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The Good ETF, Part 2 (sort of)

Friday, April 18th, 2014

About 4.5 years ago, I wrote a short piece called The Good ETF.  I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.  There are many ETFs that are Closed-end funds in disguise.  An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures.  I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article: How a 56-Year-Old Engineer’s $45,000 Loss Spurred SEC Probe.  Quoting from the beginning of the article:

Jeff Steckbeck didn’t read the prospectus. He didn’t realize the price was inflated. He didn’t even know the security he read about online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a volatility bet, or about 80 percent of his investment, after a Credit Suisse Group AG (CSGN) note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he’d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

“In theory, everybody’s supposed to read everything right to the bottom line and you take all the risks associated with it if you don’t,” he said this month by phone from Lebanon, Pennsylvania. “But in reality, you gotta trust that these people are operating within what they generally say, you know?”

No, you don’t have to trust people blindly.  Reagan said, “Trust, but verify.”  Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets.  In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print.  You need to read the fine print.  Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed.  Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they’re selling or suspend new offerings or take other actions that can affect their value, according to the letter.


“My experience with ETN prospectuses is that they’re very clear about the fees and the risks and the transparency,” Styrcula said. “Any investor who invests without reading the prospectus does so at his or her own peril, and that’s the way it should be.”


The offering documents for the VelocityShares Daily 2x VIX (VIX) Short Term ETN, the TVIX, says on the first page that the security is intended for “sophisticated investors.” The note “is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,” according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name, didn’t say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn’t have time to comb through dozens of pages every time he makes an investment, he said.

“Engineers — we’re not dumb,” said Steckbeck, who founded his own consulting company in 1990. “We’re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can’t sit there and read prospectuses all day.”

If you are investing, you need to read prospectuses.  No ifs, ands, or buts.  I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish.  Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought.  I read every prospectus for every security that I buy if it is unusual.  I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education.  I am a fan of math and science.  But truly, I want both.  We homeschool, and our eight kids are “all arounds.”  They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning.  Truly bright people are good with both math and language.  Final quotation from the article:

“The whole point of making these things exchange-traded was to make them accessible to retail investors,” said Colbrin Wright, assistant professor at Brigham Young University in Provo, Utah, who has written academic articles on the indicative values of ETNs. “The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.”

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote.  Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs].  That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs offered a more investor-driven and fluid system for share creation. We believe the system for share creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we recommend that ETN issuers reformulate the share creation system related to their securities. Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a minimum, the share creation process should be initiated by investors, rather than by the ETN issuers themselves, as we believe profit-motivated investors will be more diligent and responsive in creating ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity.  To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt.  In most cases, that doesn’t work.

So I come back to where I started.  Be skeptical of complexity in exchange traded products.  Avoid complexity.  Complexity works in favor of the one offering the deal, not the one accepting the deal.  I have only bought one structured note in my life, and that was one that I was allowed to structure.  As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing.  Do due diligence in all investing, and more when the investments are complex.  I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term.  You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

To Live off of, and Die from, the Equity Premium and Alpha

Thursday, April 10th, 2014

I’m working on my taxes.  I’m not in a good mood.  Okay, writing that made me chuckle, because I am usually in a good mood.

Let me divide my working life into four segments:

  • 1986-1998: Actuary — reasonably well paid, and significantly underpaid compared to the value I delivered.
  • 1998-2007 — Investment risk manager, Mortgage bond manager, Corporate bond manager, and Senior Analyst at a long/short hedge fund.  Paid well for my efforts, and the  rewards to clients were far more than what I was paid.
  • 2007-2010 — Almost no pay, as I deal with home issues, provide research to a small minority broker-dealer, and try to gain institutional asset management clients.  Living off of assets from earlier days.
  • 2010-2014 — Living off of asset income as I slowly build a retail and small institutional client base for my value investing.

The last two periods are the most interesting in a way, because I was drawing more income from investments than I was from any other source.  Even during my time at the hedge fund, I made more money from my own investing every year than I was paid, and I was paid well.  That said the mid-2000s were a hot time, particularly if you made the right calls on a growing global economy.

My net worth today is roughly where it was at the peak of the markets in 2007, despite my low wage income.  I have been bailed out by the returns of the equity market and my alpha.

This is not a comfortable place to be, because general equity returns are not predictable, and alpha, though I have had it for years, is not predictable either.  That said, my client base has been growing, and in another year or so, my practice should support my family even if the markets don’t do well.


Though I just told a story about me, the real story isn’t about me.  Think of all of the people who are trying to manage their lump sum in retirement.  They are relying on strong equity markets; they are hoping for alpha.  They are not ready for setbacks.

Unless you are seriously wealthy, when you are not receiving reliable income from a wage-like source, you can feel like you are in a weak position. I have felt that on occasion, but in general  I have not worried.

I write this because equity outperformance over bonds will likely be limited over the next ten years.  I peg equities at about a 5%/year average nominal return, with a diversified portfolio of bonds at around 2-3%/year.  Also the ability to add alpha is limited, because alpha is zero in total, and are you smart enough to find the managers that can do it?

In desperate times desperate men do desperate things.  Low interest rates are leading many to speculate more than they ordinarily would.  Equity allocations go higher.  Allocations to “alternatives” go higher.  People start using nonguaranteed income vehicles as if they had the structural protections of bonds.

As I always say, be careful.  Those trying to manage a lump sum for income in retirement are playing a dangerous game where if you try to draw more than 3.5%/year with regularity will prove challenging, because that is playing at the boundary of what the assets can deliver, and leaves little room for an adverse scenario.  Be careful.

Reaching For Yield

Sunday, April 6th, 2014

15 months ago I wrote a piece called Expensive High Yield – II.  High yield is still expensive.  I won’t post all of the regressions, but I have re-run them.  The results are largely the same as before.  Yields are low, and spreads are overly tight for everything except CCC bonds.

Much of this is the result of the Fed’s low fed funds rate and quantitative easing, which forces investors to take more risk.  Another aspect is the strong equity market.

Also, CCC bonds offering opportunity may not adjust for the loosening of covenant protections.  There is a tendency for investors to try to maintain yield levels while letting quality & covenants sag.  In a low interest environment, with more and more people retiring, there is a growing desire for the simplicity of yield.

My conclusion last time was this:

All of the corporate bond market is expensive relative to history, perhaps excluding CCC bonds.  That doesn’t mean it can’t get more expensive, particularly if stocks continue to move upward.   But this won’t last for more than two years; the signs of speculation are here, and that should make us cautious.

As a result, I am investing my bond strategy cautiously now.  What little yield I get comes from emerging market sovereigns.  Credit risk from corporates is small.

Well, I blew it with emerging markets; what a kick in the teeth.  I would have been better off in high yield.  As it is, for me and my bond clients, the strategy is Fire and Ice.  20% long Treasuries for deflation, 80% short credit instruments for inflation.  So far, so good.

Be wary in this environment.  So many are reaching for yield amid a weak economy with yields that are low relative to past trends.  But also be aware that a rising stock market can support the corporate bond market.  That has worked for the last two years, but it can’t work forever.

Classic: Know Your Debt Crises: This Too Shall Pass

Thursday, March 27th, 2014

The following was published at RealMoney on August 6th, 2007:

Editor’s Summary

The illiquid debt instruments at the heart of the current crisis are subject to regime shifts.

  •  We’re in a periodic repricing of illiquid debt instruments.
  • Look for the time when the bulk of the losses will be reconciled.
  • Stick with the companies that have strong balance sheets.

I appreciated Cramer’s piece Friday morning, which picks up on many themes that I have articulated for the last four years here on RealMoney.  Here are a few:

  • Hedge fund-of-funds demand smooth returns that are higher than that which a moderate quality short-term fixed-income fund can deliver.
  • This leads to the creation of hedge funds that seek yield through arbitrage strategies.
  • And the creation of hedge funds that seek yield through buying risky debts, unlevered.
  • And the creation of hedge funds that seek yield through buying less risky debts, levered.
  • And the creation of hedge funds that seek yield through buying risky debts, levered.

In the short run, yield-seeking strategies work.  If a lot of players pursue them, they work extra-well for a time, as late entrants to the trade push up the returns for early entrants, with greater demand for scarce, illiquid securities with extra yield.  Pricing grids are a necessity for such securities, because the individual securities don’t have liquid secondary markets.  The pressure of demand raises the value not only of the securities being bought, but also of those securities that are like them.  (Smart managers begin to exit then.)

I’ve been through regime shifts in the markets for collateralized debt obligations (CDOs), asset-backed securities (ABS), residential-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).  Something shifts at the back of the chain that forces everything to reprice.  For example:

1989-1994: After the real estate boom of the mid-1980s, many banks, savings & loans and insurance companies get loose in their lending standards and real estate investment, leading to a crisis when rent growth can’t keep up with financing terms; defaults ensue, killing off a great number of S&Ls, some major insurance companies and a passel of medium and small banks.

Late 1991-early 1993: The adjustable-rate mortgage market, fueled by demand from ARM funds, overbids for ARMs in an effort to provide a high floating rate yield.  As the FOMC loosens monetary policy, higher than expected prepayments force losses onto the ARM funds

Late 1993-late 1994: The FOMC threatens to, and does, start raising interest rates, which throws the residential mortgage-backed market into crisis.

Mid-1998-mid-1999: Long Term Capital Management blows up, forcing all manner of exotic ABS, CMBS and RMBS into the market for bids.  The bids back up, until the entire market reprices and then tightens in the space of one year.

1998-1999: Home equity ABS blow up, as defaults threaten to, and then do, emerge at levels far higher than anticipated.  Almost no originators survive.

1999-2001: Cruddy high-yield bonds reveal their true value as defaults threaten to, and then do, emerge.

2002-2003: The manufactured-housing ABS market blows up, as originators don’t take initial losses but roll borrowers over into new loans that reduce payments and extend payment terms, technically keeping the loans current.  The system collapses when the buildup of bad debts and repossessed homes becomes too great to roll over.

(Of the existing large securitization markets, only the CMBS market so far has not faced a real crisis, partly due to the influence of the B-piece buyers cartel: six or so firms that buy the junk-rated debt of deals and enforce credit quality standards on the individual loans by kicking out poorly underwritten loans.  But who knows?  Even that could be overwhelmed under the right circumstances.)

In each of these situations, there was a boom-bust cycle.  The markets did not adjust slowly and evenly to changing conditions; the transitions between “boom” pricing, and “bust” pricing were swift.  This is the nature of markets, particularly when enough debt is employed to amplify the process.

There is no conspiracy necessary to make the shift happen (though often the media will make it seem like there was one); the bubble pops when the financing proves insufficient to carry the assets.  After the bubble pops, it becomes a question of what the underlying assets can be liquidated for, allocating losses mercilessly according to the loan documents and bankruptcy priority.

Today the crises are nonprime lending, leveraged buyouts and other high-yield debt and over-leverage in the CDO market.  These will get worked out, as all other crises do, handing losses to those who speculated unwisely and allowing those who financed properly to prosper on the other side of the crisis.

As you invest, look for the time when more than half of the losses will be reconciled.  That will be near the bottom for homebuilders and housing finance.

That time may not come for another two years or so, but there will be money to be made once the crisis is mostly reconciled.  Just stick with the companies that have strong balance sheets.

Limit Repo Financing

Friday, March 21st, 2014

If you have a moment, read this Bloomberg article.  The brokers are utterly dishonest when they say:

Brokers contend that their borrowing is generally less risky than bank lending. Repo borrowing, for instance, is backed by collateral that can be readily sold to raise cash in case the other party defaults, said Steven Lofchie, co-chairman of the financial services group at Cadwalader, Wickersham & Taft LLP.

“If you think about a bank that is lending 90 percent against a house, versus a broker-dealer taking in 102 percent against a loan of a security, the broker-dealer’s credit risk is exponentially less,” Lofchie said.

This is true under ordinary circumstances, but not in a crisis, as we saw in 2008.  Seemingly safe securities were no longer safe, because too many overleveraged parties could not hold their positions when the prices of their seemingly safe securities started to fall.  This led to a panic, because of the structural error of financing long-dated securities with short-dated funding.  In a crisis, that is the fatal flaw of repo financing.

I think the proposals of the SEC are decent, and those that the broker-dealers propose are not.  I would go further and abolish repo markets.  They are crisis-bait.  The asset-liability mismatch invites trouble.

The proposal of the broker-dealers is flawed, because they don’t adopt a model where they match assets and liabilities.  Stable systems match assets and liabilities.  Until they do so, they should not be taken seriously.  The math of risk control wars against them.

As Light As Hydrogen

Wednesday, March 19th, 2014

Okay let’s roll the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 3/18/13DeclineAnnualizedSplits







































































































































































Tonight’s loser-in-waiting is HydroPhi Technologies [HPTG].  This one can’t even get basic science right.  It claims to be able to split water into hydrogen and oxygen, and then recombine them to create energy.  Circular processes in general lose energy, otherwise we would have perpetual motion machines.

And behind the vapid analysis is an uber-loser.  His analyses never pan out over one year.  A clever speculator might make money occasionally, but not regularly, because the stocks he pumps are like this one.  Little revenues, negative earnings, negative net worth.  This is a recipe for disaster.

Think about it — if you had a miracle energy technology, would you merge your company with a failed internet advertising company “BigClix?”  I would think not.  You would keep your company private and enjoy the significant profits.

As it is, there are no profits, so where is this great energy technology?  This is a scam, and laws should be revised to allow prosecution of those who write such promotional garbage as we have seen.  It is no good to have the 4-point type disclaimers telling some of the truth, while the big type says “Buy, buy BUYYY!!!”  Also, as far as the web version of this promotion goes, the promoters pour in half a million.  As it says in the 4-point type:

Third Party Advertiser IMPORTANT NOTICE: Esquire Media Services Inc (EMS) has managed up to a $500,000 USD advertising production budget as of January 21, 2014 in an effort to build industry and investor awareness for HydroPhi Technology Group Inc (ticker symbol: HPTG). 

It’s easy to affect the price of a company that has bad fundamentals.  It’s overvalued to start; it will only be more overvalued at the crest of the promotion.  If you attract a bunch of people to the pump-and-dump who want to play the momentum, some may think they will be clever enough to scalp a quick profit along with the insiders.  Some of them win, and others lose.  Others believe the advertising, and stay to lose a ton.

Seth Klarman recently said, “It might not look like it now, but markets don’t exist simply to enrich people.”  This needs to be remembered by all.  Markets are for trading, and trading is a negative-sum game.  Those who buy & hold valuable businesses for a span — that is a positive-sum game, because the underlying asset is appreciating.

To close: don’t buy promoted stocks.  Never.  Those who are paid directly or indirectly to encourage you to buy are at best sub-agents for the seller — they aren’t on your side.  In buying promoted stocks, it’s like going to Vegas, minus the fun.  You will lose.  You will lose a lot.   The house edge is fixed — it’s only a question of how much you will lose.

Avoid promoted stocks.  As I often say: “Don’t buy what someone else wants to sell you, buy what you have researched and know has value.”

The Rules, Part LX

Saturday, March 8th, 2014

Rapid upward moves in volatility almost always presage a bounce rally.

Again, I am scraping the bottom of the barrel, but this is a common aspect of markets.  When things get tough, scaredy-cats buy put options.  That pushes up option implied volatilities.  The same doesn’t happen when prices are rising, because that happens slower.  Prices fall twice as fast as they rise in the stock market.

Emotions play a big role with options, and many do not use them rationally.  Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.

As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up.  As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged.  Their pseudo-selling is over, and a bounce rally will happen.

Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise.  People buy equities as fears dissipate.

Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility).  Use this knowledge to guide your portfolio positioning.  At present, it is more reliable then many other measures of the market.

Next time, I end this series.  Till then.

On Finding Neglected Companies

Wednesday, March 5th, 2014

While at RealMoney, I wrote a short series on data-mining.  Copies of the articles are here: (one, two). I enjoyed writing them, and the most pleasant surprise was the favorable email from readers and fellow columnists. As a follow up, on April 13th, 2005, I wrote an article on analyst coverage — and neglect. Today, I am writing the same article but as of today, with even more detail, and comparisons to prior analyses.

As it was, in my Finacorp years, I wrote a similar piece to this but it has been lost; I can’t find a copy of it, and Finacorp is in the ash-heap of financial firms. (Big heap, that.)

For a variety of reasons, sell-side analysts do not cover companies and sectors evenly. For one, they have biases that are related to how the sell-side analyst’s employer makes money. It is my contention that companies with less analyst coverage than would be expected offer an opportunity to profit for investors who are willing to sit down and analyze these lesser-analyzed companies and sectors.

I am a quantitative analyst, but I try to be intellectually honest about my models and not demand more from them than they can deliver. That’s why I have relatively few useful models, maybe a dozen or so, when there are hundreds of models used by quantitative analysts in the aggregate.


Why do I use so few? Many quantitative analysts re-analyze (torture) their data too many times, until they find a relationship that fits well. These same analysts then get surprised when the model doesn’t work when applied to the real markets, because of the calculated relationship being a statistical accident, or because of other forms of implementation shortfall — bid-ask spreads, market impact, commissions, etc.

This is one of the main reasons I tend not to trust most of the “advanced” quantitative research coming out of the sell side. Aside from torturing the data until it will confess to anything (re-analyzing), many sell-side quantitative analysts don’t appreciate the statistical limitations of the models they use. For instance, ordinary least squares regression is used properly less than 20% of the time in sell-side research, in my opinion.


Sell-side firms make money two ways.They can make via executing trades, so volume is a proxy for profitability.They can make money by helping companies raise capital, and they won’t hire firms that don’t cover them.Thus another proxy for profitability is market capitalization.


Thus trading volume and market capitalization are major factors influencing analyst coverage. Aside from that, I found that the sector a company belongs to has an effect on the number of analysts covering it.


I limited my inquiry to include companies that had a market capitalization of over $10 million, US companies only, and no ETFs.


I used ordinary least squares regression covering a data set of 4,604 companies. The regression explained 82% of the variation in analyst coverage. Each of the Volume and market cap variables used were significantly different from zero at probabilities of less than one in one million. As for the sector variables, they were statistically significant as a group, but not individually.Here’s a list of the variables:




 Standard Error


 Logarithm of 3-month average volume




 Logarithm of Market Capitalization




 Logarithm of Market Capitalization, squared




 Basic Materials




 Capital Goods








 Consumer Cyclical




 Consumer Non-Cyclical












 Health Care





















In short, the variables that I used contained data on market capitalization, volume and market sector.

An increasing market capitalization tends to attract more analysts. At a market cap of $522 million, market capitalization as a factor adds no net analysts. At the highest market cap in my study, Apple [AAPL] at $469 billion, the model indicates that 11 fewer analysts should cover the company. The smallest companies in my study would have 3.3 fewer analysts as compared with a company with a market cap of $522 million.


Market Cap

 Analyst additions


























The intuitive reasoning behind this is that larger companies do more capital markets transactions. Capital markets transactions are highly profitable for investment banks, so they have analysts cover large companies in the hope that when a company floats more stock or debt, or engages in a merger or acquisition, the company will use that investment bank for the transaction.


Investment banks also make some money from trading. Access to sell-side research is sometimes limited to those who do enough commission volume with the investment bank. It’s not surprising that companies with high amounts of turnover in their shares have more analysts covering them. The following table gives a feel for how many additional analysts cover a company relative to its daily trading volume. A simple rule of thumb is that (on average) as trading volume quintuples, a firm gains an additional analyst, and when trading volume falls by 80%, it loses an analyst.


Daily Trading Volume (3 mo avg)

Analyst Additions



An additional bit of the intuition for why increased trading volume attracts more analysts is that volume is in one sense a measure of disagreement. Investors disagree about the value of a stock, so one buys what another sells. Sell-side analysts note this as well; stocks with high trading volumes relative to their market capitalizations are controversial stocks, and analysts often want to make their reputation by getting the analysis of a controversial stock right. Or they just might feel forced to cover the stock because it would look funny to omit a controversial company.

Analyst Neglect

The first two variables that I considered, market capitalization and volume, have intuitive stories behind them as to why the level of analysts ordinarily varies. But analyst coverage also varies by industry sector, and the reasons are less intuitive to me there.


Please note that my regression had no constant term, so the constant got embedded in the industry factors. Using the Transportation sector as a benchmark makes the analysis easier to explain. Here’s an example: On average, a Utilities company that has the same market cap and trading volume as a Transportation company would attract four fewer analysts.


Sector  Addl Analysts  Fewer than Transports
 Transportation 2.92
 Energy 2.56 (0.37)
 Technology 0.82 (2.10)
 Capital Goods 0.39 (2.53)
 Financial 0.37 (2.55)
 Consumer Cyclical 0.08 (2.84)
 Health Care 0.05 (2.87)
 Services (0.30) (3.22)
 Basic Materials (0.53) (3.46)
 Conglomerates (0.70) (3.63)
 Utilities (1.10) (4.02)
 Consumer Non-Cyclical (1.40) (4.32)


Why is that? I can think of two reasons. First, the companies in the sectors at the top of my table are perceived to have better growth prospects than those at the bottom. Second, the sectors at the top of the table are more volatile than those toward the bottom (though basic materials would argue against that). As an aside, companies in the conglomerates sector get less coverage because they are hard for a specialist analyst to understand.


My summary reason is that “cooler” sectors attract more analysts than duller sectors. To the extent that this is the common factor behind the variation of analyst coverage across sectors, I would argue that sectors toward the bottom of the list are unfairly neglected by analysts and may offer better opportunities for individual investors to profit through analysis of undercovered companies in those sectors.

Malign Neglect

Now, my model did not explain 100% of the variation in analyst coverage. It explained 82%, which leaves 18% unexplained. Some of the unexplained variation is due to the fact that no model can be perfect. But the unexplained variation can be used to reveal the companies that my model predicted most poorly. Why is that useful? If my model approximates “the way the world should be,” then the degree of under- and over-coverage by analysts will reveal where too many or few analysts are looking. The following tables lists the largest company variations between reality and my model, split by market cap group.


Behemoth Stocks


TickerCompanySectorExcess analysts
BRK.ABerkshire Hathaway Inc.07 – Financial(25.75)
GEGeneral Electric Company02 – Capital Goods(20.47)
XOMExxon Mobil Corporation06 – Energy(19.32)
CVXChevron Corporation06 – Energy(14.64)
PFEPfizer Inc.08 – Health Care(14.57)
MRKMerck & Co., Inc.08 – Health Care(12.76)
GOOGGoogle Inc10 – Technology(11.44)
JNJJohnson & Johnson08 – Health Care(11.39)
MSFTMicrosoft Corporation10 – Technology(10.39)
PMPhilip Morris International In05 – Consumer Non-Cyclical(10.21)


Too many


TickerCompanySectorExcess analysts
VVisa Inc09 – Services 2.58
DISWalt Disney Company, The09 – Services 2.95
SLBSchlumberger Limited.06 – Energy 4.15
CSCOCisco Systems, Inc.10 – Technology 5.22
QCOMQUALCOMM, Inc.10 – Technology 5.34
ORCLOracle Corporation10 – Technology 5.98
FBFacebook Inc10 – Technology 8.28, Inc.09 – Services 9.34
AAPLApple Inc.10 – Technology 10.57
INTCIntel Corporation10 – Technology 11.85


Large Cap Stocks


TickerCompanySectorExcess analysts
SPGSimon Property Group Inc09 – Services(16.15)
BF.BBrown-Forman Corporation05 – Consumer Non-Cyclical(16.03)
LUKLeucadia National Corp.07 – Financial(15.93)
LLoews Corporation07 – Financial(15.90)
EQREquity Residential09 – Services(15.87)
ARCPAmerican Realty Capital Proper09 – Services(15.75)
IEPIcahn Enterprises LP09 – Services(15.50)
LVNTALiberty Interactive (Ventures09 – Services(15.36)
ABBVAbbVie Inc08 – Health Care(15.01)
GOM CLAlly Financial Inc07 – Financial(14.87)


Too Many


TickerCompanySectorExcess analysts
UAUnder Armour Inc04 – Consumer Cyclical 16.68
BRCMBroadcom Corporation10 – Technology 17.29
RRCRange Resources Corp.06 – Energy 17.33
SWNSouthwestern Energy Company06 – Energy 17.70
RHTRed Hat Inc10 – Technology 18.08
NTAPNetApp Inc.10 – Technology 19.82
CTXSCitrix Systems, Inc.10 – Technology 19.84
COHCoach, Inc.09 – Services 20.87
VMWVMware, Inc.10 – Technology 21.60, inc.10 – Technology 22.64


Mid cap stocks


TickerCompanySectorExcess analysts
FNMAFederal National Mortgage Assc07 – Financial(13.84)
UHALAMERCO11 – Transportation(12.23)
ORealty Income Corp09 – Services(12.06)
CIMChimera Investment Corporation07 – Financial(11.49)
SLGSL Green Realty Corp09 – Services(11.46)
NRFNorthstar Realty Finance Corp.09 – Services(11.34)
FMCCFederal Home Loan Mortgage Cor07 – Financial(11.14)
EXRExtra Space Storage, Inc.11 – Transportation(10.97)
KMRKinder Morgan Management, LLC06 – Energy(10.94)
CWHCommonWealth REIT09 – Services(10.51)


Too Many


TickerCompanySectorExcess analysts
AEOAmerican Eagle Outfitters09 – Services 17.00
DRIDarden Restaurants, Inc.09 – Services 17.40
RVBDRiverbed Technology, Inc.10 – Technology 17.50
CMAComerica Incorporated07 – Financial 17.74
GPNGlobal Payments Inc07 – Financial 18.30
WLLWhiting Petroleum Corp06 – Energy 19.67
DODiamond Offshore Drilling Inc06 – Energy 21.57
URBNUrban Outfitters, Inc.09 – Services 24.06
RDCRowan Companies PLC06 – Energy 24.48
ANFAbercrombie & Fitch Co.09 – Services 26.02



Small cap stocks


TickerCompanySectorExcess analysts
BALTBaltic Trading Ltd11 – Transportation (7.96)
ERAEra Group Inc11 – Transportation (7.45)
PBTPermian Basin Royalty Trust06 – Energy (7.42)
SDRSandRidge Mississippian Trust06 – Energy (7.18)
PHOTGrowlife Inc02 – Capital Goods (6.79)
SBRSabine Royalty Trust06 – Energy (6.74)
CAKCAMAC Energy Inc06 – Energy (6.64)
FITXCreative Edge Nutrition Inc09 – Services (6.57)
BLTABaltia Air Lines Inc11 – Transportation (6.53)
VHCVirnetX Holding Corporation10 – Technology (6.49)


Too many


TickerCompanySectorExcess analysts
WLTWalter Energy, Inc.06 – Energy 12.19
ANGIAngie’s List Inc10 – Technology 12.31
FRANFrancesca’s Holdings Corp09 – Services 12.58
ZUMZZumiez Inc.09 – Services 13.49
GDPGoodrich Petroleum Corp06 – Energy 15.02
DNDNDendreon Corporation08 – Health Care 15.89
ACIArch Coal Inc06 – Energy 16.04
HEROHercules Offshore, Inc.06 – Energy 16.19
AREXApproach Resources Inc.06 – Energy 17.64
AROAeropostale Inc09 – Services 20.80


Microcap Stocks


TickerCompanySectorExcess analysts
SGLBSigma Labs Inc06 – Energy (6.18)
AEGYAlternative Energy Partners In10 – Technology (5.97)
WPWRWell Power Inc06 – Energy (5.83)
TTDZTriton Distribution Systems In10 – Technology (5.53)
SFRXSeafarer Exploration Corp11 – Transportation (5.15)
PTRCPetro River Oil Corp06 – Energy (4.99)
UTRMUnited Treatment CentersInc08 – Health Care (4.82)
BIELBioelectronics Corp08 – Health Care (4.80)
DEWMDewmar International BMC Inc01 – Basic Materials (4.74)
FEECFar East Energy Corp06 – Energy (4.61)


Too many


TickerCompanySectorExcess analysts
PRSSCafePress Inc09 – Services 3.99
SANWS&W Seed Company05 – Consumer Non-Cyclical 4.03
KIORKiOR Inc01 – Basic Materials 4.06
PRXGPernix Group Inc02 – Capital Goods 4.08
EYNONEntergy New Orleans, Inc.12 – Utilities 4.17
PARFParadise, Inc.05 – Consumer Non-Cyclical 4.40
SUMRSummer Infant, Inc.05 – Consumer Non-Cyclical 4.52
LANDGladstone Land Corp05 – Consumer Non-Cyclical 4.57
JRCCJames River Coal Company06 – Energy 6.38
GNKGenco Shipping & Trading Limit11 – Transportation 7.11

My advice to readers is to consider buying companies that have fewer analysts studying them than the model would indicate.  This method is certainly not perfect but it does point out spots where Wall Street is not focusing its efforts, and might provide some opportunities.



Full disclosure: long BRK/B & CVX

Conservation of Liquidity, under most Conditions

Monday, February 24th, 2014

Have you ever seen the graphs showing “Look at all the money sitting on the sidelines!  This market has to go up!”  Those analyses are bogus.  Why?

Several reasons, but the leading one is that much cash has to be held as part of portfolio margining, securities lending, or derivative agreements.  What would be valuable, maybe is a graph of cash that is free to be spent on new securities.

The word “new” is important.  With most trading, liquidity does not disappear.  Instead, liquidity moves from the account of the buyer to that of the seller.  When is that not so?

With initial public offerings, where the proceeds are not solely going to selling shareholders, liquidity disappears into the coffers of the new company, that it can do business.   That’s not a bad thing, aside from periods in the ’60s and late ’90s where there was a craze that led people to invest in bogus businesses that sounded cool.

When there is too much liquidity available to invest, Wall Street produces new companies to absorb the liquidity, many of which will be of dubious value, because there is money to be made.  Trot out the speculative stocks and bonds, especially near the end of the boom phase of the credit cycle.

Liquidity disappears into new corporations, and reappears when corporations are bought for cash.  Aside from a few other similar events, secondary trading has no effect on liquidity.  So when you hear that there is a lot of liquidity on the sidelines, review the above arguments and say, “There is almost always a lot of liquidity on the sidelines, but is it buying up new stock issues?”

Therefore, look at the quality of new IPOs.  Quality is a thermometer for whether the market is cold to overheating.  The same applies to corporate M&A to a lesser extent when they purchase poor assets for cash.  On the other hand, if corporate M&A is finding inexpensive assets that they buy for cash, the market as a whole may be cheap.

Secondary trading does not inform us much about market valuations.  Look to the primary markets, where cash creates new assets, and where old assets get sold for cash.  Valuations are on display there, and should inform our investing.

This May Be Gold, But It Is Not Golden

Sunday, February 16th, 2014

I’ve done a number of articles on dollar-weighted returns in mutual funds.  There are rare cases where the shareholder base is smart, usually in value funds, where the shareholders add more money on declines, and lighten up when things are going too well.

Tonight’s target is the Gold ETF SPDR Gold Shares [GLD].  As with most volatile mutual funds, people tend to get greedy or panic.  They chase performance.  Consider this list of inflows and outflows from GLD. Cash flows are assumed to occur at mid-period.


Cash Flow































Versus a buy-and-hold investor, the average holder gives up almost 3% of returns via market mistiming.  Technicians may talk down buy and hold, but buy and hold usually outperforms the average trader.  This is similar to what my friend Josh Brown talks about in his article Flows Don’t Follow Value, They Follow Performance.  Very few investors are rational businessmen, estimating likely returns over their funding horizon.  Rather they chase past success, and flee past failures.

Such has been true of the SPDR Gold Shares ETF.  Say what you will about the cheapness of large ETFs, people will still misuse them.  They will buy late in a bull phase, and sell late in a bear phase.

And so I say to all: Guard your emotions.  Be forward-looking.  Analyze likely value five years out.  Don’t make snap decisions out of regret.  Think about risk control before you buy shares, bonds, whatever.

Now, as a personal aside, it took me around eight years to learn to control my emotions.  Over the last 20 years, I have made at most a handful of errors reacting to bad market events.  I learned to analyze rather than panic back in the 90s.  It doesn’t mean that I am always right, but it does mean that I act.  I almost never react.

As for GLD, be wary about paper gold.  Is it really fully collateralized by audited gold in a warehouse?  There are lots of promises of gold being traded, but how much physical gold could you have delivered to you, should you want it?

That’s all for now.  Be careful in all of your investing; it is easy to err.


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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