This is a story of triumph and tragedy.  Jesse Livermore is notable as one of the few people who ever made it into the richest tiers of society by speculating — by trading stocks and commodities — betting on price movements.

This is three stories in one.  Story one is the clever trader with an intuitive knack who learned to adapt when conditions changed, until the day came when it got too hard.  Story two is the man who lacked financial risk control, and took big chances, a few of which worked out spectacularly, and a few of ruined him financially.  Story three is how too much success, if not properly handled, can ruin a man, with lust, greed and pride leading to his death.

The author spends most of his time on story one, next most on story two, then the least on story three.  The three stories flow naturally from the narrative that is largely chronological.  By the end of the book, you see Jesse Livermore — a guy who did amazing things, but ultimately failed in money and life.

Let me briefly summarize those three aspects of his life so that you can get a feel for what you will run into in the book:

The Clever Trader

Jesse Livermore came to the stock market in Boston at age 14, and was a very quick study.  He showed intuition on market affairs that impressed the most of the older men who came to trade at the brokerage where he worked.  It wasn’t too long before he wanted to invest for himself, but he didn’t have enough money to open a brokerage account, so he went to a bucket shop.  Bucket shops were gambling parlors where small players gambled on stock prices.  He showed a knack for the game and made a lot of money.  Like someone who beats the casinos in Vegas, the proprietors forced him to leave.

He then had more than enough money to meet his current needs, and set up a brokerage account.  But the stock market did not behave like a bucket shop, and so he lost money while he learned to adapt.  Eventually, he succeeded at speculating on both stocks and commodities, leading to his greatest successes in being short the stock market prior to the panic of 1907, and the crash in 1929.  During the 1920s, he started his own firm to try to institutionalize his gifts, and it worked for much of the era.

After the crash in 1929, the creation of the SEC and all the associated laws and regulations made speculating a lot more difficult, to the point where he could not make significant money speculating anymore.

The Poor Financial Risk Manager

Amid the successes, he tended to aim for greater wins after his largest successes, which led to him losing much of what he had previously made.  One time he was cheated out of much of what he had while trading cotton.

Amid all of that, he was well-liked by most he interacted with in a business context.  Even after great losses, many wanted him to succeed again, and so they bankrolled him after failure.  Before the Great Depression, he did not disappoint them — he succeeded in speculation and came roaring back, repaying all of his past debts with interest.

In one sense, it was live by the big speculation, and die by the big speculation.  When you play with so much borrowed money, it’s hard for results to not be volatile.

A Rock Star of His Era

When he won big, he lived big.  Compared to many wealthy people of his era, he let spending expand far more than many who had  more reliable sources of income.  Where did the money go?  Yachts, homes, staff, wives, women, women, women…  Aside from the last of his three wives, his marriages were troubled.

His last wife was a nice woman who was independently wealthy, and after Livermore lost it all in the mid-’30s, he increasingly relied on her to stay afloat.  When he could no longer be the hero who could win a good living out of the market via speculation, his deflated pride led him to commit suicide in 1940.

A Sad Book Amid Amazing Successes

Sadly, his son and grandson who shared his name committed suicide in 1975 and 2006, respectively.  On the whole, the story of Jesse Livermore’s life and legacy is a sad one.  It should disabuse people of the notion that wealth brings happiness.  If anything, it teaches that money that comes too easily tends to get lost easily also.

The author does a good job weaving the strands of his life into a consistent whole.  The book is well-written, and probably the best book out there on the life of the famous speculator that so many present speculators admire.  A side benefit is that in passing, you will learn a lot about the development of the markets during a time when they were less regulated.  (The volatility of markets was obvious then.  It not obvious now, which is why people get surprised by it when it explodes.)



Summary / Who Would Benefit from this Book

This is a comprehensive book that explains the life and times of Jesse Livermore, one of the greatest speculators in history.  It will teach you history, but it won’t teach you how to speculate.  If you want to buy it, you can buy it here: Jesse Livermore – Boy Plunger: The Man Who Sold America Short in 1929.

Full disclosure: I received a copy from a kind PR flack.

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.

The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer.

The cause for tonight’s article is a piece from the Wall Street Journal, Time to End Quarterly Reports, Law Firm Says.  Here’s the first two sentences:

Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.

Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals.

The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy.  I disagree. There are at least four things that are false in the arguments made in the article, and in books like Saving Capitalism from Short-Termism:

  • Quarterly earnings don’t produce value in and of themselves
  • Quarterly earnings cause most corporations to ignore the long-term.
  • Ending quarterly earnings will end activism, buybacks, and dividends.
  • Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing.

Why Quarterly Earnings are Valuable

I’ve written a number of articles about quarterly earnings and estimates of those earnings: Earnings Estimates as a Control Mechanism, Flawed as they are, and Earnings Estimates as a Control Mechanism, Flawed as they are, Redux.  The basic idea is this: quarterly earnings results give investors an idea as to whether the companies remain on their long-term growth path or not.  As I wrote:

Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.  Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.  The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

Don’t think of the quarterly earnings in isolation.  A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods.  A bad earnings number lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great.  Vice-versa for a good number.

Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.”  That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down.

They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem.  In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings.

In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital.  When the measurement periods get too long, discipline can be lost.

Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term

Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings.  Even if the current period’s earnings meet the estimates, the job is not done.  If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall.  The short-term is just the beginning of the long-term.  It is not either/or but both/and.  A company has to try to explain to investors how it is growing the value of the firm — if present targets aren’t being met, why should there be any confidence that the future will be good?

Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal.  The quarterly earnings measure whether the progress toward completing the goal is adequate or not.  Now, the measure is not perfect, but who can think of a better one?

Ending Quarterly Earnings Would Not End Activism, Buybacks, and Dividends

I can think of an area in business where earnings estimates don’t play a role — private equity.  Are the owners long-term oriented? Yes.  Are they short-term oriented?  Yes.  Is capital managed tightly?  Very tightly.  All excess capital is dividended back — it as if activists run the firms permanently.

If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders.  Activists would still analyze companies to see if they are badly managed, and in need of change.  If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe.  Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings.

On the Use of Excess Capital

Investing, particularly for the long-term, is not risk-free.  In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete.  In such an environment, it can make a lot of sense to focus on shorter-term investments that are more certain as to the success of the project.  It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently.  Companies that shrink their balance sheets tend to outperform those that grow them.

As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors.  The same is true of large versus small investments for organic growth away from M&A.  Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing.  There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not.

In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that.  That’s how biotech firms work, and it is why so many of them fail.  The few winners are astounding.

Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity.  All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted returns, and not wasted on speculative projects with uncertain returns.  The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive.

Remember, bad investments are just expenses in fancy garb — it just takes the accounting longer to recognize the losses.  Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality.  Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash.  Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company.


If quarterly earnings are abolished, intelligent corporations won’t change much.  Investment won’t go up much, and the time horizon of most management teams will not rise much.  If you need any proof of that, look at how private equity and large mutual insurers manage their firms — they still analyze quarterly results, and are conservative in how they deploy capital.

The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors.  Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies.

Other Aleph Blog Articles for Consideration

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

I’m currently reading a book about the life of Jesse Livermore.  Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit.  He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.

What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks.  Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market.  Remember, in those days, margin loans required only 10% initial equity, not the 50% required today.  A modest move down in the stock market could create a self-reinforcing panic.

All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet).  In both cases you had a mix of:

  • High leverage
  • Short lending terms with long-term assets (stocks) as collateral.
  • Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
  • Inflated asset values on the stock collateral.
  • Inadequate loan underwriting standards at many trusts and banks
  • Inadequate solvency standards for regulated financials.
  • A culture of greed ruled the day.

Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today.  The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.

In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.

Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.

I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any?  Leave a comment.

Subprime lending is returning also, though not in housing yet…

Parting Thoughts

I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis.  Since risky borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era.  There would be some art to this.  A raw leverage ratio, or fixed charges ratio in the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough.  The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)

In a highly leveraged situation with chains of lending, confidence becomes crucial.  Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!”  The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death.  Confidence only deserves to exist among balance sheets that are conservative.

That’s all for now.  Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.

One of the constants in investing is that average investors show up late to the party or to the crisis.  Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.

One reason why this happens is that information gets distributed in lumps.  We don’t notice things in real time, partly because we’re not paying attention to the small changes that are happening.  But after enough time passes, a few people notice a trend.  After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc.  More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press.  The final phase is when general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!

That slow dissemination and gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger.  As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.

There is another aspect to this, and that stems from the way that people commonly evaluate managers.  We use past returns as a prologue to what is assumed to be still greater returns in the future.  This not only applies to retail investors but also many institutional investors.  Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes.  (This also happens with hedge funds… there is nothing special in fund analysis there.)

For the retail crowd it is worse, because most investors look at past returns when evaluating managers.  Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating.  This not only applies to individuals, but also committees that choose funds for defined contribution plans.  If they don’t choose the funds with four or five stars, they get complaints, or participants don’t use the funds.

Another Exercise in Dollar-Weighted Returns

One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar-weighted (weighted geometric average/IRR) returns.  The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned.  Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar-weighted returns.  Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar-weighted returns gets.  The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.

(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade.  There may be intelligent ways to trade, but they are always a minority among market actors.)

HSGFX Dollar Weighted Returns

HSGFX Dollar and Time Weighted Returns

That brings me to tonight’s fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets.  The results started out promising, attracting assets in the process, and then didn’t do so well, and assets have slowly left.  For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014.  The fund’s fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption.  At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.

To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.”  The cash flow for each fiscal year is equal to the net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders.  Once I have the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar-weighted rate of return.

In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar-weighted rate of return.  The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.

From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%.  That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors.  This is not meant to be a criticism of Hussman’s performance or methods, but simply a demonstration that a lot of people invested money after the fund’s good years, and then removed money after years of underperformance.  They timed their investment in a market-timing fund poorly.

Now, Hussman’s fund may do better when the boom/bust cycle turns if his system makes the right move somewhere near the bottom of the cycle.  That didn’t happen in 2009, and thus the present state of affairs.  I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it.  But when I realized that I did not have the personal ability/willingness to buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.

One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not invest in Mr. Hussman’s funds.  Past returns by themselves tell you almost nothing about future returns.  The hard questions with a fund like this are: when will the cycle turn from bullish to bearish?  (So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?

Those questions are impossible to answer with any precision, but at least those are the right questions to ask.  What, you’d rather have the answer to a simple question like how did it return in the past, that has no bearing on how the fund will do in the future?  Sadly, that is the answer that propels more investment decisions than any other, and it is what leads to bad overall investment returns on average.

PS — In future articles in this irregular series, I will apply this to the Financial Sector Spider [XLF], and perhaps some fund of Kenneth Heebner’s.  Till then.

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless.  But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust.  Half of the interview aired — the part on domestic matters.  The part on Greece and China didn’t air, and what a pity.  I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy.  People had a hard time figuring out where to put their money.  Savings and fixed income didn’t offer much.  Real Estate was great if you could afford it.  The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes.  Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago.  Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods.  Short-termism and following momentum is most of what creates bubbles.  Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt.  Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down.  When the amount of equity in the  account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made.  When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels.  This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom.  (Note: that article won a small award. Powerpoint presentation here.)  The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly fake, because all of the borrowing is temporarily pulling future prosperity into the present.  When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not.  Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers.  In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling).  They are trying to be more liberal about liquidating margin debt.  They are limiting share sales by major holders.  They are postponing IPOs.  They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble.  I think they are deluded.  Yes, they are relatively more powerful in their own country than US regulators and policymakers.  But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have low forward-looking returns.  If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more.  For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here.  It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself.  Remember, margin of safety matters.  More on that coming in a future post.

My last post has many implications. I want to make them clear in this post.

  1. When you analyze a manager, look at the repeatability of his processes.  It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life.  Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
  2. When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero.  It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself.  It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
  3. Often when countries open up to foreign investment, valuations are relatively low.  The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money.  Eventually an adjustment comes, and shakes out the undisciplined investors.  But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
  4. Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc.  After the paper is published, money starts getting applied to the idea, and the strategy will do well initially.  Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels.  Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies.  Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist.  Those are almost always the best years for a factor (or other) anomaly strategy.
  5. During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by the early purchasers.  During a credit bust, it is rare for a new security type to fare well.
  6. Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety.  Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
  7. Always think about the carrying capacity of a strategy when you look at an academic paper.  It might be clever, but it might not be able to handle a lot of money.  Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
  8. Also look at how an academic paper models trading and liquidity, if they give it any real thought at all.  Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
  9. Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds.  I.e., there should be “new money allowed” indexes.
  10. Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing.  It produced great returns 9 years out of 10.  but once distressed investing and event-driven because heavily done, the idea lost its punch.  Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not do as well in the future.
  11. The same applies to a lot of clever managers.  They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past.  If they have the opportunity to sell, they will disproportionately do so then.
  12. Corporate management teams are like rock bands.  Most of them never have a hit song.  (For managements, a period where a strategy improves profitability far more than most would have expected.)  The next-most are one-hit wonders.  Few have multiple hits, and rare are those that create a culture of hits.  Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it.  Thus, advantages accrue to those who can spot clever managements before the rest of the market.  More often this happens in dull industries, because no one would think to look there.
  13. It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this.  You will end up getting there once the period of genius is over, and valuations have adjusted.  It might be better to buy the burned out stuff and see if a positive surprise might come.  (Watch margin of safety…)
  14. Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway.  Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably.  if you must pay attention to macro in investing, always ask, “Is it priced in or not?  How much of it is priced in?”
  15. Most asset allocation work that relies on past returns is easy to do and bogus.  Good asset allocation is forward-looking and ignores past returns.
  16. Finally, remember that some ideas seem right by accident — they aren’t actually right.  Many academic papers don’t get published.  Many different methods of investing get tried.  Many managements try new business ideas.  Those that succeed get air time, whether it was due to intelligence or luck.  Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here.  Just be cautious with new investment strategies, whatever form they may take.  Make sure that you maintain a margin of safety; you will likely need it.

Investing ideas come in many forms:

  • Factors like Valuation, Sentiment, Momentum, Size, Neglect…
  • New technologies
  • New financing methods and security types
  • Changes in government policies will have effects, cultural change, or other top-down macro ideas
  • New countries to invest in
  • Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc.
  • New asset classes or subclasses
  • Durable competitive advantage of marketing, technology, cultural, or other corporate practices

Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives.  When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out.

For an example, think of Ben Graham in the early days.  He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression.  As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities.

As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left.  Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate.

The returns generated during its era were phenomenal, but for the most part, they were never to be repeated.  Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles.  It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea.

Value investing principles, rather than dying there, broadened out to consider other ways that securities could be undervalued, and the analysis process began again.

My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten.

Now think of the technologies that led to the dot-com bubble.  The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed.  The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight.

My second point is that often the price performance of an investment idea overshoots.  Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting.  It might happen because of expected demand that does not occur, or too much short-term leverage applied to long-term assets.

Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea?  A new investment factor is discovered:

  1. it earns great returns on a small amount of assets applied to it.
  2. More assets get applied, and more people use the factor.
  3. The factor develops its own price momentum, but few think about it that way
  4. The factor exceeds the “carrying capacity” that it should have in the market, overshoots, and burns out or crashes.
  5. It may be downplayed, but it lives on to some degree as an aspect of investing.

On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor.  By the time a lot of money was applied to the factor, the future excess returns were either small or even negative.  On a dollar-weighted basis, the verdict on the factor might not be so hot.

So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future?  Not very useful.  Dollar weighted?  Better, but still of limited use, because the discovery era will likely never be repeated.

What should we do then to make decisions about any factor/idea for purposes of future decisions?  We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated.  That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present.

It leaves us with a mess, and few firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.”

That’s all for now.  As always, be careful with your statistics, and use sound business judgment to analyze their validity in the present situation.

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets.  In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums?  I don’t have the article in front of me but I’ll toss out a few.

  • Many were Credit-oriented.  Lend and make money.
  • Some were volatility-oriented.  Sell options on high volatility assets and make money.
  • Some were currency-oriented.  Buy government bonds where they yield more, and short those that yield less.
  • Some had you act like a bank.  Borrow short, lend long.
  • Some were like value investors.  Buy cheap assets and hold.
  • Some were akin to arbitrage.  Take illiquidity risk or deal/credit risk.
  • Others were akin to momentum investing.  Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

  • Someone will start a hedge fund off this.
  • Many of these are correlated; with enough leverage behind it, the hedge fund could leave a very large hole when it blows up.
  • Yes, who wouldn’t want to be a bank without regulations?
  • What an exercise in data-mining and overfitting.  The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
  • Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc.  (Even those are not truly free; animals have to be fed and cared for.)  They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that pays all of its interest and principal.  Usage: “Is it ‘money good?'”  “Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you.  There are a few problems though:

  • Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
  • Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another.  What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle?  What insurance company wouldn’t want to sell off its junk bonds at that time as well?  And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing.  Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be.  Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

Today I saw an article about a high school investing contest, and like most contests of that type, it does not teach investing, but speculation.

I’ve wanted to try this for about ten years or so.  I’d like to try running a stock picking contest, but only if I can offer decent prizes, and get enough participants.  I’ve written about this before, these would be the rules:

  1. No leverage and no shorting
  2. No trading — buy & hold
  3. No Exchange Traded Products, and only common stocks
  4. Minimum market capitalization of $100 million
  5. Only stocks traded on US exchanges
  6. Forced diversification — a portfolio of ten stocks equally weighted
  7. One stock from each of ten volatility buckets, to reduce speculation
  8. Highest geometric mean return wins — this gives a bonus to consistency, which also reduces speculation.  (Alternative rule: the best return on the seventh best stock in each portfolio wins.)
  9. Six month time frame.
  10. One entry per person.

The most critical rules are seven and eight.  The idea is to get people to think like investors, not speculators.  By forcing investors to buy a broad range of companies from conservative to aggressive will force them to evaluate individual companies, with an eye to avoiding big losers.  Rule number one, as many say, is don’t lose money.  This would honor the idea of avoiding losses while trying to make gains.  It would be a lot like what intelligent investing in a portfolio of stocks is really like.

The idea is to promote stock-picking.  Now lest you think I have taken all of the speculation out of this, let me tell you what my rules don’t stop:

  • Factor tilts — you can assemble a portfolio with price momentum
  • Industry and sector tilts
  • Foreign tilts
  • Size tilts
  • Valuation tilts
  • Investing in special situations
  • Copying famous investors

Now, Who Would Be Sponsors?

I can’t fund this on my own.  Also, I don’t think registration fees could fund such a contest.  Parties that could benefit from the branding and free advertising would include financial information companies and brokerages — they are some of the logical beneficiaries of promoting stock-picking.  So, would the following consider sponsoring such a contest?

  • Wall Street Journal, Yahoo Finance, Bloomberg, Marketwatch, Reuters, Money, Value Line, theStreet.com, etc.
  • Nasdaq OMX, Intercontinental Exchange
  • Schwab, E-Trade, Scottrade, Interactive Brokers, Ameritrade, Fidelity, ETrade, etc.

I don’t know, but I would want to have at least 1,000 entrants and $50,000 in prize money if were going to run a contest like this.  I’m sure it would be a lot of fun, and would teach investors a lot about investing, as opposed to speculation.

Thoughts?  Send them to me.  (Especially if you are interested in sponsoring the event.)

I imagine the SEC (or the Fed, IRS, or the FSOC) saying: “If we only have enough data, we can answer the policy questions that we are interested in, create better policy, prosecute bad guys, and regulate markets well.”

If they deigned to listen to an obscure quantitative analyst like me, I would tell them that it is much harder than that.  Data is useless without context and interpretation.  First, you have to have the right models of behavior, and understand the linkages between disparate markets.  Neoclassical economics will not be helpful here, because we aren’t rational in the ways that the economists posit.

Second, in markets you often find that causation is a squirrelly concept, and difficult to prove statistically.  Third, the question of right and wrong is a genuinely difficult one — what is acceptable behavior in markets?  Do we run a market for “big boys” who understand that this is all “at your own risk,” or a market that protects the interests of smaller players at a cost to the larger players?  Do we run a market that encourages volume, speed and efficiency, or one that avoids large movements in prices?

This article is an attempt to comment on the Wall Street Journal article on the SEC’s effort to create the Consolidated Audit Trail [CAT], in an effort to prevent future “flash crashes,” like the one we had five years ago.  I don’t think the efforts of the SEC will work, and I don’t think the goal they are pursuing is a desirable one.

People take actions in the markets for a wide number of reasons.  Some are hedging; some are investing; others are speculating.  Some invest for long periods, and others for seconds, and every period in-between.  Some are intermediaries, while others are direct investors.  Some are in one market, while others are operating in many markets at once.  Some react rapidly, and others trade little, if at all.  Just seeing that one party bought or sold a given security tells you little about what is going on and why.

Following price momentum works as an investment strategy, until the volume of trading following momentum strategies gets too high.  Then things go nuts.  Actions that by themselves are innocent may add up to an event that is unexpected.  After all, that is what dynamic hedging led to in 1987.  There was no sinister cabal looking to drive the market down.  And, because the event did not reflect any fundamental change to where valuations should be, price came back over time.

My contention is even with the huge amount of data, there will still be alternative theories, information that might be material excluded, and fuzziness over whether a given investment action was wrong or not.

After that, we can ask whether the proposed actions of the government provide any significant value to the market.  Some are offended when markets move rapidly for seemingly no reason, because they lose money on orders placed in the market at that time.  There is a much simpler, money saving solution to that close to home for each investor: DON’T USE MARKET ORDERS!  Set the price levels for your orders carefully, knowing that you could get lifted/filled at the level.

This is basic stuff that many investors counsel regarding investing.  If you use a market order you could get a price very different than what you anticipate, as I accidentally experienced in this tale.  I could complain, but is the government supposed to protect us from our own neglect and stupidity?  If we wanted that, there is no guarantee that we would end up with a better system.  After all, when the government sets rules, it does not always do them intelligently.

One of the beauties of capitalism is that it enables intelligent responses as a society to gluts and shortages without having a lot of rules to insure that.  Volatility is not a problem in the long run for a capitalist society.

If you lose money in the short run due to market volatility, no one told you that you had to trade that day.  Illogical market behavior, as in 1987 or the “flash crash” could be waited out with few ill effects.  Most of the difficulties inherent in a flash crash could be solved by people taking a longer view of the markets, and thinking like businessmen.

“It’s Baseball, Mom.”

I often spend time watching two of my younger children play basketball, baseball and softball.  They are often in situations where they might get hurt.  In those situations, after an accident, my wife gets antsy, while I watch to see if a rare severe injury has happened.  My wife asked one of my sons, “Don’t you worry about getting hurt?”  His response was, “It’s Baseball, Mom.  If you don’t get hurt every now and then, you aren’t playing hard enough.”  That didn’t put her at ease, but she understood, and accepted it.

In that same sense, I can tell you now that regardless of what the SEC does, there will be accidents, market events, and violent movements.  There will be people that complain that they lost money due to unfair behavior.  This is all a part of the broader “game” of the markets, which no one is required to play.  You can take the markets on your own terms and trade rarely, and guess what — you will likely do better than most, and avoid short-term volatility.

The SEC can decide what it wants to do with its scarce resources.  Is this the best use for the good of small investors?  I can think of many other lower cost ways to improve things… even just hiring more attorneys to prosecute cases, because most of the true problems the SEC faces are not problems of knowledge, but problems of the will to act and bear the political fallout for doing so.  And that — is a different game of baseball.