Imagine that you are in the position of a high cost crude oil producer that has a lot of debt to service.  The price that you can sell your oil for is high enough that you make some cash over your variable cost.  The price is low enough that you are not recouping the cost of what you paid to buy the right to develop the oil, the development cost, and cost of equity capital employed.

In this awkward situation you continue to produce oil, because it may keep you from defaulting on your debts, even though you are not earning what is needed to justify the GAAP book value of your firm.  You’re destroying value by producing, but because of the debt, you don’t have the option of waiting because not surviving loses more money than pumping oil and seeing if you can survive.

Where there is life, there is hope.  Who knows, one of three things could “go right:”

  1. Enough competitors could fail such that global industry capacity reduces and prices rise.
  2. Demand for oil could rise because it is cheap, leading prices to rise.
  3. You could get bought out by a more solvent competitor with a longer time horizon, who sees the assets as eventually valuable.

Trouble is with #1, you could fail first.  With #2, the process is slow, and who knows how much the Saudis will pump.  With #3, the price that an acquirer could pay might not be enough for shareholders, or worse, they could buy out your competitors and not you, leaving you in a worse competitive position.

One more thought: think of the Saudis, the Venezuelans, etc… all of the national oil companies.  They’re not in all that different a spot than you are.  They need cash to fund government programs or they may face unrest.  For some like the Saudis, who assets in reserve, the odds are lower.  For the Venezuelans, who have had their economy destroyed by the politics of Chavez, the odds are a lot higher.

There will be failures among energy producers, and that could include nations.  Failures with each will be temporary as debts get worked through/compromised and new management takes over, and high cost supply gets shut down.  The question is: who will fail and who won’t.  The job of the hypothetical firm that I posited at the beginning of this article is to survive until prices rise.  What will a survivor look like?

  • Relatively high contribution margins (Price – variable cost per barrel)
  • Relatively little debt
  • Debt has long maturities and/or low coupons.

Now, I’m going to give you 40% of the answer here… I’m still working on the contribution margin question, but I can give you a useful measure regarding debt.  My summary measure is total debt as a ratio of market capitalization.  It’s crude, but I think it is a good first pass on debt stress, because the market capitalization figures carry an implicit estimate of the probability of bankruptcy.

Anyway here’s a list of all of the oil companies in the database that have debt greater than their market cap:

CompanyCountrytickerMkt capDebt / Market Cap
Energy XXI LtdBermudaEXXI17126.93
SandRidge Energy Inc.United StatesSD26416.63
Comstock Resources IncUnited StatesCRK1469.45
Linn Energy LLCUnited StatesLINE1,1728.81
EXCO Resources IncUnited StatesXCO2137.2
Cosan Limited(USA)BrazilCZZ1,0156.34
W&T Offshore, Inc.United StatesWTI2456
Halcon Resources CorpUnited StatesHK6205.89
BreitBurn Energy Partners L.P.United StatesBBEP6145.05
Magnum Hunter Resources CorpUnited StatesMHR1885.05
California Resources CorpUnited StatesCRC1,3254.92
Sanchez Energy CorpUnited StatesSN3684.74
Crestwood Equity Partners LPUnited StatesCEQP5434.64
Rex Energy CorporationUnited StatesREXX1714.51
Penn West Petroleum Ltd (USA)CanadaPWE4034.19
Atlas Resource Partners, L.P.United StatesARP3654.09
Gastar Exploration IncUnited StatesGST1083.8
Petroleo Brasileiro PetrobrasBrazilPBR35,7483.71
Stone Energy CorporationUnited StatesSGY2923.59
Bill Barrett CorporationUnited StatesBBG2523.19
EP Energy CorpUnited StatesEPE1,5523.15
Memorial Production Partners LUnited StatesMEMP5993.05
Premier Oil PLC (ADR)United KingdomPMOIY8282.95
Triangle Petroleum CorporationUnited StatesTPLM2862.88
Ultra Petroleum Corp.United StatesUPL1,2812.68
Bonanza Creek Energy IncUnited StatesBCEI3332.55
Northern Oil & Gas, Inc.United StatesNOG3592.47
Denbury Resources Inc.United StatesDNR1,4792.37
Jones Energy IncUnited StatesJONE3542.36
Chesapeake Energy CorporationUnited StatesCHK4,9172.35
Vanguard Natural Resources, LLUnited StatesVNR8332.27
LRR Energy LPUnited StatesLRE1282.23
Pengrowth Energy Corp (USA)CanadaPGH7052.21
Legacy Reserves LPUnited StatesLGCY4612.1
Aegean Marine Petroleum NetworGreeceANW3911.85
GeoPark LtdChileGPRK2021.8
Mitsui & Co Ltd (ADR)JapanMITSY23,7271.74
Oasis Petroleum Inc.United StatesOAS1,3901.69
Santos Ltd (ADR)AustraliaSSLTY3,8131.59
Whiting Petroleum CorpUnited StatesWLL3,5931.46
Midcoast Energy Partners LPUnited StatesMEP5581.45
Paramount Resources Ltd (USA)CanadaPRMRF1,0061.35
Encana Corporation (USA)CanadaECA5,9441.33
Clayton Williams Energy, Inc.United StatesCWEI5971.25
Clean Energy Fuels CorpUnited StatesCLNE4681.23
EV Energy Partners, L.P.United StatesEVEP4051.23
WPX Energy IncUnited StatesWPX1,6601.2
Baytex Energy Corp (USA)CanadaBTE1,0681.19
ONEOK, Inc.United StatesOKE7,4531.18
SunCoke Energy Partners LPUnited StatesSXCP5051.18
TransAtlantic Petroleum LtdUnited StatesTAT1261.13
Global Partners LPUnited StatesGLP1,0711.12
NGL Energy Partners LPUnited StatesNGL2,6591.12
Sprague Resources LPUnited StatesSRLP4951.11
Amyris IncUnited StatesAMRS2661.07
Sunoco LPUnited StatesSUN1,6051.06
SM Energy CoUnited StatesSM2,3601.05
Solazyme IncUnited StatesSZYM2021


This isn’t a complete analysis by any means. Personally, I would be skeptical of holding any company twice as much debt as market cap without a significant analysis.  Have at it your own way, but be careful, there will be a lot of stress on oil companies with high debt.

Photo Credit: Dr. Wendy Longo || This horizon is distant...

Photo Credit: Dr. Wendy Longo || This horizon is distant…

I ran across two interesting articles today:

Both articles are exercises in understanding the time horizon over which you invest.  If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.

Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell.  Some people don’t have much choice in the matter.  They have retired, and they have a lump sum of money that they are managing for long-term income.  No more money is going in, money is only going out.  What can you do?

You have to plan before volatility strikes.  My equity only clients had 14% cash before the recent volatility hit.  Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened.  That flexibility was built into my management.  (If the market recovers enough, I will rebuild the buffer.  Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)

If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term.  With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio.  If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then.  That also would rebalance the portfolio.

Again, plans like that need to be made in advance.  If you have no plans for defense, you will lose most wars.

One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time.  When the time for converting assets to cash is far distant, using a single point may be a decent approximation.  When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that.

Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement.  The same would apply to an early spike in inflation rates followed by deflation.

The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes.  If it doesn’t include the Great Depression, it is not realistic enough.  Run them forwards, backwards, upside-down forwards, and upside-down backwards.  (For the upside-down scenarios normalize the return levels to the right side up levels.)  The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions.  History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.

You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time.  Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.

One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad.  Trouble is, few were able to take advantage of them because they had already drawn down on their investments.  The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns.  They had to be lower, because many people could not hold their investments for the eventual recovery.  Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.

It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low.  That’s not all that much different than some had to do in the recent financial crisis.  Now, who is willing to throw *that* into financial planning models?

The simple answer is to be more conservative.  Expect less from your investments, and maybe you will get positive surprises.  Better that than being negatively surprised when older, when flexibility is limited.

Photo Credit: edkohler || Buy Now and smile!

Photo Credit: edkohler || Buy Now and smile!


One of my clients asked me what I think is a hard question: When should I deploy capital?  I’ll try to answer that here.

There are three main things to consider in using cash to buy or sell assets:

  • What is your time horizon?  When will you likely need the money for spending purposes?
  • How promising is the asset in question?  What do you think it might return vs alternatives, including holding cash?
  • How safe is the asset in question?  Will it survive to the end of your time horizon under almost all circumstances and at least preserve value while you wait?

Other questions like “Should I dollar cost average, or invest the lump?” are lesser questions, because what will make the most difference in ultimate returns comes from  the above three questions.  Putting it another way, the results of dollar cost averaging depend on returns after you put in the last dollar of the lump, as does investing the lump sum all at once.

Thinking about price momentum and mean-reversion are also lesser matters, because if your time horizon is a long one, the initial results will have a modest effect on the ultimate results.

Now, if you care about price momentum, you may as well ignore the rest of the piece, and start trading in and out with the waves of the market, assuming you can do it.  If you care about mean reversion, you can wait in cash until we get “the mother of all selloffs” and then invest.  That has its problems as well: what’s a big enough selloff?  There are a lot of bears waiting for rock bottom valuations, but the promised bargain valuations don’t materialize because others invest at higher prices than you would, and the prices never get as low as you would like.  Ask John Hussman.

Investing has to be done on a “good enough” basis.  The optimal return in hindsight is never achieved.  Thus, at least for value investors like me, we focus on what we can figure out:

  • How long can I set aside this capital?
  • Is this a promising investment at a relatively attractive price?
  • Do I have a margin of safety buying this?

Those are the same questions as the first three, just phrased differently.

Now, I’m not saying that there is never a time to sit on cash, but decisions like that are typically limited to times where valuations are utterly nuts, like 1964-5, 1968, 1972, 1999-2000 — basically parts of the go-go years and the dot-com bubble.  Those situations don’t last more than a decade, and are typically much shorter.

Beyond that, if you have the capital to spare, and the opportunity is safe and cheap, then deploy the capital.  You’ll never get it perfect.  The price may fall after you buy.  Those are the breaks.  If that really bothers you, then maybe do half of what you would ultimately do, but set a time limit for investment of the other half.  Remember, the opposite can happen, and the price could run away from you.

A better idea might show up later.  If there is enough liquidity, trade into the new idea.

Since perfection is not achievable, if you have something good enough, I recommend that you execute and deploy the capital.  Over the long haul, given relative peace, the advantage belongs to the one who is invested.

If you still wonder about this question you can read the following two articles:

In the end, there is no perfect answer, so if the situation is good enough, give it your best shot.


Photo Credit: Moyan Brenn || My, now doesn't that look peaceful...

Photo Credit: Moyan Brenn || My, now doesn’t that look peaceful…

There is the temptation when market prices move fast after they have been at recent highs to assume that things are going to fall apart.  Well, guess what?  That could happen.

I don’t think it is likely though, if falling apart means a scenario like 2008-9, 2000-2 or 1973-4.  In order to have a significant drawdown in the market, you have to have a lot of leverage collapse, whether that is financial or operating leverage.

Financial leverage is bad debt.  We have areas of that — student loans, agricultural loans, a modest amount of subprime lending for autos, and a decent amount of lending to junk-rated corporations, but not enough to create a self-reinforcing situation where bad debts can’t be borne by lenders, and lenders then collapse.

Operating leverage is bad assets — building up too much productive capacity such that there will not be enough demand to absorb it for the foreseeable future.  Or, building capacity that isn’t productive… either way, assets will have to be written down.

There have been a number of parties kvetching about a lack of investment from US corporations, but let’s take this a different direction.  There hasn’t been a lot of bad investment from US corporations… and part of that may be due to dividend and buyback policies.  Yes, there are some IPOs that have come out that look marginal.  I’ve looked at a variety of spin-offs where the underlying business is attractive, but they loaded the spin-off with a sizable slug of debt in order to pay a final dividend to the parent company saying farewell.  But on the whole, I don’t see a lot of money being wasted by corporations on investments.  That is another reason why profit margins are high.

Now, a lot of the furor in the markets stems from China, and the effects that slowing growth and/or bad debts in China will have on the US economy.  Personally, I don’t think this is an issue to worry about, unless you have a lot of investments in China and other emerging markets.  In general, US markets don’t get deeply hurt by slowdowns or even crises in other countries.  Even if it means a slowdown in revenue growth for large US corporations, it would also likely mean that US interest rates might fall, which would often make equities fall less as bonds rally.

Also, for foreign affairs to affect the US in a big way, the US would have to have a lot of lending exposure to those nations that are struggling.  (Think of the LDC nations in the early ’80s.)  Maybe this is one of the benefits of running current account deficits — we don’t have money to lend to foreign countries from our net export earnings.

Think of all the significant foreign crises of the last 30 years.  LDC crisis, Plaza Accords leading to Japan’s lost decades, Mexico, Asian Crisis, European Union difficulties with their fringe nations, Iceland, Greece, Greece, Greece, China, etc.  There was always temporary indigestion in US markets, but when did it ever weigh on the US markets for a long period?  Really, it never did.  So why are we concerned over China?

Regarding the Fed, I abstract from this old post, which quoted a 2005 piece on Fed policy at, and what blew up at the end of each tightening cycle.  I list blow-ups up to that point, and mention that I think US Housing is next:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

Position: None

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.) — [DM: these links are dead now.]


Some worry now about future Fed policy — what will blow up when the Fed tightens too much?  I would encourage everyone to relax.  First, we don’t know that the Fed will do anything soon.  Second, we don’t know if they will do anything much.  Third, we don’t even know if the Fed has a coherent theory of monetary policy anymore.  Face it: Yellen has never tightened rates once.  Bernanke never tightened rates aside from finishing out Greenspan’s plan to invert the yield curve at the beginning of his Chairmanship.  Almost no one on the FOMC has any significant practical experience with tightening rates.  What will guide them out of their zero interest rate policy?  What will be enough?

Even so, tightening cycles usually end with something blowing up.  Maybe this time it is the emerging markets.  I don’t see a large concentration of US-based bad debt that the Fed might inadvertently blow up, at least not yet.  (Maybe the day will come when the US Treasury might complain about rising financing rates.  After all, debt is high, but affordable while rates are low.)

Valuation is the main issue as I see it at present, as I commented in my recent piece “Stocks or Bonds?”  When stocks are priced at a level that discounts 4.5%/year returns over the next 10 years, you don’t have a lot of margin for error, especially when you can create a safer bond portfolio that yields the same.

Now, since I wrote that piece, the S&P 500 is down around 10.5%.  The bond portfolio is down around 4.5% (it was a risky portfolio, and some of the emerging markets bonds hurt), while the Barclays’ Aggregate is up 1%.  High-yield bond spreads have widened over that time by ~1.2%.

The anticipated return on the S&P 500 has maybe risen by 1%/year over the next 10 years, to 5.5%.  That said, so has the yield on the risky bond portfolio.  I see the selloff as being in-line with the yields of risky debt, which at some higher level of spread, will attract buyers, given that there have been no significant defaults recently.

The US stock market could go down another 20% from here, but I think it will be less.  My main point is that we shouldn’t get a big washout, but just a correction of valuation levels that got too high relative to other risky assets, like junk bonds.

So don’t panic.  You could still move some assets from stocks to bonds if you want to sleep better, but don’t do anything severe.


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.

Excess Returns

Suppose you wanted a comprehensive book on all of the ways that there are to get excess returns from the stock market as a type of value investor (as of year-end 2013), and you wanted it in one slim volume.  This is that book.  As with most desires there is the “be careful what you wish for, you just might get it” effect.  This book is not immune.

At Aleph Blog, I try to write book reviews that always include what sort of reader might benefit from a given book.  Because this book packs so much into such a small space, it is not a book for beginners unless they are prodigies.  If you are a beginner, better to warm up with something like The Intelligent Investor, by Ben Graham.  Beginners need time to see concepts described in greater detail, and more slowly.

Though it is a book on value investing, it is expansive in what it considers value investing.  It includes topics as varied as:

  1. Behavioral Economics
  2. Market-timing from a valuation standpoint
  3. Growth at a reasonable price [GARP] investing
  4. Private investing
  5. Shorting
  6. Event-driven investing
  7. Barriers to considering investments that keep others from buying them at attractive prices
  8. Studying informed investors (insiders & 13F filings
  9. Catalysts that may unlock value
  10. Emerging markets
  11. Financial statements
  12. Competitive Analysis
  13. Analyzing Growth Potential
  14. Analyzing Management
  15. Valuation techniques
  16. Common mistakes; why most average investors go wrong
  17. Understanding different types of industries and companies
  18. Attitudes — Modesty, Patience & Independent Judgement
  19. And more…

In a book of around 300 pages, this is ambitious.  It gives you one or two passes over important topics, so you are only getting a taste of the ideas involved.  This is also predominantly a book on qualitative investing.  Pure quantitative value investing doesn’t get much play.  Non-value anomalies don’t get much coverage.

The other thing the book lacks is a way to pull it all together in a practical way.  Yes, the last chapter tries to pull it all together, but given the breadth of the material, it gets pulled together in terms of the attitudes you need to do this right, but less of a “how do you structure an overall investment process to put these principles into practical action.”  Providing more examples could have been useful, and really, the whole book could have benefited from that.

Additional Resources

Now, if you want a greater taste of the book without buying it, I’ve got a deal for you: this is a medium-sized slide presentation that summarizes the book.  Pretty sweet, huh?  It represents the book well, so if you are on the fence, I would look at it — after that you would know if you want to buy it.


Summary / Who Would Benefit from this Book

This is a good book if you understand qualitative value investing, but want to get an introduction to all the nuances that can go into it.  If you want to buy it, you can buy it here: Excess Returns: A comparative study of the methods of the world’s greatest investors.

Full disclosure: I received a copy from the author.

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.



If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea.  This can take a number of forms:

  • Getting tips from friends who have bought some stock that is currently popular in the market.
  • Doing the same thing with investors who talk or write about investing.  The best investment advice is not flashy, and does not make for good video.
  • Looking at charts and buying something that is rising rapidly, because popular media say this is “The Next Big Thing.”
  • Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail.  (If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign.  Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
  • Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests.  If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think.  At best, he will give you consensus ideas and managers that deliver him above average remuneration.
  • Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year!  (Please read Mark Hulbert before buying a newsletter.)
  • Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity.  It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.

Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that.  Earning returns from your investable assets is a business in its own right, and there are costs to doing it well.  You should not be surprised that doing well with it will take some time and effort.

You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches.  The markets aren’t rigged in any material way.  The principles of investing are well-known, but applying them takes creativity, time and effort.  There are no significant players with a new theory who make amazing money investing in secondary markets for stocks and bonds.

Most of the things that I listed above involve low-thought imitation of others.  There is little advantage in investing to mimicry.  Even if it worked for someone else, the prices are different now, and easy gains have been made.  You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average.  You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally.  If you choose to do it yourself, you will need to learn more than that.  It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.

In most areas of life, most things that pay off well take effort.  If people present you with easy or hidden ways to make above average money, be skeptical.  Doing it right takes discipline and effort.  (If you want the easy route while avoiding all the pitfalls see the postscript.  It is boring, but it works.)


As an aside — you can always index, and beat most average investors over the long haul.  Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole.  Make sure they have low fees.  Buy them, hold them, and be done.  You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it?  Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.


A few days ago, I was trying to buy a little bit of a defense company that I own for myself and clients.  It was relatively inexpensive, and had fallen out of favor.  Now, it’s not the most liquid beastie on the US market, so I put in an order to buy 2000 shares, while showing 100 shares, offering to buy at the current bid of $25.50 while allowing purchases at up to $25.57, while the ask was at $25.65.  I then shifted away from my trading application, and went to do other work.

After an hour, I went back to my trading screen, and saw that 1200 shares had executed between $25.50 and 25.57, but now the price was much higher, and by the end of the day, higher still.  It is even higher now.

At the time, I took a look, and lo and behold: I got the bottom tick — the lowest price on that stock ever (for now).  I also noted that I had almost all of the volume when it went down to the low price.  But 1200 shares is small compared to the total trading in the name, and $30,000 is also a small amount of money.  I concluded that it was a happy accident that I got the bottom tick.

I’ve had the same experience working at a hedge fund.  I would occasionally get the bottom tick when buying, or the top tick when selling, and most of the time I ended up saying that it had to happen to someone — it was us that day.  That said, the total amount of volume was almost always low near the top or bottom, so getting that versus a trade nearby was not worth that much.

To have a lot of volume near a top or bottom, you need two or more determined and anxious traders with large capacity to trade, a need for speed, and opposite opinions.  That happens sometimes, but in experience, not that often.  Near a peak, you would need a buyer anxious to buy a lot more NOW.  Near a trough, a seller wanting to sell it all NOW.

Most of the time, large institutional investors are cautious, and try to minimize their impact on market prices — being too aggressive will likely give them a worse result than being patient.  The exception would be someone who thinks he knows a lot more than the market, but feels that edge will erode soon, and therefore has to do the trade in full NOW.

That doesn’t happen often.  Practically, that means to not be so picky about levels in buying and selling.  If you are getting the trade off and there is decent volume at a price near where you want to do the trade, do the trade, and don’t worry much about the small amount of profit that you might be giving up.  Better to focus on ideas that you think have long term potential for profit, than to waste time trying to squeeze the last bit of profit out of a trade where incremental returns will be minuscule.