Category: Portfolio Management

An Anomalous View of Stock Investing

An Anomalous View of Stock Investing

Posted on by David Merkel

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening.? I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional.? I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG With Est Growth, PEG With Hist Growth, and two of O’Shaughnessy’s screens – Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street.?? That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment.? There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle.? I mentioned how much I like the CXO Advisory blog.?? One page to visit is the Big Ideas page, if you like academic finance papers.? I want to give you my short synopsis of what seems to work:

  • Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
  • Price momentum
  • Low accrual accounting entries as a fraction of earnings or assets
  • Piotroski’s accounting criteria
  • Low net stock issuance
  • Positive earnings surprises
  • Low historical return volatility
  • Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues.? Let me summarize them one more time:

  • Look for a cheap valuation.
  • Look for mean reversion, but don’t try to catch a falling knife.
  • Grab positive price momentum and earnings surprises.
  • Look for sound accounting, and management that is loath to dilute shareholders.
  • Avoid volatile stocks
  • Look for neglected stocks

That’s my my quick summary for what seems to work in stock selection.? I invite commentary on this.? I downloaded a lot of the papers cited, and will be reading them over the next few months.

How to Manage a Portfolio

How to Manage a Portfolio

Posted on by David Merkel

Given the title above, I feel embarrassed to write, because the topic is too basic. I write because too few managers think clearly on the topic. The following analysis applies to long only funds and hedge funds; it also applies to equity and bond funds. The impetus to write this note arrived because the Fidelity Magellan Fund is reopening because cash inflows will make the life of the portfolio manager easier… not that he will get many inflows for now.

My view is that it should not be hard to manage a shrinking portfolio. It is much harder to manage a rapidly growing portfolio. (I have experienced that, and that is a topic for another day.) Here is the key concept: the portfolio manager must rank his portfolio by expected returns, adjusted for risk. This applies to both the longs and shorts. If there are cash inflows to a portfolio, assets should be allocated to the highest returning assets. If cash outflows, assets should be liquidated from the situations with the lowest expected returns. It is that simple, and I did that when I was a corporate bond manager. It worked well.

The reason why it will not be implemented at many asset management shops is that it takes work to do it, and we all avoid work if we can. But maintaining lists of long and short ideas ranked by likely risk-adjusted returns will yield better decision making, if one will do it.

What of the January Effect?

What of the January Effect?

Posted on by David Merkel

I’m not feeling well this evening, so this will be a short post dealing with one simple issue.? (If I have strength, I may do one more.)

The January Effect is one of the best known calendar anomalies.? Stocks and high yield bonds tend to do well after the first day of the new year. This happens because these assets get oversold as some investors sell losing positions for tax reasons.? This tends to be more powerful for stocks that have done poorly over the past year, and for small companies, and value stocks.? This year it seemingly hasn’t happened.? Why?

First, all anomalies exist within a broader market environment.? When enough market players jump onto an anomaly, the anomaly outperforms in the short run, but peters out, because all interested parties have bought in.? If that were true of the January Effect, we would see the gains made in December, rather than January.? That’s not what happened this year.? (Anomalies tend to do best when they are ignored.)

Second, in a market where small value stocks may be overvalued, the January Effect could disappear for a year while small value stock valuations adjust back to normal, or below that.? That might be true this year.

We are in the winter season, not just for the calendar, but for small stocks and value investing. ? I feel the winter chill in all that I do at present, and no, I am not talking about the lack of insulation in my hovel.? I have the winter wind in my face now (much as I remember walking home from high school in Milwaukee), and yet I know that this is the time that my best purchases are likely to be made.? I have to focus on my core disciplines, and buy good long-term cash flow streams cheaply.

Before I close, I would say that a new favorite blog of mine is the CXO Advisory Group blog.? For quantitative investors, there is a wealth of knowledge there.

Industry Ranks and Additional Stocks

Industry Ranks and Additional Stocks

Posted on by David Merkel

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.

Time for the Next Portfolio Reshaping

Time for the Next Portfolio Reshaping

Posted on by David Merkel

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.

Make Money While You Sleep — II

Make Money While You Sleep — II

Posted on by David Merkel

Thanks to Eddy Elfenbein for sending over the data on how the market does over multiple nights when the market is closed.? Unfortunately, the data is skewed because of 9/11, where the market was closed for seven days, and the change from the close to the open was -4.59%.? What should be done with that data point?? When the market closed on Monday 9/10/01, traders expected that the market would reopen as normal on Tuesday, but it didn’t.? The seven day hiatus was not planned, so traders treated it as a one night gap on Monday, but it opened as a seven night gap the next Monday, with negative results.

Now, if you throw out the 9/11 data point, the average price return over a one night gap is 0.005% over the last eight years.? For a multiple night gap, the return is higher — 0.012%.? If you include in 9/11, it is lower — 0.002%.

But what of dividends?? Where do they belong?? They belong to the nighttime returns, because on the morning that a stock goes ex-dividend, on average the price drops at the open to reflect that.? Now, assume a 1.5%/year dividend rate (rounding, the actual is a little higher).? Now the returns for a one night gap are 0.010%, and for a multiple night gap it is 0.024%.? Even counting in 9/11, the result is 0.014%, higher than the single night gap.

One commenter on last night’s post commented that it might not be the risk of holding stock overnight as much as the possibility or occurrence of news flow.? Before the fact, risk and potential news flow are similar concepts.? After all, how does risk shift, but often through news flow changing the opinions that people hold regarding assets?

For a long term investor like me, this all doesn’t matter much.? I’m not going to buy a bunch of futures contracts or ETFs near the close and sell them into the open.? Still, this could be another example of a market anomaly that stems from the perception of a risk which does not occur on average.

Make Money While You Sleep

Make Money While You Sleep

Posted on by David Merkel

Eddy Elfenbein often comes up with cute ideas on how the market works, and this article is no exception.? Someone holding the stock market overnight, at least over the past decade, does better than someone owning stocks during the day.? (I assume that? Eddy has made the proper corrections for dividends, and things like that.)? Now, why might this be?? This is my theory: though daytraders are a part of this, it is not that we are all a bunch of daytraders, but that enough players in the market view the daylight hours as less risky than the night, because they can’t trade then.? Newsflow happens more often while the market is closed.? Thus, there is a tendency to clear out positions before the session closes.? (Now, no net position clearing occurs.? Someone has to hold the stock overnight; they receive a slight discount in the price to do it.)

Another way to think about it is that people get paid to take risk, and there is risk in holding stock overnight.? Now, if we wanted to test this hypothesis, there is even more risk holding stock over the weekend.? How do the overnight returns vary overnight, versus over multiple nights?? Perhaps Mr. Elfenbein can run that calculation as well.

Momentum, Schmomentum

Momentum, Schmomentum

Posted on by David Merkel

My biggest insecurity when it comes to my investing comes from the concept of momentum.? For the past 7+ years, I’ve been leaning against the wind, buying companies with bad momentum, and for the most part, it worked.? In general, falling stocks have bounced back.? Over the last six months it has not seemed to work so well.? Now, I had a period that was much worse in the middle of 2002.? I even scraped excess money together to invest in late September of 2002.? I am less confident here.

I have a number of ideas that work with respect to momentum:

  • In the short run, momentum persists.
  • In the intermediate-term, momentum reverts.
  • Sharp moves tend to mean revert, slow moves tend to persist.

My own proprietary oscillator indicates that we are very close to a short-term bounce point.? The recent move down has been too rapid, and sellers should be tired.? One more hard down day, and a bounce should occur.

Back to my own portfolio management.? Since I am a value investor, I have leaned toward longer holding periods, which implies to me that I should be playing for the intermediate-term reversal of momentum phenomenon.? But the short-term momentum anomaly is probably stronger.? Consider these two pieces from Crossing Wall Street.? Eddy illustrates the point well.

So, as I head into my next portfolio reshaping, I am scratching my head, and wondering how I should use momentum in my investing.? Suggestions are welcome.

Random Notes

Random Notes

Posted on by David Merkel

A few random notes:

  1. When I left my prior employer, one of the first things I did was buy a new laptop from Dell. It was much slower than I expected, and I began experimenting to see if I couldn’t speed it up. Now, here are a few tips: a) install sysinternals process explorer — it gives you much more information than task manager, and will show you what programs are hogging system resources. b) shut off or cripple the many little programs that lurk in the background, many of which occupy a decent amount of resources while waiting for program updates to be released over the internet. Do the updates manually, say, once a quarter. c) Reduce the number of programs that load at startup. d) I turned off the advanced graphics that were kind of pretty from Windows Vista. e) all of these helped, but the big bopper was removing McAfee and replacing it with ZoneAlarm Security Suite. McAfee was a real resource hog, and after removing it and installing ZoneAlarm, everything is faster. Everything. There is a limit to security systems; if they are pressed too far, they kill productivity. Productivity and security must be balanced.
  2. QBE’s gain is the Nasdaq’s loss. North Pointe, a not-all-that-well-known property-casualty insurer has sold out to QBE of Australia. Personally, I really liked NPTE’s management team, and thought they were on the right track. I appreciate insurance management teams that can focus on profitable niches, and are willing to let business go if they can’t make an underwriting profit. If QBE is smart, they will give prominent positions in their US operations to James Petcoff (the CEO) and Brian Roney (the CFO).
  3. Just as an aside, I felt like republishing this off topic post from RealMoney:

 David Merkel
How to Sell More Popcorn
11/3/2006 2:07 PM EST

When I was in college, I needed to make money, so I got a job working at a convenience store. The young lady who trained me showed me how to operate the popcorn maker. After adding the oil and the popcorn, she reached for the flavoring container and dumped the lot in. Her comment, “Just watch, the extra flavoring really creates sales.” She was right. As people walked in the door, a larger number than I would have expected bought popcorn. But there was a problem. The popcorn didn’t taste good. Too much salt and fake butter flavor. It led to few, if any repeat customers.

About a month later, when I was on the night shift, I tried an experiment where I cleaned out the popcorn maker, cleared out the old popcorn, and the popped a fresh batch using a little less than the instructions would indicate, much less the young lady who trained me. The smell was there, but it wasn’t overpowering. Since popcorn wasn’t usually done on the night shift, though, it would be noticeable.

The surprise: repeat customers for popcorn in the graveyard shift because it tasted good. Word of mouth spread, so I made popcorn regularly.

I believe in UPOD (underpromise, overdeliver) as Jim Cramer often points out. It applies to investing in two ways: first, buy companies whose managements do UPOD, and not OPUD. Positive surprises drive stocks higher, negative ones drive them lower.

That said, there is a second way that UPOD plays into investing. It’s what you tell your investing clients or readers. No strategy works all the time. No strategy is perfect even in the long run. No analyst is always right. Underselling your investment abilities, and demonstrating humility, may not attract as many clients in the short run, but it keeps them in the longer run, with continued diligent work.

And with that, I have to grab lunch; writing about the popcorn has made me hungry.

Position: None

Tickers mentioned: NPTE DELL

On Benchmarking

On Benchmarking

Posted on by David Merkel

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

Theme: Overlay by Kaira.