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Systemic Risk Stems from Asset-Liability Mismatches

Thursday, January 23rd, 2014

What happens when a crisis hits?  There are demands for cash payment, and the payments can’t be made because the entities have short liabilities requiring immediate payment, and long illiquid assets that no longer can be sold for a price consistent with average market conditions.  When there are many firms for which this is true, and they rely on each other’s solvency, that creates a systemic crisis.

Whether through:

  • Owning long assets, and financing short, or
  • Using the repo market to hold long assets, thus disguising it for accounting purposes as short assets
  • Taking deposits, and investing long,

it creates an imbalance.  It is almost always more profitable in the short-run to finance short and lend long.  But when there is a demand for cash, such institutions are on the ropes and might not survive.  Less than half of the major American investment banks existing in 2007 were alive in 2009 to today.

But what if you were clever as a financial institution, and had liability structures that were long, or distributed the risk of what you were doing back to clients.  You would always have adequate liquidity, and would not be in danger of default for systemic reasons.

Thus, I think the Financial Stability Oversight Commission [FSOC] is nuts to regulate insurers such as MetLife, Prudential, AIG and Berkshire Hathaway.  They do not face the risk of a run on the bank.  Look at the history of insurers: those that failed due to a run on the bank were those that:

  • Issued guaranteed investment contracts that would be immediately payable on ratings downgrade.
  • Issued P&C reinsurance contracts that would be immediately payable on ratings downgrade.

Aside from that, there were badly run companies that failed but no systemic risk.  There was also AIG, which faced a call on cash from its derivatives counterparty, but not the insurance entity.

As for investment managers, they have no systemic risk.  It does not matter if Blackrock, Pimco, Fidelity and Vanguard would all fail.  Mutual fund holders would find their funds transferred to solvent entities, and any losses  they might receive are the ordinary losses they could receive if the management  firms were still solvent.

Someone lend the FSOC a brain.  Big size does not equal systemic risk.  Systemic risk stems from a call on liquidity at financial firms that borrow short and lend long for their own accounts.  That does not include asset managers and insurers, no matter how big they are.

What this says to me is that financial reform in DC is brain-dead.  (Surprised?  Nothing new.)  They have fixated on the idea that big is bad, when the real problem is asset-liability mismatches, amplified by size and connectedness.  Big banks are a problem.  Big insurers and asset management firms are not.

Tough for Buffett to Lose this One

Wednesday, January 22nd, 2014

I have no idea what premium Buffett is receiving for insuring against one or more people having a perfect NCAA Tournament bracket, but it is unlikely that he will lose on this underwriting bet.  Those seeking insurance on unlikely events think the events are more likely than they actually are.  That said, for Quicken Loans, they don’t want to bet the company, and they do want publicity, so contracting with Buffett is worth their while.

Imagine for a moment that the average person submitting a bracket had a 78.6% chance of getting each game right, and the maximum 10 million people sent in their brackets.  What is the likely number of correct brackets?  One.

But does the average person get more than three out of four games right?  I don’t think so.  Are there some people that are better than others so that they get games right 90% of the time?  Well, if they are 1,163 out of the ten million, on average, one of them will have a perfect bracket.

Here’s a further problem.  Every tournament has significant upsets.  Someone who has a good understanding of how good the teams are will know how to pick the most likely team to win.  It is tough to pick the upsets, and tougher to pick all of the upsets.  There is no good model for upsets, or they wouldn’t be upsets.


As an aside, the prize is $500 million as a lump or $25 million for 40 years.  The breakeven yield rate on that is 4.21%.  Buffett knows he can beat 4.21%.

This contest is like the lottery.  If I had one piece of advice for lottery winners it would be to take the payments over time.  The discount rates on most lotteries are far higher than 4.21%, and really, taking them over time gives you a chance to learn how to manage more money then you know what to do with.  Taking the payments over time gives you the freedom to learn from mistakes.  We all make mistakes, but when we get all the money at once, we make more.


Good Over-the-Counter “Pink” Stocks

Saturday, January 18th, 2014

I really appreciate my readers.  Here’s an e-mail from one:


Just read your recent blog post “E-mails on Insurance.”

You made the comment that “aside from non-sponsored ADRs no good companies trade on the pink sheets.”

Of course that is true in a general sense. I also am sure you have been inundated with lots of email taking exception to that comment.

One company I have loosely followed over time (that I came across just by chance many years ago) is Computer Services (CSVI) []. There is no volume in the stock so institutional managers have no ability to take a position, but the firm has done a great job of growing the business while maintaining profitability (been an opportunistic acquirer of small bank processor companies) and is probably a candidate for consolidation by a Fiserv or someone like that. Anyhow, I think if you take a look at the firm, you will see that there is at least one solid company traded on the pinks (and I am sure there are others, I just don’t go fishing there).

My comment “aside from non-sponsored ADRs no good companies trade on the pink sheets.” is an overstatement.  To prove that, I give you a list of 148 companies that:

  • Have been profitable for the last four fiscal years.
  • Are US companies
  • Are not ADRs

2370 companies that trade over-the-counter reduce to 148 companies — 6.24% of the whole, explaining why my overstatement is largely, but not totally correct.  I would not tell someone to look amid these companies to find good ones, but there are some good ones there.  I have listed them in declining order of market capitalization.

CompanyTickerSectorIndustryMkt CapDollar VolumeP/EP/BP/S
Belk IncBLKIA09 – Services0951 – Retail (Department & Discount)   2,057.80            -   12.40     1.66     0.51
First National Bank AlaskaFBAK07 – Financial0727 – Regional Banks      604.00            -   14.90     1.23     5.45
First Citizens Bancorporation,FCBN07 – Financial0727 – Regional Banks      572.70     33.20     9.60     0.64     1.87
Computer Services, Inc.CSVI10 – Technology1036 – Software & Programming      476.10   146.81   18.20     3.80     2.31
Hills BancorporationHBIA07 – Financial0727 – Regional Banks      345.00       3.65   13.30     1.29     4.03
Farmers & Merchants BancorpFMCB07 – Financial0727 – Regional Banks      324.40     20.85   13.60     1.54     4.27
FRMO Corp.FRMO07 – Financial0721 – Misc. Financial Services      302.80     23.45   26.90     3.66   16.64
HomeFed CorporationHOFD02 – Capital Goods0215 – Construction Services      299.80     22.83   62.40     1.79     7.93
First Opportunity Fund, Inc.FOFI07 – Financial0721 – Misc. Financial Services      262.10   269.95     7.20     0.86   58.25
International Wire Group HoldiITWG01 – Basic Materials0127 – Misc. Fabricated Products      255.40       2.61   19.60     6.69     0.21
Canandaigua National CorporatiCNND07 – Financial0724 – Money Center Banks      249.90       6.65   12.20     1.66     3.41
Viskase Companies, Inc.VKSC01 – Basic Materials0109 – Containters & Packaging      237.90   214.50   24.10     0.67
Conrad Industries, Inc.CNRD11 – Transportation1118 – Water Transportation      226.80   249.58     9.10     1.95     0.86
United Capital Corp.UCAP10 – Technology1024 – Electronic Instruments & Controls      187.40       4.80   13.40     1.34     1.58
Isabella Bank CorpISBA07 – Financial0727 – Regional Banks      184.70     52.67   15.50     1.14     3.39
Profire Energy, Inc.PFIE02 – Capital Goods0209 – Construction – Supplies and Fixtures      160.20     98.83   41.90   10.81     5.97
Cambridge BancorpCATC07 – Financial0727 – Regional Banks      150.50     59.33   11.50     1.47     3.20
Citizens Financial Services InCZFS07 – Financial0718 – Investment Services      148.30     24.55   10.90     1.64     4.06
Mestek, Inc.MCCK02 – Capital Goods0218 – Misc. Capital Goods      144.40       0.86     8.80     1.03     0.41
Webco Industries, Inc.WEBC01 – Basic Materials0127 – Misc. Fabricated Products      143.50     16.95   15.50     0.57     0.22
First Keystone Corp.FKYS07 – Financial0727 – Regional Banks      137.80     18.75   12.80     1.42     4.32
MVB Financial CorpMVBF07 – Financial0724 – Money Center Banks      135.30     14.40   22.10     1.67     5.34
First Mid-Illinois Bancshares,FMBH07 – Financial0727 – Regional Banks      130.30       4.40   12.90     1.32     2.43
First Real Estate Investment TFREVS09 – Services0933 – Real Estate Operations      126.70     13.69   42.40     7.73     3.08
First Manitowoc Bancorp, Inc.BFNC07 – Financial0730 – S&Ls/Savings Banks      120.80     33.30   11.30     1.19     3.07
Peoples Financial Services CorPFIS07 – Financial0727 – Regional Banks      120.40     62.40   14.60     1.90     4.37
First Farmers & Merchants CorpFFMH07 – Financial0727 – Regional Banks      111.20       3.30   13.30     1.05     3.05
Yasheng GroupHERB05 – Consumer Non-Cyclical0509 – Crops      105.50       3.88     0.80     0.05     0.11
Farmers & Merchants Bancorp InFMAO07 – Financial0727 – Regional Banks      105.10     62.01   11.40     0.98     3.37
Nova Lifestyle IncSTVS04 – Consumer Cyclical0421 – Furniture & Fixtures         89.20     93.77   16.80     2.50     1.17
Golden Growers CoopGGROU05 – Consumer Non-Cyclical0509 – Crops         89.10       1.44   18.50     2.30     0.93
First Guaranty Bancshares, IncFGBI07 – Financial0727 – Regional Banks         88.20       7.01   10.50     1.03     1.72
QNB CorpQNBC07 – Financial0730 – S&Ls/Savings Banks         83.40     49.82     9.70     1.12     2.62
CCFNB Bancorp IncCCFN07 – Financial0727 – Regional Banks         78.40     26.99   12.00     1.05     3.75
Calvin B. Taylor Bankshares, ITYCB07 – Financial0727 – Regional Banks         75.70       3.84   17.80     0.95     5.11
Juniata Valley Financial CorpJUVF07 – Financial0730 – S&Ls/Savings Banks         73.20       7.85   18.80     1.50     4.35
Northwest Indiana BancorpNWIN07 – Financial0730 – S&Ls/Savings Banks         72.70       7.68     9.80     1.08     2.76
Franklin Financial Services CoFRAF07 – Financial0727 – Regional Banks         71.80     36.33   13.10     0.77     1.97
Rand Worldwide IncRWWI10 – Technology1036 – Software & Programming         67.60     24.38   41.70     2.05     0.85
Centrix Bank & TrustCXBT07 – Financial0727 – Regional Banks         67.40       7.17   12.00     1.29     2.26
Peoples BancorpPBNI07 – Financial0730 – S&Ls/Savings Banks         66.80       7.20   21.60     0.88     3.59
Reserve Petroleum CoRSRV06 – Energy0609 – Oil & Gas Operations         66.20     20.75   10.90     2.05     3.49
Harleysville Savings FinancialHARL07 – Financial0730 – S&Ls/Savings Banks         65.60     19.95   13.90     1.10     2.09
William Penn Bancorp IncWMPN07 – Financial0730 – S&Ls/Savings Banks         65.50     28.80   23.40     1.15     4.86
Kentucky Bancshares, Inc.KTYB07 – Financial0727 – Regional Banks         65.30       6.00     9.10     0.92     2.36
Community Bancorp VermontCMTV07 – Financial0727 – Regional Banks         64.50       5.31   13.70     1.50     2.82
Hennessy Advisors IncHNNA07 – Financial0718 – Investment Services         64.30       9.81   13.10     2.23     2.74
Monarch Cement CoMCEM02 – Capital Goods0212 – Construction – Raw Materials         63.40     13.42   21.00     0.96     0.69
Armanino Foods Of DistinctionAMNF05 – Consumer Non-Cyclical0515 – Food Processing         63.10     47.48   21.90     9.85     2.25
Q.E.P. Co., Inc.QEPC02 – Capital Goods0209 – Construction – Supplies and Fixtures         62.10     17.14     5.80     1.08     0.21
Commercial National FinancialCNAF07 – Financial0727 – Regional Banks         60.10     17.85   12.10     1.33     4.17
Croghan Bancshares, Inc.CHBH07 – Financial0727 – Regional Banks         57.90       8.63   12.80     0.86     2.72
Burnham Holdings IncBURCA02 – Capital Goods0209 – Construction – Supplies and Fixtures         57.20       6.66   12.80     1.29     0.42
Standard Financial Corp.STND07 – Financial0727 – Regional Banks         56.10     51.56   19.30     0.71     3.39
Choiceone Financial Services ICOFS07 – Financial0727 – Regional Banks         54.90     13.34   11.30     0.90     2.85
LICT CorporationLICT09 – Services0915 – Communications Services         54.00            -     6.70
Capital Properties IncCPTP09 – Services0939 – Rental & Leasing         52.80       4.80   34.80   34.78     6.86
Middlefield Banc CorpMBCN07 – Financial0727 – Regional Banks         52.70   101.40     8.10     1.00     1.87
CSB Bancorp Inc (Ohio)CSBB07 – Financial0730 – S&Ls/Savings Banks         52.00     20.90   10.10     1.00     2.49
Jeffersonville BancorpJFBC07 – Financial0727 – Regional Banks         51.70     17.69   11.80     1.03     2.71
Georgia-Carolina Bancshares InGECR07 – Financial0727 – Regional Banks         51.70     59.45     7.80     0.90     2.78
PSB Holdings Inc (Wisconsin)PSBQ07 – Financial0727 – Regional Banks         50.60     10.72     8.30     0.90     1.86
Consumers Bancorp, Inc.CBKM07 – Financial0730 – S&Ls/Savings Banks         49.30       2.72   14.00     1.33     2.86
Quality Products, Inc.QPDC02 – Capital Goods0218 – Misc. Capital Goods         47.70       3.78     8.30     4.84     1.63
Northway Financial, Inc.NWYF07 – Financial0727 – Regional Banks         47.10     10.26     6.70     1.03     1.41
Granite Falls Energy LLCGFGY01 – Basic Materials0103 – Chemical Manufacturing         45.90            -   15.30
George Risk Industries IncRSKIA09 – Services0972 – Security Systems & Services         45.20       9.89   11.40     1.40     4.27
F&M Bank CorpFMBM07 – Financial0727 – Regional Banks         43.30     11.21     9.00     0.84     1.63
Southern Michigan BancorpSOMC07 – Financial0727 – Regional Banks         42.50       5.33     9.40     0.77     2.15
Noble Roman’s, Inc.NROM09 – Services0942 – Restaurants         42.30     69.62   30.90     3.28     5.63
Minden Bancorp IncMDNB07 – Financial0730 – S&Ls/Savings Banks         41.60       3.50   12.80     0.98     4.07
Surrey BancorpSRYB07 – Financial0727 – Regional Banks         41.50       4.68   16.50     1.36     3.91
Corning Natural Gas Holding CoCNIG12 – Utilities1206 – Natural Gas Utilities         40.20       7.99   20.40     1.78     1.74
Pioneer RailcorpPRRR11 – Transportation1112 – Railroads         37.00       6.72   21.30     2.80     1.77
Ziegler Companies, Inc., TheZGCO07 – Financial0718 – Investment Services         35.70     27.00   17.60     1.10     0.45
XCel Brands IncXELB07 – Financial0721 – Misc. Financial Services         35.60       0.35     5.70     1.04     2.33
Security Federal Corporation (SFDL07 – Financial0730 – S&Ls/Savings Banks         35.40       8.42   13.20     0.63     1.14
Regency Affiliates IncRAFI12 – Utilities1203 – Electric Utilities         33.90       1.44     9.00     1.05
New Ulm Telecom IncNULM09 – Services0915 – Communications Services         33.50       5.90     8.90     0.59     0.90
Heritage Bankshares, Inc.HBKS07 – Financial0727 – Regional Banks         29.60       8.45   14.10     1.00     2.79
Home Loan Financial CorporatioHLFN07 – Financial0730 – S&Ls/Savings Banks         29.50       2.60     8.60     1.17     2.82
High Country Bancorp, Inc.HCBC07 – Financial0730 – S&Ls/Savings Banks         29.50       9.90   15.20     1.24     3.15
Commercial Bancshares, Inc. OCMOH07 – Financial0727 – Regional Banks         29.10     14.76   10.30     0.95     2.06
South Street Financial Corp.SSFC07 – Financial0730 – S&Ls/Savings Banks         28.70   121.25   28.50     1.05     2.29
CreditRiskMonitor.Com IncCRMZ10 – Technology1018 – Computer Services         27.90       1.75   87.50     6.48     2.38
Smtp IncSMTPD10 – Technology1018 – Computer Services         25.80     27.23   20.60   15.57     4.46
West End Indiana Bancshares InWEIN07 – Financial0730 – S&Ls/Savings Banks         25.70       7.40   18.30     0.80     2.10
Northeast Indiana BancorpNIDB07 – Financial0730 – S&Ls/Savings Banks         25.50       6.21     9.30     0.92     2.55
Summit Financial Services GrouSFNS07 – Financial0718 – Investment Services         25.20     23.80   15.40     2.51     0.31
First Bancorp of Indiana, Inc.FBPI07 – Financial0730 – S&Ls/Savings Banks         24.90       2.85   16.00     0.86     1.88
Spindletop Oil & Gas CoSPND06 – Energy0609 – Oil & Gas Operations         24.40       3.17     7.30     1.28     1.89
Frederick County Bancorp (MD)FCBI07 – Financial0727 – Regional Banks         24.10       7.20   15.80     0.91     1.90
Meritage Hospitality Group IncMHGU09 – Services0942 – Restaurants         24.00       3.26     6.60     2.35     0.21
Pinnacle Bankshares CorpPPBN07 – Financial0727 – Regional Banks         24.00       7.95   17.90     0.85     1.54
CNB Financial Services IncCBFC07 – Financial0727 – Regional Banks         23.60            -   15.10     0.83     1.97
Investors Heritage Capital CorIHRC07 – Financial0709 – Insurance (Life)         23.50       8.28   11.70     0.44     0.29
Trans World CorporationTWOC09 – Services0912 – Casinos & Gaming         22.50       3.32   12.80     0.53     0.63
Pinnacle Bancshares, Inc.PCLB07 – Financial0727 – Regional Banks         21.70       4.46     9.10     0.82     2.33
FFW CorporationFFWC07 – Financial0730 – S&Ls/Savings Banks         21.40       6.74     9.10     0.93     1.66
ASB Financial Corp. (OH)ASBN07 – Financial0730 – S&Ls/Savings Banks         20.70       5.85   13.40     0.98     1.96
SBT Bancorp IncSBTB07 – Financial0727 – Regional Banks         20.50     21.95   13.50     1.06     1.72
Seychelle Environmental TechnoSYEV02 – Capital Goods0218 – Misc. Capital Goods         20.40     20.22   19.80     4.65     3.46
Great American BancorpGTPS07 – Financial0727 – Regional Banks         19.80       2.70   13.40     0.80     2.26
Sierra Monitor CorporationSRMC10 – Technology1030 – Scientific & Technical Instruments         19.70     12.68   15.00     2.41     1.10
Logansport Financial Corp.LOGN07 – Financial0724 – Money Center Banks         19.60       2.50     9.00     0.86     2.30
Seneca-Cayuga Bancorp IncSCAY07 – Financial0724 – Money Center Banks         19.60       1.24     9.50     1.00     1.64
Micropac Industries, Inc.MPAD10 – Technology1033 – Semiconductors         18.90       3.67   20.90     0.96     0.97
Texas Vanguard Oil CoTVOC06 – Energy0609 – Oil & Gas Operations         18.60       1.31   22.60     1.40     3.04
Issuer Direct CorpISDR09 – Services0909 – Business Services         18.30     46.92   20.90     7.19     3.26
Environmental Tectonics CorporETCC02 – Capital Goods0203 – Aerospace and Defense         17.90       3.22   21.70     2.47     0.55
Wells Financial Corp.WEFP07 – Financial0730 – S&Ls/Savings Banks         17.80     13.50   13.60     0.67     1.99
Sono-Tek CorporationSOTK02 – Capital Goods0218 – Misc. Capital Goods         17.40     37.68   60.00     2.79     1.89
DynTek, IncDYNE10 – Technology1036 – Software & Programming         17.00       0.80     5.00     2.23     0.13
Riverview Financial CorporatioRIVE07 – Financial0727 – Regional Banks         16.90     12.81   12.00     0.63     1.30
Paradise, Inc.PARF05 – Consumer Non-Cyclical0515 – Food Processing         16.60       3.20   18.80     0.78     0.66
Bank McKenney (VA)BOMK07 – Financial0727 – Regional Banks         16.60       4.30     9.10     0.73     1.55
Quaint Oak Bancorp IncQNTO07 – Financial0730 – S&Ls/Savings Banks         15.60     30.88   23.60     0.85     2.38
Greenville Federal Financial CGVFF07 – Financial0730 – S&Ls/Savings Banks         15.40       2.20   17.50     0.82     2.55
BV Financial IncBVFL07 – Financial0730 – S&Ls/Savings Banks         14.40       1.20   30.00     1.15     2.49
Jaclyn, Inc.JCLY04 – Consumer Cyclical0403 – Apparel/Accessories         13.70       2.70   15.40     0.62     0.08
OPT-Sciences CorpOPST10 – Technology1030 – Scientific & Technical Instruments         13.50       1.74   12.90     1.05     2.04
Citizens Bancshares CorporatioCZBS07 – Financial0727 – Regional Banks         13.30       1.94   11.40     0.40     1.02
Chino Commercial Bancorp (CA)CCBC07 – Financial0727 – Regional Banks         13.20       2.39   19.20     1.45     3.09
IEH CorporationIEHC10 – Technology1024 – Electronic Instruments & Controls         12.10     20.74     8.50     1.26     0.82
ITEX CorporationITEX07 – Financial0718 – Investment Services         11.60     15.20   10.50     0.88     0.72
Zynex Inc.ZYXI08 – Health Care0812 – Medical Equipment & Supplies         11.20       9.67     1.20     0.39
Great Lakes Aviation, Ltd.GLUX11 – Transportation1106 – Airline         10.50       8.07     0.27     0.08
Fairmount Bancorp IncFMTB07 – Financial0727 – Regional Banks           9.80       1.01   49.40     0.70     2.58
Solitron Devices, Inc.SODI10 – Technology1033 – Semiconductors           9.50     32.63   11.20     0.85     1.10
Repro-Med Systems, Inc.REPR08 – Health Care0812 – Medical Equipment & Supplies           7.70       3.80   21.00     1.62     0.96
Union Electric CompanyUELMO12 – Utilities1203 – Electric Utilities           7.60       4.70   25.40     2.39     2.78
Surge Components, Inc.SPRS10 – Technology1024 – Electronic Instruments & Controls           7.50     10.84     4.10     0.74     0.32
Home Financial BancorpHWEN07 – Financial0730 – S&Ls/Savings Banks           7.50       1.68   13.30     0.92     2.21
Alliance Distributors Holding,ADTR10 – Technology1015 – Computer Peripherals           7.50       2.70     5.70     1.31     0.11
Community Investors Bancorp InCIBN07 – Financial0730 – S&Ls/Savings Banks           7.10       6.48   73.60     0.57     1.15
M&F Bancorp, Inc.MFBP07 – Financial0727 – Regional Banks           7.10       4.38     0.30     0.65
China Industrial Steel IncCDNN01 – Basic Materials0121 – Iron & Steel           6.60       1.38     4.50     0.03
FPB Financial Corp.FPBF07 – Financial0730 – S&Ls/Savings Banks           5.20            -     8.90     0.97     1.78
NexCore Healthcare Capital CorNXCR08 – Health Care0806 – Healthcare Facilities           5.10       0.02     2.00     0.45     0.37
Precision Auto CarePACI09 – Services0909 – Business Services           5.00       0.17     7.30     0.26     0.19
Scientific Industries, Inc.SCND10 – Technology1030 – Scientific & Technical Instruments           4.80       2.34   12.40     0.89     0.68
Tidelands Royalty Trust BTIRTZ07 – Financial0721 – Misc. Financial Services           4.70       9.01     9.20     7.91     6.73
Foxby CorpFXBY07 – Financial0721 – Misc. Financial Services           4.70       1.09     6.50     0.77   23.62
TNR Technical, Inc.TNRK10 – Technology1024 – Electronic Instruments & Controls           3.80       4.31   12.30     0.99     0.41
Information Analysis IncorporaIAIC10 – Technology1036 – Software & Programming           2.40       1.97     1.19     0.44
Microwave Filter Co., IncMFCO10 – Technology1024 – Electronic Instruments & Controls           1.70       1.50     1.03     0.53
Bayou City Exploration, Inc.BYCX06 – Energy0609 – Oil & Gas Operations           1.50       0.81     2.70     0.73     0.44
Tongli Pharmaceuticals (USA) ITGLP08 – Health Care0803 – Biotechnology & Drugs           0.90       0.01     0.40     0.04     0.07

Lotsa little banks and tech companies.  Hey, I’m going to throw those with over $100 million of market cap into my next portfolio reshaping.  I’m still small enough as a manager to deal with small companies if they are well-managed.  This can bring me back to my microcap value days, where I invested 1992-1998.  Once I made an offer to buy more than 5% of a company, and I asked my bosses if they would have any problems if I had to make a 13F filing.  They gave me the go ahead; I made my offer and it was turned down.  Pity, because if it had worked, it would have been a great investment.

The table above is a beginning for due diligence.  I do not recommend any of the stocks there.  I do note that my reader’s stock is high on the list.

Some of these stocks could be good investments, but you would have to do the research to figure out which ones are good.  On the bright side, almost no one is analyzing these companies, so your analysis has more punch relative to company outsiders.  Insiders will still do better.

All that said, I suspect that these stocks will do well on average.

Where to Find Data

Saturday, January 11th, 2014

Here’s another letter from a reader:

Hi David,

I have been a long time reader of your blog but writing for the first time. To me a key part of the investment process for a generalist investor has to be a way to efficiently screen stocks to generate  investment ideas and also measure historical returns and fundametals for various industry groups under various economic conditions. I am curious as to what data sources you use in your own work for historical stock market and fundamental data? Do you pull this into your own database and do you use Excel or  a statistical package for any quantitative backtests for your screens?

In a previous job I used FactSet to pull historical monthly pricing and quarterly fundamental data for a universe of over 100 regulated utility stocks (both current and past public firms). I also taught myself a fair bit of statistics along the way including logistic regressions and discriminant analysis in order to backtest different models for identifying outperformers, dividend growth/cuts etc. Unfortunately I had to do this all in Excel, which made the whole process pretty painful right on from cleaning up outliers, sorting etc. I guess for simple queries of stock performance and tracking various fundamental metrics over time it would work touse Excel.

One motivation for asking is that I hope to one day become an investing blogger myself, and am wondering if there are low cost ways of accesing this kind of data. Additionally I am always interest in real world methods people follow to prune the thousands of possible stocks to invest in to a smaller more promising subset that people can invest more time analyzing on a fundamental basis. To me the hallmark of a successful investor is the willingness to unturn many investing stones until a promising idea is found.

I am a tightwad when it comes to paying up for data or software.  I use the following:

  • FRED
  • Yahoo Finance
  • Value Line via my local library
  • AAII Stock Investor (A screening package, but more than that)
  • The Wall Street Journal
  • FINRA TRACE — bond data
  • Bureau of Labor Statistics
  • Federal Reserve (but not FRED)
  • Microsoft Excel
  • If I need to do something complex, I can use the open source statistics package R.

AAII Stock Investor and Value Line are my main screeners.  I pay $100/year for AAII, and nothing for Value Line.  Oh, my library gives me Morningstar for free as well.  Both subscriptions are very full, and very useful as well.

Now all that said, though it is important to be able to access the data, developing the ability to interpret it is far more important.  There can be too much rigor in trying to analyze quantitative data.  You need to identify the three most significant variables that affect the result being analyzed and focus on analyzing them.  Most investment questions can be analyzed through the three most important variables.

Though I do backtests occasionally, I am happier to stick with theory, and base my actions off that.  Backtests are fraught with all sorts of bias, and basically say that the future will be like the past, only more so.

It would be great to have Bloomberg, FactSet, and some off-the-shelf statistics/programming package that integrates with them.  But life is tough, and we don’t always have that luxury, so we have to seek out data on the cheap, and analyze it cheaply also.

That’s how I do it now, but if I get more clients, I will start paying up for data and software.

Book Review: Rule Based Investing

Friday, January 3rd, 2014

Everyone would like a “money machine.”  Follow simple rules, and “Wow, this makes money.”  This is that kind of book but it has better foundations than most in its class.

The book examines three types of investing, most of which are foreign to average investors.  Most investors don’t invest in equity by shorting it, and most investors are not currency traders.

But that is what the book encourages.  I’m going to digress here, because I have to explain some salient matters, and say what I think, so that my later critique makes sense.

Volatility and credit are cousins.  After all when markets go nuts, and everything is in disarray, those that have been trying to borrow at low interest in one currency, and invest at higher interest in another currency get hosed.  Why?  Because in volatile times, the riskier currencies face capital flight versus safer currencies that have the confidence of the markets.

All of the methods mentioned in this book as a result are making bets on volatility/credit, and try to control the bet by monitoring implied volatility, credit spreads, and momentum.  They limit when they are in the market and when they are out.

I don’t have a problem with the theory here, but with the ability of average people to carry it out.  This book would be good for quantitative hedge fund managers; I am less certain about individuals here.

As an aside, what the book describes is how PIMCO has done so well at bond investing over its history — shorting volatility to pick up yield.

But the main criticism is this: the author optimized the book to fit her full data set.  When you read the last chapter, and see that you could have earned 30%+/year for 13 years, if you were as clever as the author, you should think, “Yes, if I had 20/20 foresight.”  The methods will not do as well in prospect as in retrospect.


There is little that I disagree with in the book on a theoretical basis.  Where I differ comes in two areas: individual investors will not have the fortitude to carry out what is a complex method of investment.  Secondly, when enough hedge fund money adopts these strategies, the pricing in the market will shift, and the hedge funds will no longer have easy money.

Who would benefit from this book: If you are willing to do the work of a volatility-selling hedge fund manager, this is the book for you.  If you want to, you can buy it here: Rule Based Investing.

Full disclosure: The publisher sent me the book after he offered me a review copy.

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.


Why Buy Convertible Bonds?

Sunday, December 29th, 2013

I sometimes answer questions for those at that ask basic investing questions.  Usually I point to old articles of mine, but this time someone asked a question that I have not answered before, and here it is:

What’s a convertible note? I’ve Googled for the answer but can’t find a simple answer. Why would one take a note when investing rather than equity?

Some people want the best of both worlds.  I want upside potential, but I want a guaranteed downside where I still make money.  That’s a convertible bond (or note, same thing).  The convertible bond promises to pay you income though interest payments, but allows for the possibility that you will want to exchange the bond for a fixed number of shares in the company.  When would you want to do such an exchange?  You would exchange when the stock price rises to the point where the bond is worth more converted into stock.

Let’s look at this question from the other side for a moment.  Why would a company issue a convertible bond?  There are several reasons:

  • Typically, companies that issue convertible bonds have credit ratings that are junk or low investment grade.  They want a low interest payment for a company of their credit quality, and so they trade potential issuance of more stock at a time where it would hurt, for lower current interest payments.
  • Often, the companies that offer convertible bonds are growth companies that need capital, but they might have a hard time doing an ordinary junk bond.  Convertible bonds have a ready buyer base.
  • Convertible bonds can be the “financing of last resort” for companies that are in financial trouble.  (Article one, article two)

Now, many convertible bonds are issued by companies that subsequently don’t do well, and the bonds get bought by junk bond managers who buy them as junk bonds — they are called “busted converts.”  They trade as if there is no conversion option, and some clever junk bond managers buy them, knowing that if a few of them have stocks that rally significantly, they will make enough extra money to aid their performance.

For what it is worth, the same ideas apply to convertible preferred stock, except that is bought primarily by individuals, while the bonds are bought by institutional investors.  Also note that preferred stock has weaker credit quality than bonds.  In liquidation, bonds get paid before preferred stock.

Final Notes

Convertible bonds changed when hedge funds emerged to invest in cheap convertible bonds, because the conversion option was frequently undervalued.  As they became a larger force in the market convertible bonds rose in value, until they were largely not attractively priced.

Prior to that era convertible bond funds regularly outpaced other bond funds.  They behaved kind of like a funny type of balanced fund.

As an investment grade corporate bond manager, I bought a convertible bond once, where it was “busted,” and was attractive just for the income alone.  As it was, after I left the firm, the stock rallied to the point where converting to stock made sense.

This is tough: convertible bonds make sense for those that want the possibility of extra income if the stock price rises, but are willing to take a lower income on the convertible bond versus straight debt.

Oh, one more thing, again, generally only lower rated companies issue convertible debt, so you have to live with a higher level of default risk.  Yes, convertible bonds offer the best of both worlds… so long as the issuer doesn’t default.

Unconstrained Will Get Overdone

Tuesday, December 24th, 2013

Maybe I’ve just had a couple of unusual random draws from the information urn, but it seems to me that unconstrained mandates are getting more favorable investment attention from investment consultants than they used to.  The “style box” is breaking down a little, and I think that is a good thing.

My view of the investing world starts with industries, not market cap size, and not even growth/value.  Much as I end up on the value side, I am flexible on what constitutes value in different industries.  I range from growth at a reasonable price to deep value.  It depends on the state of the industry.

All that said, let me talk a little about what it takes to be a good unconstrained manager.  Organizationally, you have to understand a lot of things better than the rest of the world.  Do you understand the market, factor, and industry cycles, as well as asset level misvaluations? Investors have the choice of the informationless index, which typically does well versus the average active manager.

As consultants analyze unconstrained managers, their models will get stretched.  The more degrees of freedom a manager has, the tougher it is to evaluate them.  If an unconstrained manager made a brilliant tactical move once, can he do it twice?  Three times?  More?

Think of the few market players that got short prior to the 1987 crash.  Aside from Elaine Garzarelli, none were heard from again, and Garzarelli never had a second episode like that in 1987.

It is really tough to come up with significant ideas that will make a huge difference in security returns.  Home run hitters usually do not hit for average.

What I suspect will happen is this: the initial unconstrained managers will do well, but they will reach capacity limits, and lesser managers will put out “me too” products.  Consultants will buy into those products to some degree, and a decent number of them will fail to meet expectations.  The investors hiring the consultants will wonder why they hired them.  If there is no skill to picking unconstrained managers, then why not pick them directly themselves, or just go back to indexes?

I write this as one that mostly manages equities, long-only.  I like having no constraint on market cap, value factors, industry, and country selection.  I like to roam the world in search of value.  I like to concentrate on industries when I have a good thesis.  Why should I have non-economic criteria limiting my choices, if I reason well?

That’s why I like unconstrained mandates.  I run one for upper-middle class individuals, and small institutions.  But every manager will not do well with it, because most investment organizations are not designed to think that broadly.

Thus I expect that investment consultants will revert to the “style box” (or something new like it) once they realize that few managers can consistently generate alpha over a full market cycle whether unconstrained of constrained.  At least with constrained, the variation when they do badly is more limited, which protects the consultant, who also does not want to end up in the fourth quartile, where business is lost.

Book Review: Why Stocks Go Up and Down, Fourth Edition

Tuesday, December 3rd, 2013

Book Cover

This is a good book to help the inexperienced learn about investing.  It begins by teaching the rudiments of accounting through the adventures of a man and his company who have built a better mousetrap.

He starts the business on his own, but needs more capital.  In the process of growing, he taps bank loans, private investors, public investors, bonded debt, and preferred stock.  All of this is done with simple explanations in a step-by-step manner.

The book then explains bonds and preferred stocks.  At first I was a little skeptical, because this is supposed to be a book about stocks, and the authors made a small initial error in that section.  That was the last error they made.  I became impressed with their ability to explain corporate bonds and preferred stocks, even some arcane structures like trust preferred securities, and other types of hybrid debt.

Now, if I were trying to shorten the book, a lot of those sections would have been cut.  For those that do want to learn about bonds in the midst of a stock book, you get a free bonus.  If you don’t want to spend the time on bonds, you can skip those sections with little effect on your ability to understand the rest of the book.

Then the book turns to trickier aspects of accounting, explaining cash flow from operations, and free cash flow.  It’s all good stuff, but here is my first problem with the book: what is the most common way of giving a distorted picture of earnings?  Revenue recognition policies.  The book does not talk about revenue recognition, and the most basic idea of Generally Accepted Accounting Principles [GAAP], which is revenue gets taken into earnings proportionate to the delivery of goods and services.  With financial companies, revenues are earned proportionate to release from risk.

That brings up another point.  The book is very good for describing the analysis of an industrial company, but does little to describe how to deal with financial companies.  Financial companies are different, because most of the cash flow statement has no meaning.

Then the book moves on to valuation of common stocks, and that is where I have my biggest problem with the book.  Though they mention other means of valuing stocks, their main valuation method is earnings.  The book does not mention price-to-book as a metric, which is a considerable fault.  Price-to-book is the main way to value financials versus ROE, while price-to-sales is a very good way to measure industrials relative to relative to profit margins.

Further, it suggests that P/E multiples should remain constant as a company grows.  I’m sorry, but P/E multiples tend to shrink as a company grows.  This is because the highest margin opportunities are exploited first, and then lesser opportunities.  For the P/E to remain constant, or even expand means that new opportunities are being exploited that have higher margins.  Investors should not count on that.

These mistakes are minor, though, compared to the good that the book does for an inexperienced investor.


Already expressed.

Who would benefit from this book: This is a classic book that will aid inexperienced investors to learn the basics.  Just remember, it is only the basics, and it covers most things, but not all things. It would be an excellent book for one of your relatives or friends that think they know what they are talking about in investing, but really doesn’t know.  If you want to, you can buy it here: Why Stocks Go Up and Down.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

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.

Two More Good Questions

Friday, November 29th, 2013

I had two more good questions in response to my piece Why I Resist Trends.  Here we go:

I think you have some idea which ones are the best by the discount to intrinsic value. If you were running a business (which you are when you are investing) and you had 10 projects with lets say a minimum return of 5% but a spread of 20% to 5% wouldn’t you first invest in the 20% return project and fund each project in descending order of return. By equally weighing aren’t you equally investing in the 5% and 20% projects? If you were a CEO shouldn’t the shareholders fire you? I know the markets have more volatility than projects due to the behavioral aspects of investing but in my view equally weighting is more important when you do not know much about your investment and less important when you do. I think you know a lot about the companies you invest in. Why not try an experiment. Either in real time or historically take a look at what would have happened overtime if you would have weighed you selections by discount from intrinsic value. I think you will be pleasantly surprised. I and John Maynard Keynes have been pleasantly surprised.

I do this in a limited way.  In the corporate bond market we have the technical term “cheap.”  We also have the more unusual technical term “stupid cheap” for bonds that are very undervalued.

When I have a stock that is “stupid cheap” I make it a double weight, if it passes margin of safety and other criteria.  On one rare occasion I had a triple weight.

But I meant what I said  in Portfolio Rule Seven — “Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best.”  I have been surprised on multiple occasions as to what would do best.  Investing is not as simple as assessing likely return.  We have to assess downside risks, and possibilities that some things might go better than the baseline scenario.

I don’t use a dividend discount model, or anything like it.  I don’t think you can get that precise with the likely return on a stock.  My investing is based on the idea of getting very good ideas, as opposed to getting the best ideas.  I don’t think one can get the best ideas on any reliable basis.  But can you find assets with a better than average chance of success?  My experience has been that I can do that.

So, I am happy running a largely (but not entirely) equal-weight portfolio.  It is an admission of humility, which tends to get rewarded in investing.  Bold approaches fail more frequently than they succeed.

By the way, though Keynes was eventually successful, he cratered a couple times.  I have never cratered on a portfolio level, because of my focus on margin of safety.

On to the next question:

What are the tests you use to check if accounting is fair?

Start with my portfolio rule 5, here’s a quick summary:

Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

  1. For nonfinancials, review the difference between cash flow from operations and earnings.  Companies where cash flow from operations does not grow and  earnings grows are red flags.  Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.  The latter portion of that rule can be applied to financials.

  2. For nonfinancials, review net operating accruals.  Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.    The values of assets on the balance sheet are squishier than most believe.  The accruals there are not entirely trustworthy in general.

  3. Review taxable income versus GAAP income.  Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.  b) management is clever in manipulating GAAP earnings.  It is the job of the analyst to figure out which it is.

  4. Review my article “Cram and Jam.”  Does management show greater earnings than the increase in book value plus dividends?  Bad sign, usually.  Also, does management buy back stock aggressively — again, that’s a bad sign.

Then add in my portfolio rule 6, here’s a quick summary:

Cash flow is the lifeblood of business.  In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

  • I want to avoid companies that do big scale acquisitions.  Large acquisitions tend to waste money.

  • I also want to avoid companies that do acquisitions that are totally unrelated to their existing business.  Those also waste money.

  • I want to avoid companies that buy back stock at all costs.  They waste money by paying more for the stock than the company is worth.

  • This was common in the 50s and 60s but not common today, but who can tell what the future will hold?  I want to avoid companies that pay dividends that they cannot support.

Portfolio rule 6 does not deal with accounting per se, but management behavior with free cash flow.  Rules 5 and 6 reveal large aspects of the management character — how conservative are they?  How honest are they?  Do they use corporate resources wisely?

On Ethics in Business and Investing

I would add in one more thing on ethics of the management team — be wary of a company that frequently plays things up to the line ethically and legally, or is always engaged in a wide number of lawsuits relative to its size.

I know, we live in a litigious society — even good companies will get sued.  But they won’t get sued so much.  I realize also that some laws and regulations are difficult to observe, and interpretations may vary.  But companies that are always in trouble with their regulator usually have a flaw in management.

A management team that plats it “fast and loose” with suppliers, labor, regulators, etc., will eventually do the same to shareholders.  Doing what is right is good for its own reasons, but for investors, it is also a protection.  A management that cheats is in a certain sense less profitable than they seems to be, and eventually that reality will manifest.

All for now, and to all my readers, I hope you had a great Thanksgiving.

On Investment Ideas, Redux

Tuesday, November 26th, 2013

Would I disclose proprietary ideas of mine?  I’ve done it before.  Why would I do it?  Because it would take a lot to make the ideas usable.  Remember my commentary from when I was a bond manager: I was far more open with my brokers than most managers, but I never gave them the critical bits.

So a reader asked me:

Any chance you could expand on what quantitative metrics you are using to compare potential investments? Could you also name a few of the 77 13fs you track? Thanks

I will go above and beyond here.  You will get the names of all 78 — here they are:

  • Abrams
  • Akre
  • Altai
  • Ancient Art
  • Appaloosa
  • Atlantic
  • Bares
  • Baupost
  • Blue Ridge
  • Brave Warrior
  • Bridgewater
  • BRK
  • Capital Growth
  • Centaur
  • Centerbridge
  • Chieftain
  • Chou
  • Coatue
  • Dodge & Cox
  • Dreman
  • Eagle Capital
  • Eagle Value
  • Edinburgh
  • Fairfax
  • Farallon
  • Fiduciary
  • Force
  • FPA
  • Gates
  • Glenview
  • Goldentree
  • Greenhaven
  • Greenlight
  • H Partners
  • Hawkshaw
  • Hayman
  • Hodges
  • Hound
  • Hovde
  • Icahn
  • Intl Value
  • Invesco
  • Jana
  • JAT
  • Jensen
  • Joho
  • Lane Five
  • Leucadia
  • Lone Pine
  • M3F
  • Markel
  • Matrix
  • Maverick
  • MHR
  • Montag
  • MSD
  • Pabrai
  • Parnassus
  • Passport
  • Pennant
  • Perry
  • Pershing Square
  • Pickens
  • Price
  • Sageview
  • Scout
  • Soros
  • Southeastern
  • SQ Advisors
  • Third Point
  • Tiger Global
  • Tweedy Browne
  • ValueAct
  • Viking Global
  • Weitz
  • West Coast
  • Wintergreen
  • Yacktman

What I won’t tell you is what I do with their data, because it is different from what most do.  But you can play with it.

Then you asked about factors.  Here are my factors:

  • Price change over the last year
  • Price change over the last three years
  • Insider buying
  • Price-to-earnings, both current and forward
  • Price-to-book
  • Price-to-sales
  • Price-to-free cash flow
  • Price-to-sales
  • Dividend yield
  • Neglect (Market cap / Trading volume)
  • Net Operating Assets
  • Stock price volatility over the last three years
  • Asset growth over the last three years
  • Sales growth over the last three years
  • Quality (gross margins / assets)

Now that I have “bared all,” I haven’t really bared all, because there is a lot that goes into the preparation and analysis of the data that can’t be grasped from what I have revealed here.  To go into that would take more time than I can spend.  That’s one reason why as a corporate bond manager, I would share more data with my brokers than most would do, because I knew that the last 20% that I reserved was the real gold.  That I would not share.

Beyond that, there are my industry rotation models, which I share 4-6x per year, and then my qualitative reasoning, which makes me reject a lot of ideas that pass my quantitative screens.

That’s what I do.  It’s not perfect, and my qualitative reasoning has its faults as well.  I encourage you to develop your own theories of value, as Ken Fisher encouraged me to do back in early 2000.  Develop your edge, with knowledge that you have that few others do.  I’ll give you an example.

I understand most areas in insurance.  I don’t get everything right, but it does give me an edge, because insurance accounting and competition is a “black box” to most investors.  Insurance has been one of the best performing industries over time, but many avoid it because of its complexity and stodginess.

Behind the hard to understand earnings volatility, there is sometimes a generally profitable franchise that will make decent money in the long run.  But few get that, and that is an “edge” of mine.  Develop your own edge.

That’s all for now.  Invest wisely, and be wary, because the market for risk assets is high, and what if the Fed stops supporting it?  Make sure your portfolio has a margin of safety.


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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