall Street Hates You

I have a saying, “Don’t buy what someone wants to sell you. Buy what you have researched.”

And so I would tell everyone: don’t give brokers discretion over you accounts, and don’t let them convince you to buy unusual bonds, or obscure securities of any sort.  By unusual bonds, I mean structured notes, and eminent men like Joshua Brown and Larry Swedroe encourage the same thing: Don’t buy them.

The Education of a Mortgage Bond Manager, Part III

Why being careful with credit ratings is smart.

The Education of a Mortgage Bond Manager, Part IV

Be wary of odd asset classes; they are odd for a reason.

The Education of a Mortgage Bond Manager, Part V

Where I do odd things in order to serve my client.

The Education of a Mortgage Bond Manager, Part VI

The Education of a Mortgage Bond Manager, Part VII

The Education of a Mortgage Bond Manager, Part IX

Odd stuff, but particularly insightful into some of the perverse dynamics inside investment departments.

The Education of a Mortgage Bond Manager, Part VIII

How I led the successful effort to modify the Maryland Life Insurance Investment Law, and acted for the good of the public.

The Education of a Mortgage Bond Manager, Part X (The End)

Where I explain the odd bits of being portfolio manager, while succeeding with structured bonds amid difficult markets.

Berkshire Hathaway & Variable Annuities

I explain the good, bad, and ugly off of Berkshire Hathaway’s reinsurance deal with CIGNA.

Advice to Two Readers

Where I opine on some Sears bonds, and also on flu pandemic risk at RGA.

What I Would & Would Not Teach College Students About Finance

Mostly, I would teach them to think broadly, and realize the most of the complex investment math is easy to get wrong.

My Theory of Asset Pricing

My replacement for MPT using contingent claims theory.

On Insurance Investing, Part 4

On finding companies with conservative insurance reserving

On Insurance Investing, Part 5

On the squishy stuff, where there are no hard guidelines.

On Time Horizons

People shorten and lengthen their time horizons at the wrong time.

The Education of an Investment Risk Manager, Part IV

On two odd situations inside a life insurance company.

The Education of an Investment Risk Manager, Part V

On how we replaced a manager of managers.

Value Investing Flavors

Explains how there are many ways to do value investing.

Classic: Using Investment Advice, Part 1

Classic: Using Investment Advice, Part 2

Classic: Using Investment Advice, Part 3

Classic: Using Investment Advice, Part 4 [Tread Warily on Media Stock Tips]

Understand yourself, understand the advisor, understand the counsel that is offered, and finally, we wary of what you here through the media, including me.

Classic: Avoid the Dangers of Data-Mining, Part 1

Classic: Avoid the Dangers of Data-Mining, Part 2

There are many ways to torture the data to make it confess what you want to hear.  Avoid that.

Classic: The Fundamentals of Market Tops

Where I explain what conditions are like when market tops are near.

At the Towson University Investment Group’s International Market Summit, Part 5

Where I answer the question: Where does academic theory fail in finance and in economics?

Classic: Separating Weak Holders From the Strong

Classic: Get to Know the Holders’ Hands, Part 1

Classic: Get to Know the Holders’ Hands, Part 2

Articles that explain the fundamental  basis that underlies technical analysis.

Classic: The Long and Short of Trend Investing

How to play trends without getting skinned.

Full Disclosure: long RGA and BRK/B

Of Faith and Markets

Monday, July 28th, 2014

Here’s another letter from a reader.  If reading about my faith turns you off, stop reading now, because this will be thicker than usual.

Hi David,

 I’ve just started reading your blog, and greatly enjoy it. I noticed you integrated your faith with your perception of the world and economics/policy. I am a Christian who is attracted to the wonder of the financial markets. So many individuals making so many decisions being affected in so many ways; it can be overwhelming. My question regards how you view financial markets within your faith.

 I was originally going to work at an internship at a hedge fund in 2008. I thought it’d be the dream: making big money! But that summer, when all hell broke lose, the hedge fund closed down before I could even start. Fast forward six years, and I’m working in corporate finance at a non-financial company – nothing to do with the markets. I want to jump back in, but not as a trader. I feel there was some Divine Providence in how I’ve perceived my “close call” with the trading world. I’m currently trying to understand how I can approach careers involving the financial markets that don’t force me to leave my faith at home. How do you approach the world of finance with your faith?

 Thank you so much for taking the time to read this, and God Bless.

 

Dear Friend,

I went through a similar experience early in my Christian walk, because sadly, I ran into some Evangelicals who denigrated earning money – Evangelical Leftists were more common in the late ‘70s.  Thus, I turned against Finance though I was good at it.  My Master’s thesis anticipated price and earnings momentum, and most quantitative long-short equity hedge funds.  Too bad for me; I aimed at doing development work in the Third World.  As it was, when I figured out that development economics tended to inhibit growth, and its opposite encouraged it, I gave up.  I started a career in finance as an actuary.

When I did that, I realized that I must do many things:

Be a good example to those around me.

  • Be friendly and pleasant to my co-workers.
  • Oppose fraudulent practices.
  • Be honest with those with whom I dealt.
  • Apologize when I sin or make mistakes.
  • Avoid bad language.  That not only means foul language, but also cruel language, even if it is technically clean.
  • Work hard.
  • Learn, learn, and learn.  A dirty secret about Evangelical Christians is that we read more than non-Christians, and have more Ph.Ds per capita.  Okay, the Jews have us beat there, and badly.
  • Avoid working on the Lord’s Day [Sunday].
  • Don’t be afraid about using the Bible as an analogy or as an example.  After all, people cite all manner of garbage as authorities, and the Bible is not permitted?  Is it because the Bible claims universal authority that people want to ban it?  Yes, that is why.  No one wants the Owner of the Earth to remind us of His claims.
  • I was always honest with coworkers about my faith in moments where it was natural, but I never beat them over the head with it.
  • Love your coworkers, and those with whom you interact.
  • Avoid investments in companies that have sinful goals — gambling, illicit sex, etc.  Also avoid companies that try to cheat people.

Practically, the most important thing is to be honest, keep your word, aim for competence, and be faithful in your dealings with others.

Any vocation can be pursued in a worldly or Christian way – most of it is the attitude that you bring to it.  “Whatever you do, do it heartily, as unto the Lord.”

One final note: one time, I was given a very hard time by a boss who was under a lot of pressure.  Nominally, I was his assistant, and so the rest of the team was amazed with what he put me through, while I largely kept a good attitude (it was not perfect).  One of my co-workers, a Christian, came to me privately and asked how I was doing.  I said that I was fine.  She knew me well, and said that she was praying for me, and that the entire staff was astounded that I would put up with what the boss was doing.  I told her that he was the boss, under a lot of pressure, and that if I pushed back, it could do a lot of harm to all of us.  I was not doing it for me.

It made an impression on the staff, and though they liked me, when the boss left six weeks later, they chose me to run the unit.  Truth, management above chose me, but without their support and love, I would not have been half the leader that I was.

So, serve for the good of others, and you will succeed.  “Love your neighbor as yourself.” [Lev 19:18]

Sincerely,

 

David

On Returns-Based Style Analysis

Saturday, July 26th, 2014

Sometime in the next few weeks, I am going to dig into my pre-2003 [pre-RealMoney] files and see if there is anything there to share with readers.  Most of my best stories I have already told in my various series.  The one I will tell tonight I don’t think I have told.

In 1994, we had a problem at Provident Mutual’s Pension Division.  Our main external equity manager was having a very lousy year as value managers that focused on absolute yield were getting taken to the cleaners.  This was after a few years of poor performance — the joke was, given the great performance of the past, “Hey, can you develop the 19-year track record?”  (The last 5 years as a group were horrid, but the previous 14 were great.)

Aside: there aren’t many absolute yield managers in equities today.  Back when dividend yields were higher, and corporate bond yields were higher, both absolute and relative yield managers flourished as interest rates and dividend yields crested in the early 1980s, and the stocks paying high dividends got bid up as interest rates fell, much as the same thing happened to zero coupon and other noncallable long duration bonds.

The process started with a call from a manager of managers who proposed that we start up “multiple manger funds,” where we would be the manager of managers.

This offered several advantages:

  • It offered us an easy out with our long-held failing manager, because we are not firing them, just making them a portion of the assets in the value fund.
  • It would make eliminating them easier in a second step, with less PR damage.
  • It would make us look like we were taking action and control in a new way for our clients. (They loved it.)
  • As it was, we did a good job selecting managers, and the funds performed well.
  • We could negotiate lower fees with the managers,
  • It gave us a great marketing story.
  • Our margins and growth improved.

I was critical to the process, being the only member of the team with investment expertise.  Everyone else was a marketer or the divisional head.  (I take that back, one member of the marketing area was genuinely sharp with investments.)  After we chose the managers, I set the allocations.

Now onto tonight’s topic (what a long intro): At the beginning of our relationship with the manager of managers, they did a traditional holdings-based analysis of how a manager managed assets.  About one year into the process, they introduced returns-based style analysis.

Though the Wikipedia article just cited has a bevy of errors, it will still give you a flavor for what it is.  Let me give my own explanation:

It takes a lot of effort and wisdom to look at quarterly portfolio snapshots and analyze what a manager is doing.  You almost have to be as wise as the manager himself to analyze it, but many fund analysts developed the skill.

But returns-based style analysis offered the holy grail: we can understand what the manager is doing simply by comparing the returns of the manager versus returns on  variety of asset indexes, using constrained multiple regression.

The idea was this: the returns of a manager are equal to his alpha versus a composite index that best fits his performance.  Since we were dealing with long-only managers, the weights on the index components could not be negative.

The practical upshot to the manager of mangers was: “Whoopee!  We can analyze every manager under the sun just by looking at their return patterns.  No more time-consuming work.”

After the first meeting with the manager of managers, I expressed my doubts, and asked for a special meeting with their quants.  A week later, I had a meeting with a few members of their staff, of which one was the quant, a nice lady 10 years my junior, who I felt sorry for.  She started her presentation at a very basic level, and asked “Do you have any questions?”  I asked, “Isn’t this just an quadratic optimization problem where you are choosing weights on the convex hull?”  She paused, and said, “Oh, so you *do* understand this.”  The meeting ended son after that — we agreed on the math, and in math, there is no magic.

But that placed me on the warpath; I genuinely felt the advice we were getting had declined in value.  I wrote a 16-page report to our manager explaining why returns-based style analysis was inferior.

  • There is no way to correctly estimate error bounds, because of nonlinear constraints.  (Note: two years later, I guy came up with an approximate way to do it in an article in the Financial Analysts Journal.  I called him, and we had a great talk.  That said, approximate is approximate, and I haven’t seen any adopt it.)
  • Because many of the indexes are highly correlated with each other, small differences in manager returns make a huge difference in the weight calculated for each index.
  • If a manager is changing investments because he senses a factor like market cap size or valuation is cheap, it will get interpreted as a change in his index, and will not come out as alpha, but as beta.
  • If I don’t believe that the CAPM and MPT are valid, why should I believe this monstrosity?
  • And more… I hope I find my 16-page paper in my files.

After six more months we terminated the manager of managers, and hired a better one.

  • Lower fees
  • Lower fees from managers (they had greater bargaining power)
  • We reduced our fees to clients
  • Better marketing name
  • Holdings based manager analysis

After that, things were much better, and we continued to grow.

My years at Provident Mutual were exceedingly fruitful — this was just one of many areas where my efforts paid off well.

All that said, there is no way to fix returns-based style analysis.  It is a bogus concept and needs to be abandoned.  Those who use it do not grasp the limits of econometrics, and are Sorcerer’s apprentices.

PS — Need I mention that the originator of the idea, Bill Sharpe, is not all that sharp with econometrics?  He’s a bright guy, but it is not his strong suit.

PPS — there are not many actuaries with a background in econometrics.  That is why I have written this.

Balancing Quality Against Valuation

Friday, July 25th, 2014

A letter from a reader:

Hi David,

I am XXX, from India. I started reading your blog since few months. Few of the things i learnt, and much more are really complex for me to understand, the learning is ON.

Somehow i decided that ” being good value investor and control the behaviour” is a gift of long practice and learning. So it takes time and for me the learning is still in lower phase. I am in middle of understanding Financial statements.

But before that i want to invest and enjoy the power of compounding. Till now i used Mutual Fund, Fixed Deposit (bank) for my wealth creation. As part of my milestone, i want to go ahead with shares for my Kids education and retirement.

I like to Buy Consumer staples like Nestle india, Gillete India, Glaxo Smith india which are past compounders. Given a India’s Economic growth and Population growth, I foresee these socks can do well. But it is already at very high PE (Nestle – 42, GSk consumer- 39, GSK pharma – 52, Gillette -141). I don’t foresee any panic selling on these stocks. What i will do? how i do buy Quality business with good valuation?

Kindly guide.

thanks for sharing such wonderful posts.

Dear Friend,

You have described the optimal situation: buy businesses that have well-protected boundaries, and buy them cheap.  I wish I could do that.  Everyone would like to do that.

But that is where judgment comes in.  I would rather own cyclical businesses with competent and honest management  teams, than own high growth businesses at very high multiples of earnings.  I would also rather own slow growth businesses at modest multiples of earnings.  Ask yourself: where am I getting a reliable stream of earnings and growth relative to what I am paying for the stock?

In general, with growth stocks, never pay more than 2 times the earnings growth rate  for the P/E of the company.

Often you have to look at companies that are neglected, and I would like to recommend a book to you: Investing in India.  The author avoids highly valued companies in India, and aims to invest in companies that are fair to outside minority, passive shareholders.

Look at more stocks than just the highest quality stocks, and look at the valuation tradeoff between highest quality stocks, and lower quality stocks.  Most value investors accept the lower quality stocks, if their ability to produce value relative to their price is better than that of higher quality stocks.

All that said, part of the question is how long will the high quality stocks have a significant advantage.  In the US, on average, that advantage has not been long.  Maybe things are different in India, but maybe not.  Be careful.  Remember, the cardinal virtue of value investing is having  a margin of safety, not cheapness.

Sincerely,

David

Book Review: Reducing the Risk of Black Swans

Thursday, July 24th, 2014

71e0AKDi3XL This is a very short book. I read the whole thing in 40 minutes.  It has one main idea: what if you could create a less variable portfolio that returns as much as the traditional 60% S&P 500, 40% Barclays Aggregate blend?  Wouldn’t you want that?

Most of us would want that.  I would want earning more at the same level of volatility as the market, but that is another matter.

The authors take us through a variety of backtests, showing us portfolios that did well in the past, if you had invested in them.

They show how investors could have done better by tilting their portfolios toward value socks, small stocks, and international stocks, eventually showing a portfolio invested 60% in 5-year Treasuries, and 40% in stocks that tilt small, value, and international.

Voila! Same returns, with less volatility than the 60% S&P 500, 40% Barclays Aggregate blend.

But there is a catch here.  This is the past being amplified — will the future be the same?  Value stocks are undervalued on average, and small stocks outperform on average, but what if you are in an environment like now, where small stocks are overvalued, value is neutral to undervalued?  Tilt to value, yes, but maybe don’t tilt small.

Also, with yields so low on five-year Treasuries at 1.65%, that should be reflected into the future for the strategy, so maybe the amount of bonds should be reduced?

The biggest weakness that the book has, and this is true of many books, is that it follows a mean-variance framework.  The market is far more volatile than a normal distribution, with crises happening far more frequently than a normal distribution would anticipate.

Quibbles

Investing is not a science; it is an art.  Our principles are vague and subject to many forces beyond our recognition and control.

They make the rookie mistake of describing the calculation of long-term investment returns as a arithmetic mean (Page 16).  Pros do a geometric mean, which calculates the continuously compounded average return of a buy-and hold investor.

On page 18, their explanation of correlation is weak.  That said, even great publications like The Economist have blown that in the past, then using my explanation of correlation verbatim (back in the mid-90s).

Summary

This is a good book as it teaches you to tilt you portfolios to value and small companies on average.  The person who would benefit most from this book is someone who wants to get more out of his investments, but doesn’t want to spend a lot of time on it.  If you want to, you can buy it here: Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

A Letter from a Young Investor

Saturday, July 19th, 2014

Before I get to the letter, I recommend reading, You’re Ready for Retirement, but Your Savings Aren’t by Jonathan Clement, if you have access to the Wall Street Journal.  Main point: if you can work until age 70, do that, and then retire.

Here’s the letter:

Hi David,

A little background about myself.  I am a 24-year male, and have been working for a little over a year.  The only knowledge I have on investing is passive index fund investing through the book Bogleheads.  I don’t really look at my holdings other than to re-balance every year.

I am currently investing for retirement by maxing out a RothIRA, maxing out a 401k  (that allows a Brokerage account) and some in a taxable Vanguard index fund.  My holdings consist of the total stock and total bond market index funds (90/10). From my current positions my portfolio return has been 20.6%. I calculated the return by return = (market_change + dividends) / total_money. I don’t know if this is a correct formula. The time frame of my holdings is from Jan2012 – June2014. 

I went to a finance workshop that my church was hosting and there was a panel of finance experts (CPA, lawyer, financial advisor) that were indirectly encouraging active investing over passive investing through personal anecdotes. 

Looking at my current portfolio performance, I have a hard time seeing the value in spending time in learning how to actively invest and about finance in general. Currently, I do not follow up on business and market news nor am I reading any economic/investing blogs or magazines. Again, my only investing knowledge is from the Bogleheads book, and so I feel that active investing would be a daunting task. 

Do you have a comparison of an active investment portfolio’s returns (that uses your 8 portfolio rules) against an index fund (such as the Vanguard total stock market) during a bull and bear market?  Also, do you have any advice on where to begin learning about active investing in general? How should one invest for different goals, say investing for retirement in 40 years vs. investing for a home purchase in the Bay Area in 5-10 years? I’m having a hard time seeing how I would balance time in regards to learning about investing, advancing my career through outside studying, serving in my local church, spending time to witness to family, friends and co-workers, and communion with God.  It seems like passive investing is a simpler solution with a decent average long-term return of 7%. I know I am young, have a lot to learn about life and sometimes stubborn in my thinking, so any thoughts and/or advice would be greatly appreciated.

These are the questions I will try to answer:

  1. Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?
  2. Do I have a track record that is publicly available?
  3. Where to learn about active investing?
  4. How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?
  5. Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

But  I will answer them in a different order.

Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

You can’t be good at active investing without putting time in at least at the level of a hobby, say, one hour per day, six days a week.  When I launched into studying investments at age 27, I already had two advantages — A mother who was self-taught in investing (and beat most mutual fund managers handily), and an academic background in economics and finance (which had its pluses and minuses).

But my commitment to learning about investing was one hour per day, six days a week.  After 5 years, I was an investment actuary, which was pretty rare at that time.  After 11 years, I was hired into the investment department of a medium-sized life insurer.  17 years later, I worked for a notable hedge fund.  23 years later, I started my own firm.

Now, there were some spillover benefits for serving the church.  I have served on various boards of my denomination, chairing some of them, but my knowledge of finance has been a benefit to many of them, and I have been able to prevent a wide variety of errors.  Even this week, a Christian group in western Pennsylvania reached out to me regarding a “too good to be true investment,” and I told them it was likely a fraud.  There are ways that we can serve the church with such knowledge.  Brothers and sisters that I know come asking for advice, and I do not turn them down.

Now, all that said — no, it is probably not worth your time to learn about active investing.  I wrote two articles a while ago taking both sides of the argument:

Decide what you want to emphasize in your life and service to God.  The church benefits from a few “numbers guys” (as some refer to me in my denomination), but it doesn’t need a lot of them, if the group trusts them, and they are wise and upright.

Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?

I don’t think you have to move to active management — you might move to some sort of tilt on you passive management, though.  Over the long run, tilting to value stocks and smaller stocks has been a smart idea.  Cap-weighted indexes have most of their assets invested in behemoths that like Alexander the Great, have “no more worlds left to conquer.”  Investing a disproportionate amount passively in mid- and small-cap stocks can be a wise idea, as can passive investing with a value bias.  Two sides of the issue:

But, maybe wait a while before you add some mid- and small-cap value index funds… valuations are relatively high for small and mid-cap stocks at present.  I have a hard time finding truly cheap stocks at present.

Where to learn about active investing?

As for books, you could look through my book reviews, and scan for the word “value.”  You could visit the website Valuewalk.com; I have to admit I am impressed with what Jacob Wolinsky has done — it is the “go to” site for value investing.

You can also read the letters of notable value investors — Buffett, Klarman, Marks, and more…

How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?

Let me tell you a story.  My congregation is near DC.  My congregation asked me to manage the building fund, and for years, I beat the market, but DC area real estate still appreciated faster.

At the same time, many congregations in the denomination, had received buildings for low prices, or virtually free, but those were mostly in rural areas.  So at prayer meeting in January 2009, after losing a large amount of the building fund, I asked God to drop a building in our lap, as I could not see any way that I would ever do it through my investing, good as it was.

Two months later, we bid on a short sale for a house with a church use permit.  We had the assets free and clear for it, and closed in May 2009.

Here is my point to you: geographically constrained markets like the Bay Area — there is no good way for the liquid stocks and bonds to keep up with real estate price increases. Buying a house in the Bay Area is a tough matter, and it might make sense to match assets and liabilities.

You might want to try to buy real estate related assets in the Bay Area — not sure how you could do that, but it would be the investment closest to funding what you want to own.

As for investing for retirement 40+ years from now, maintain a posture of 70-80% risk assets, and 30-20% safe assets.  I have been 70/30 most of my life.  Optimal is 80/20, but I take more idiosyncratic risk, and 70/30 just feels better to me.  My investments are more concentrated, and the cash levels out the jolts.

Do I have a track record that is publicly available?

Yes and no.  I send it to those who inquire after my services, but I will send you a copy after I publish this.  I’ve done well, but I know that it might be due to chance.  That said, my clients get the same investments that I have, so my interests are aligned with them, aside from the fee they pay me.  I have no other compensation from my investment management.

On Several Questions from a Reader

Saturday, July 19th, 2014

As time has gone along, I realize that my blog is different.  I do things that most bloggers don’t do, e.g. book reviews, answer e-mails publicly, and a few other things.  Also, my audience is far more international than most, with a large contingent from India.  Well, here is another e-mail from a reader in India:

Hi David,

I am a big fan or your articles and read regularly when I get time. I respect you for what you are trying to do with your blog – it is a free education for people like us. I also write a blog but it is mostly a commentary sorts than educating blog like yours.

I am writing to you today because I want to seek out your advice on my portfolio (and my ongoing investment education). 

Screening technique

I normally use Reverse DCF with 15% discount rate, 3% terminal growth rate and future growth assumption of a quarter of historical (5 or 10 years) FCF growth rate. For eg. if historical FCF growth rate of a company is 40%, and reverse DCF suggest market is factoring 10%, that company gets shortlisted.

I also try to invest in companies with 5 years avg ROCE of more than 25% – assumption being management being prudent and high quality will generate good returns on capital available to them.

When I am done screening the stocks, I read their previous 2-3 annual reports to get the feel of the business, how do they money and what are the underlying risks etc. I also read their commentaries on the business prospects and any extraordinary or hidden/ contingent charges they might have. I try to find out what makes the business earn so consistent results.

The screen I use normally allow me to avoid the folly of forecasting. I avoid making an elaborate model and try to forecast future earnings and cash flows. I just try to buy the security at a good discount to what my Reverse DCF model suggests.

Selling strategy

Now, lot of my stocks (8/13) have doubled in 1-3 years duration. I, as a rule, take out my capital when my stock doubles i.e sell half of my holdings. I assume that whatever I have thought about the future prospects of the business could be wrong. Some of my stocks are trading below the level I took out my capital and some of them have turn out to be multi-baggers. What are your thoughts on this selling strategy.

I also have issues with a stock if it has been on my watchlist and has run up a bit. I think this is anchor bias everyone talks about. But I still want to know your thoughts. Do you buy in a single trade or do you build your position slowly.

One more thing, I know you write a lot about portfolio structure, what do you suggest to do if the business you have made the highest allocation to is generating lower returns and vice-versa.

I know I am bothering you a lot, but knowing your thoughts will help me a lot.

I also tried my hands on liquidation analysis that Peter Cundill speaks about in his book – There’s always something to do.

I bought a stock, which was trading way below its liquidation value ( if you buy the entire market cap, sell all the assets at half the prices, and pay off all the liabilities, you still will be left with some cash). I have read their ARs and have found nothing wrong with management, of course their business is not generating lot of profits. I have put a google alert on company’s name if there is some news report or some analysis on the company that may alert me if they’re fraud. So my question is how do you (or a retail investor like me) make sure that management is not fraud or accounts are not cooked.

I know these are lot of questions – that too from a stranger sitting in India but I’ll be happy if you give me some sense of direction – whether I am doing things right or what should I change.

Keep writing and educating,
Thanks,

I don’t use DCF or reverse DCF because of the many assumptions employed in DCF.  I am happier using simpler techniques like P/E, P/B, P/S, and then trying to critique them considering what I know about the company and industry in question.

As for you insistence on a high ROCE — that can work in India, but is less likely to work in the developed world, because few companies can beat the 25% threshold, that have reasonable valuations.

I take out assets from companies as they rise.  I do it more regularly and slowly than you do — it is a risk control mechanism.  On the downside, it is a way to make more money, by buying quality companies when they are down.

For more thoughts on selling, look at my portfolio rules seven and eight.

Regarding watchlist assets that have risen in value, I follow portfolio rule eight, and only buy assets that would be a net improvement to the portfolio.  Timing will almost never be right, but if you have a favorable valuation for the asset in question, and a sound balance sheet, you will do well.

Regarding portfolio construction, I only look at the likely future.  I will hold onto a company that has done badly, but still offers an opportunity of doing well in the future.  The objective is to be forward-looking.

I buy positions all-at-once, or as close to it as I can, because a few positions are illiquid.  There is no reason to delay in investing if your thesis is a good one.

Regarding crooked managements — the first question to ask is how are you going to grow revenues.  If the answer is at all unbelievable, run away.  There are other tests:

1) look at their results over many years, and compare it to their commentary.  Don’t give any credit for one-time (negative) events because over the long run, managements that have too many one time events are bad managements.

2) use statistics like normalized operating accruals to see if the accounting is conservative or liberal.

3) Analyze growth in book value plus dividends versus earnings.  Growth in book value plus dividends is a better measure of value than earnings is.

4) look at management incentives — the best managers are idealists.  They love what they do, and would do it for free. if they could.  You want a management team that is hungry; you son’t want a management team that feels full.

Thanks for writing me, and I hope you prosper in your investing in India.

Sincerely,

David

On Current Credit Conditions

Friday, July 18th, 2014

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

Book Review: The Risk Wise Investor

Wednesday, July 16th, 2014

00001 What do you think about first when you look at an investment? Do you think of how much you might make, or how much you might lose?

Most successful investors think about how much they could lose, which makes this book a very good one to read, versus many investment books that spend little time on risk, but try to sell you on likely returns.

We win by not losing, while taking moderate and prudent risks.  This book encourages you in that direction.

Broadminded Wisdom

By broadminded, I don’t mean someone who is not willing to call some things right and wrong, but rather, someone who is willing to consider many facets of the problem as he suggests his advice.

He considers (chapter-by-chapter):

1) The modern problem of data overload, and how it distorts our decisions.

2) How good investment risk control is very much like the way we control non-investing risks in our own daily lives.

3) The long-term history of how financial risk management emerged, and how it has sharpened in the present era.

4) What level of risk are we trying to deal with?  Those that want to have no risk against extreme contingencies set themselves up for losses if society remains intact.  On the other hand, if you are only attempting to smooth out small setbacks, what happens when you face a true market crisis?

5) Should you consider risk to be a quantitative or qualitative matter?  The author opts for both.  I would argue you are better off with the qualitative, and a businessman’s instinct on the quantitative, as opposed to that of an academic.

6) Learn to train you emotions.  Do not give into fear or greed.

7) As a result, add to risk assets in bad times, lighten up in good times.

8 ) Think for yourself, and don’t follow the crowd.

9) Control what you can control, hedge what you can’t control, if it makes sense

10) Realize that not all risks are the same size — focus on the big ones that are within your capacity to minimize.

11) Risk management is a process.  Identify the outcomes you want to avoid and avoid them, considering what you might give up in the process.

12) Consider what great risk management looks like outside of finance, and use the analogies to aid your investing.

13) How good financial advice can help, and what that looks and feels like.  The book gives many good questions to ask those who might advise you.

14)  Dealing with financial panics and crises.  There are no easy answers here, but if you can invest more when things are at their worst, or when things stop getting worse, you can do well.

The book has a summary, where it draws all of the stands of thought together.  If after reading the book, you follow the summary, you will have a useful way of managing your investment portfolio.  Now that said, managing investment risk is not easy, because markets are not stable.  You need to be ready to not do so well during booms, while being willing to take risk when things look really bad.  (But maybe wait until prices cross the 10-month moving average…)

Quibbles

None.

Summary

This is a very good book on risk control in investment management, and most investors, retail and professional, could benefit from it.  If you want to, you can buy it here: The Risk-Wise Investor: How to Better Understand and Manage Risk.

Full disclosure: The author asked me if I would like a copy and I said “yes.”

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.

Aiming for Transparency

Saturday, July 12th, 2014

Here’s another letter from a reader:

David,

I’m starting this fund, and I wanted to get your opinion.

 It is best explained on YouTube in 55 seconds: let me know what you think https://www.youtube.com/watch?v=frwOrQd3f6w. It (hopefully) will provide incentive for transparency in funds.

 Thank you!

Okay, I can’t embed the short video, so click on the link above and watch it — it is less than a minute, and well-done.

To the writer:

I admire your efforts at providing transparency here, but let me tell you where I think this may have unintended negative consequences.

Anytime you provide total transparency, you invite front-running, if the manager is any good.  New ideas are often most potent at their beginning, and given the delay between notifying mutual fund shareholders, voting and implementation, critical time is sacrificed, and some of your shareholders may front-run you.

Imagine a person investing the minimum in your fund so that he could front-run your picks with a greater amount of money.  But even if front-running does not happen, it is generally wise to move rapidly once the manager has come to a decision.  The delay from having shareholders vote on it is likely a money-loser.  Also during times of crisis, the manager may have some of his best ideas, but when average people are scared, will they be willing to pull the trigger?  I have my doubts.

In general, I favor investment methods where decision-making is done by individuals.  If I were running a hedge fund, or a large mutual fund, I would delegate all decisions to the sector/industry analysts.  Let sharp opinions prevail.  I’ve worked in areas where groupthink muddies investment decisions — it does not lead to outperformance.

Transparency

You don’t need to have shareholders vote on investments to have transparency.  You could do what I do, because all of my investors have full transparency.

I manage separate accounts using Interactive Brokers.  We buy and sell as a group.  We all get the same buy and sell prices.  I don’t trade often, but any investor can monitor his/her account all day long.  They can set up a daily download so that they can see what actions have been taken, if any.  There is total transparency, to the degree that my investors want to make the effort.  And remember, making investors go through a lot of effort is a negative.

If I Were in Your Shoes

If I wanted to give your investors transparency, I would give them access to a website showing the portfolio in real time, set up in such a way that only they could see it.  I would not let them vote on investments.  If you are hiring a manager, let him manage.  Second-guessing and delay are a waste of time and money.

Now those are my thoughts, and maybe your views on running a democratic fund are important to you.  Do what you think is best — just remember that democracy is not the same as transparency, and to achieve transparency, democracy is not needed.  Information is power, and you want to be careful in how you share it.

All that said, I hope you succeed, and that it works out well for you and your shareholders!

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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