In some ways, this is a boring time in insurance investing.  A lot of companies seem cheap on a book and/or earnings basis, but they have a lot of capital to deploy as a group, so there aren’t a lot of opportunities to underwrite or invest wisely, at least in the US.

Look for a moment at two victims of the Financial Stability Oversight Council [FSOC]… AIG and Metlife.  I’ve argued before that the FSOC doesn’t know what it is doing with respect to insurers or asset managers.  Financial crises come from short liabilities that can run financing illiquid assets.  That’s not true with insurers or asset managers.

Nonetheless AIG has Carl Icahn breathing down its neck, and AIG doesn’t want to break up the company.  They will spin off their mortgage insurer, United Guaranty. but they won’t get a lot of help from that — valuations of mortgage insurers are deservedly poor, and the mortgage insurer is small relative to AIG.

As I have also pointed out before AIG’s reserving was liberal, and recently AIG took a $3.6 billion charge to strengthen reserves.  Thus I am not surprised at the rating actions of Moody’s, S&P,  and AM Best.  Add in the aggressive plans to use $25 billion to buy back stock and pay more dividends over the next two years, and you could see the ratings sink further, and possibly, the stock also.  The $25 billion requires earning considerably more than what was earned over the last four years, and more than is forecast by sell-side analysts, unless AIG can find ways to release capital and excess reserves (if any) trapped in their complex holding company structure.

AIG plans to do it through (see pp 4-5):

  • Reducing expenses
  • Improving the Commercial P&C accident year loss ratio by 6 points
  • Targeted divestitures (United Guaranty, and what else gets you to $6 billion?)
  • Reinsurance (mostly life)
  • Borrowing $3-5B (maybe more after the $3.6B writedown)
  • Selling off some hedge fund assets to reduce capital use. (smart, hedge funds earn less than advertised, and the capital charges are high.)

Okay, this could work, but when you are done, you will have reduced the earnings capacity of the remaining company.  Reinsurance that provides additional surplus strips future earnings out the the company, and leaves the subsidiaries inflexible.  Trust me, I’ve worked at too many companies that did it.  It’s a lousy way to manage a life company.

Expense reduction can always be done, but business quality can suffer.  Improving the Commercial lines loss ratio will mean writing less business in an already overcompetitive market — can’t see how that will help much.

I don’t think the numbers add up to $25 billion, particularly not in a competitive market like we have right now.  This is part of what I meant when I said:

…it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise.  Insurance is a set of complex businesses, and few understand most of them, much less all of them.  It would be easy to naively overestimate the ability to improve profitability at AIG if you don’t know the business,  the accounting, and how free cash flow emerges, if it ever does.

They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings.  Icahn and his friends might be surprised at how little value could initially be released, if any.

Thus I don’t see a lot of value at AIG right now.  I see better opportunities in MetLife.

MetLife is spinning off their domestic individual life lines, which is the core business.  I would estimate that it is worth around 15% of the whole company.  In the process, they will be spinning off most of their ugliest liabilities as far as life insurance goes — the various living benefits and secondary guarantees that are impossible to value in a scientific way.

The main company remaining will retain some of the most stable life liabilities, the P&C operation, and the Group Insurance, Corporate Benefit Funding, and the International operations.

I look at it this way: the company they are spinning off will retain the most capital intensive businesses, with the greatest degree of reserving uncertainty.  The main company will be relatively clean, with free cash flow being a high percentage of earnings.

I will be interested in the main company post-spin.  At some point, I will buy some MetLife so that I can own some of that company.  The only tough question in my mind is what the spinoff company will trade at.  Most people don’t get insurance accounting, so they will look at the earnings and think it looks cheap, but a lot of capital and cash flow will be trapped in the insurance subsidiaries.

There is no stated date for the spinoff, but if the plan is to spin of the company, a registration statement might be filed with the SEC in six months, so, you have plenty of time to think about this.

Get MET, it pays.

One Final Note

I sometimes get asked what insurance companies I own shares in.  Here’s the current list:

Long RGA, AIZ, NWLI (note: illiquid), ENH, BRK/B, GTS, and KCLI (note: very illiquid)

In general, I tend not to go in for macro themes.  Why?  I tend to get them wrong, and I think most investors also get them wrong, or at least, don’t get them right consistently.

I do have one macro theme, and it has served me well for a long time, though not over the past two years.  I was using the theme as early as 2000, but finally articulated it in 2006.

At that time, I was running my equity strategy for my employer, as well as in my personal account.  They used it for their profit sharing plan and endowment.  They liked it because it was different from what the firm did to make money, which was mostly off of financial companies, both public and private.  They didn’t want employees to worry that their accrued profit sharing bonuses would be in jeopardy if the firm’s ordinary businesses got into trouble.  In general, a good idea.

At the end of the year, I needed to give a presentation to all of the employees on how I had been managing their money.  Because my strategies had been working well, it would be an easy presentation to make… but as I looked at the prior year presentation, I felt that I needed to say more.  It was at that moment that the macro theme that i had been working with became clear to me, and I called it: Our Growing World.

The idea is this: in a post-Cold War world where most economies have accepted the basic idea of Capitalism to varying degrees, there should be growth, and that growth should create a growing middle class globally.  This middle class would be less well-off than what we presently see in America and Western Europe, at least not initially, but would manifest itself in a lot of demand for food, energy, and a variety of commodities and machinery as the middle class grew.

Now, I never committed everything to this theme, ever.  Maybe one-third of the portfolio was influenced by it, on averaged.  Most of what I do was and still is more influenced by my industry models, and by bottom-up stock-picking.

That said, the theme has a cyclical bias, and cyclicals have been kicked lately.  I still think the theme is valid, but will have to wait for overinvestment and overproduction in certain industries to get rationalized globally.  Were this only a US problem, it might be easier to deal with because we’re far more willing to let things fail, and let the bankruptcy process sort these matters out.  Governments in the rest of the world tend to interfere more, particularly if it is to protect a company that is a “national champion.”

But the rationalization will take place, and so until then in cyclical industries I try to own financially strong companies that are cheap.  They will survive until the cycle turns, and make good money after that.  That said, the billion dollar question remains — when will the cycle turn?

More next time, when I write about my industry model.

Photo Credit: Paul Saad

Photo Credit: Paul Saad || What’s more cyclical than a mine in South Africa?

This is the first of a series of related posts.  I took a one month break from blogging because of business challenges.  As this series progresses, I will divulge a little more about that.

When I look at stocks at present, I don’t find a lot that is cheap outside of the stocks of companies that will do well if the global economy starts growing more quickly in nominal terms.  As it is, those companies have been taken through the shredder, and trade near their 52-week lows, if not their decade lows.

Unless an industry can be done away with in entire, some of the stocks an economically sensitive industry will survive and even soar on the other side of the economic cycle.  At least, that was my experience in 2003, but you have to own the companies with balance sheets that are strong enough to survive the through of the cycle.  (In some cases, you might need to own the debt, and not the common equity.)

The hard question is when the cycle will turn.  My guess is that government policy will have little to do with the turn, because the various developed countries are doing nothing to clear away the abundance of debt, which lowers the marginal productivity of capital.  Monetary policy seems to be pursuing a closed loop where little incremental lending gets to lower quality borrowers, and a lot goes to governments.

But economies are greater than the governments that try to milk them.  There is a growing middle class around the world, and along with that, a growing need for food, energy, and basic consumer goods.  That is the long run, absent war, plague, resurgent socialism, etc.

To give an example of how markets can decouple from government policy, consider the corporate bond market, and lending options for consumers.  The Fed can keep the Fed funds rate low, but aside from the strongest borrowers, the yields that lesser borrowers borrow at are high, and reflect the intrinsic risk of loss, not the temporary provision of cheap capital to banks and other strong borrowers.

It’s more difficult to sort through when accumulated organic demand will eventually well up and drive industries that are more economically sensitive.  Over-indebted governments can not and will not be the driver here.  (Maybe monetary policy like the 1970s could do it… what a thought.)

So, what to do when the economic outlook for a wide number of industries that look seemingly cheap are poor?  My answer is buy one of the strongest names in each industry, and then focus the rest of the portfolio on industries with better current prospects that are relatively cheap.

Anyway, this is the first of a few articles on this topic.  My next one should be on industry valuation and price momentum.  Fasten your seatbelts and don your peril-sensitive sunglasses.  It will be an ugly trip.

Photo Credit: t m || Seven sisters sitting on the hill

Photo Credit: t m || Seven sisters sitting on the hill

1) I started in this game as an amateur, and built up my skills gradually, reading widely.  My academic studies ended at age 25, and it was after that that I began learning the practical knowledge.  Though I had investment-related jobs, I never held a position in investing, until I was 38, and I never wrote on investing for the public in any significant way until I was 42, when Cramer invited me to write for RealMoney.  I’m now 55, and I think I am still growing in my knowledge of investing.

i write this to simply say that you don’t have to take a traditional path into the investment business.  I am grateful that I want through the circuitous path through the insurance industry, because it deepened my perspective on investing.  All of the asset-liability modeling, where I often tried to challenge existing paradigms, helped me to understand why often the conventional wisdom is true.  Where it is not true, there is usually an anomaly to profit from.

The other reason that I write this, is that it is possible to get significant knowledge as an amateur, and on a book basis, as good as many professionals.  You won’t get the respect from professionals until you are a professional, but who cares?  You can do better for yourself in investing.  Just don’t get arrogant and forget to put risk control forst.

2) After all of the political fights are over, OPEC nations will once again agree that they will cut production as a group.  Remember, much of OPEC has a low cost of production, and so when production decreases in a coordinated way, profits will rise for almost all OPEC nations.

In the long run, economics triumphs over politics.  The challenge comes in the short-run from trying to figure out who cuts how much from what baseline.  Even after that, discipline takes a while to achieve, because the incentive to cheat is high.

I stand by the view that in the intermediate term, crude oil prices will be around $50.  Demand for crude oil is growing globally, not shrinking, and marginal supplies would price out at around $50/barrel, if OPEC nations act to maximize their profits, rather than engage in a market share war.  (Prices would be higher still  if OPEC nations acted to maximize the present value of their long-run profits, but I doubt that will happen until the profligate producers deplete their reserves.

3) The ferment in high yield bonds is unlikely to peak before there are significant defaults.  It’s possible that we get a rally from here in the short run — yield spreads are relatively wide compared to earnings yields on stock.  At this point, it doesn’t pay so well to borrow money and buy back stock.  That isn’t stopping many corporations from doing their buybacks.  Buybacks should be tactical rather than constant.  Only buy back when there is a significant discount to the fair market value of the firm.

That said, it’s unusual for a large amount of credit stress to go away without defaults.  It’s rare to see a credit problem work out by firms growing out of it.  Thus what might be more likely than a junk rally is a fall in stock prices.  Perhaps the most optimistic scenario would be that only energy is affected — it has defaults, and the rest of the market continues to rally.  Not impossible.

4) Regarding F&G Life — congrats to holders, you won.  A dumb aggressive foreign buyer jumped on the grenade for you. (Now let’s see, has that ever happened before to F&G Life?)  Be grateful and sell.  Let the arbs take the risk of the deal not going through.

5) One phrase that all investors should learn is, “I missed that one.”  You can’t catch every opportunity.  Some will pass you by despite your best efforts.  Rather than jump on late, it is better to look for the next opportunity, lest you buy high and sell low.

On the opposite side of timing, if you tend to get to opportunities too early, maybe consider waiting until the price breaks the 200-day moving average from below.  Let the market confirm that it agrees with your thesis, and then invest.

6) Regarding the Fed, I think too much is being made out of them for now.  I will be watching the yield curve for clues, and seeing if the curve flattens or steepens.  I expect it to flatten more quickly than the market currently expects, limiting the total amount of Fed tightening.

As it is, every time the Fed tightens, the short interest-bearing deposits at banks reprice up, with some lesser amount pass-through to lending rates.  I would expect bank profits to be squeezed.

Aside from that, most of what the FOMC will say tomorrow will just be noise.  They don’t have a theory that guides them; they are just making it up as they go, so they wander and try to discover what their goals should be.

7) I’ve sometimes commented that at the start of a tightening cycle that those who have been cheating blow up, like Third Avenue Focused Credit, which bought assets far less liquid than the shares of its mutual fund.  At the end of the tightening cycle, something blows up that would be a surprise now, which sometimes jolts the FOMC to stop tightening.  The question here is: what could that group of economic entities be?  China, Brazil, repo markets, agricultural loans, auto loans, or something else?  Worth thinking about — we know about energy, but what else has issued the most debt since the end of 2008?

(As an aside, the recent moves to make China more integrated with the global economy also make it more subject to financial risks that are global, and not just local, of which it has enough.)

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best.  First, I don’t like infographics or video.  I want to learn things quickly.  Give me well-written text to read.  A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem.  Do you want to reduce the volatility of your asset portfolio?  I have the solution for you.  Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard.  Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?”  In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments.  Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Not much.  The diversification from investor behavior is largely gone (the liability side of correlation).  Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets?  Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what?  Much the same thing happened here as happened with non-“blue chip” stocks.  Initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Some, but less.  Not everyone was willing to do all of these.  The diversification from investor behavior was reduced (the liability side of correlation).  These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short.  Many of those blew up last time.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again?  Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point.  Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder.  Think of cash, which doesn’t earn much or lose much.  Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time.  Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%).  This isn’t a call to go nuts and sell all of your risky asset positions.  That requires more knowledge than I will ever have.  But it does mean having some dry powder.  The amount is up to you as you evaluate your time horizon and your opportunities.  Choose wisely.  As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life.  Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification.  You will have to wait for those ideas to be forgotten.  Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

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This book is not what I expected; it’s still very good. Let me explain, and it will give you a better flavor of the book.

The author, Jason Zweig, is one of the top columnists writing about the markets for The Wall Street Journal.  He is very knowledgeable, properly cautious, and wise.  The title of the book Ambrose Bierce’s book that is commonly called The Devil’s Dictionary.

There are three differences in style between Zweig and Bierce:

  • Bierce is more cynical and satiric.
  • Bierce is usually shorter in his definitions, but occasionally threw in whole poems.
  • Zweig spends more time explaining the history of concepts and practices, and how words evolved to mean what they do today in financial matters.

If you read this book, will you learn a lot about the markets?  Yes.  Will it be fun?  Also yes.  Is it enough to read this and be well-educated?  No, and truly, you need some knowledge of the markets to appreciate the book.  It’s not a book for novices, but someone of intermediate or higher levels of knowledge will get some chuckles out of it, and will nod as he agrees along with the author that the markets are a treacherous place disguised as an easy place to make money.

As one person once said, “Whoever called them securities had a wicked sense of humor.”  Enjoy the book; it doesn’t take long to read, and it can be put down and picked up with no loss of continuity.

Quibbles

None

Summary / Who Would Benefit from this Book

If you have some knowledge of the markets, and you want to have a good time seeing the wholesome image of the markets skewered, you will enjoy this book.  if you want to buy it, you can buy it here: The Devil’s Financial Dictionary.

Full disclosure: The author sent a free copy to me via his publisher.

If you enter Amazon through my site, and you buy anything, including books, 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.

I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch.  As he said in his blog post at The Wall Street Journal’s The Experts blog:

WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance.  “No problem,” you might think—buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.”

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

CGMFX Dollar Weighted_1552_image002That’s why I wanted to write this post.  Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions.  As such, his investors buy high and sell low with his funds.  The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database.  The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data.

The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports.  This is all public data, but somewhat difficult to aggregate.  I do it by hand.

I use annual cashflows for most of the calculation.  For the buy and hold return, i got the data from Yahoo Finance, which got it from Morningstar.

Note the pattern of cashflows is positive until the financial crisis, and negative thereafter.  Also note that more has gone into the fund than has come out, and thus the average investor has lost money.  The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance.

This would be an ideal fund to rebalance.  Talented manager, will do well over time.  Add money when he does badly, take money out when he does well.  Would make a ton of sense.  Why doesn’t it happen?  Why doesn’t at least buy-and-hold happen?

It doesn’t happen because there is a Asset-Liability mismatch.  It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short.  If you underperform for less than a few years, they yank funds.  The poetic justice is that they yank the funds just as the performance is about to turn.

Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in.  It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out.  The more volatile the fund, the more rapidly that happens.  And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months.

Pretty astounding I think.  This highlights two main facts about retail investing that can’t be denied.

  1. Asset prices move a lot more than fundamentals, and
  2. Most investors chase performance

These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees.  remember as well that passive investing does not protect retail investors from themselves.  I have done the same analyses with passive portfolios — the results are the same, proportionate to volatility.

I know buy-and-hold gets a bad rap, and it is not deserved.  Take a few of my pieces from the past:

If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets.  If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets.  Rebalance to those percentages yearly.  If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon.  (Why 120?  End of the mortality table. 😉 Take it from an investment actuary. 😉 We’re the best-kept secret in the financial markets. 😀 )

Okay, gotta close this off.  This is not the last of this series.  I will do more dollar-weighted returns.  As far as retail investing goes, it is the most important issue.  Period.

s-l1000

Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.

This post was also prompted by a post by another blogger of sorts publishing at LinkedIn.  I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement.  The successful traders seem to have systems that go beyond the simple systems that they write about.  If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed.  That’s why the books I am mentioning are longer-term investment books.

General Books on Value Investing

Don’t get me wrong.  I like many books on value investing, but the first three are classic.  Graham is the simplest to understand, and Klarman is relatively easy as well.  Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so.  But even Ben Graham recognized that value investing needed to change at the end of his life.

Whitman takes more of a private equity approach, and aims for safe and cheap.  Can you find mispriced assets inside a corporation or elsewhere where the value would be higher if placed in a different context?  Whitman is a natural professor on issues like these, though in practice, the stocks he owned during the financial crisis were not safe enough.  Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing.  This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”

The last book is mostly unknown, but I think it is useful.  Penman takes apart GAAP accounting to make it more useful for decision-making.  In the process, he ends up showing that very basic forms of quantitative value investing work well.

Books that will help you Understand Markets Better

The first link is two books on the life of George Soros.  Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot.  Why is there momentum?  Why is the tendency for price to converge to value weak?  What do markets look and feel like as they are peaking, troughing, etc?  Expectations are a huge part of the game, and they affect the behavior of your fellow market participants.  Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.

Consider what things are like now as people justify high equity valuations.  At every turning point, you find people defending vociferously why the trend will go further.  Who is willing to think differently at the opportune time?

Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time.  They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds by a little and cash by a lot.

For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.

Books on Managing Risk

After the financial crisis, we need to understand better what risk is.  Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure.  We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders.  For the latter, think of the Chinese using too much margin to carry stocks.  For the former, think of Fannie Mae and Freddie Mac.  They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions.  (You can drown in a river with an average depth of six inches.  Averages reveal; they also conceal.)

Hot money has a short attention span.  It needs to make money NOW, or it will leave.  When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.”  So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s.  Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.

As for the last book, hedge funds as a group are a dominant form of hot money.  They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group.  With any individual hedge fund, your mileage may vary, there are some good ones.

These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way.  Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it.  A few simple changes have been made, along with a bunch of ineffectual complex changes.  The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.

An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.

Summary

I chose some good books here, some of which are less well-known.  They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of The Most Important Thing, by Howard Marks.  Oops, also great, and all for now.

PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet.  You can figure that out for yourselves.  Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.

I was asked to participate with 57 other bloggers in a post that was entitled 101 ETF Investing Tips.  It’s a pretty good article, and I felt the tips numbered 2, 15, 18, 23, 29, 35, 44, 48, 53, 68, 85, 96, and 98 were particularly good, while 10, 39, 40, 45, 65, 67, 74, 77, 80, and 88 should have been omitted.  The rest were okay.

One consensus finding was that Abnormal Returns was a “go to” site on the internet for finance.  I think so too.

Below were the answers that I gave to the questions.  I hope you enjoy them.

1) What is the one piece of advice you’d give to an investor just starting to build a long-term portfolio?

You need to have reasonable goals.  You also have to have enough investing knowledge to know whether advice that you receive is reasonable.  Finally, when you have a reasonable overall plan, you need to stick with it.

2) What is one mistake you see investors make over and over?

They think investment markets are magic. They don’t save/invest anywhere near enough, and they think that somehow magically the markets will bail out their woeful lack of planning.  They also panic and get greedy at the wrong times.

3) In 20 years, _____. (this can be a prediction about anything — investing-related or otherwise)

In 20 years, most long-term public entitlement and private employee benefit schemes that promised fixed payments/reimbursement will be scaled back dramatically, and most retirees will be very disappointed.  The investment math doesn’t work here – if anything, the politicians were more prone to magical thinking than naïve investors.

4) Buy-and-hold investing is _____.

Buy-and-hold investing is the second-best strategy that average people can apply to markets, if done with sufficient diversification. It is a simple strategy, available to everyone, and it generally beats the performance of average investors who buy and sell out of greed and panic.

5) One book I wish every investor would read is _____. (note that non-investing books are OK!)

One book I wish every investor would read is the Bible. The Bible eliminates magical thinking, commends hard work and saving, and tells people that their treasure should be in Heaven, and not on Earth.  If you are placing your future hope in a worry-free, well-off retirement, the odds are high that you will be disappointed.  But if you trust in Jesus, He will never leave you nor forsake you.

6) The one site / Twitter account / newsletter that I can’t do without is _____.

Abnormal Returns provides the best summary of the top writing on finance and investing every day.  There is no better place to get your information each day, and it comes from a wide array of sources that you could not find on your own.  Credit Tadas Viskanta for his excellent work.

7) The biggest misconception about investing via ETFs is_____.

The biggest misconception about investing via ETFs is that they are all created equal.  They have different expenses and structures, some of which harm their investors.  Simplicity is best – read my article, “The Good ETF” for more.

8 ) Over a 20-year time horizon, I’m bullish on _____. (this can be an asset class, fund, technology, person — anything really!)

Over 20 years, I am bullish on stocks, America, and emerging markets.  Of the developed nations, America has the best combination of attributes to thrive.  The emerging markets offer the best possibility of significant growth.  Stocks may have a rough time in the next five years, but in an environment where demographic and technological change is favoring corporate profits, stocks will do better than other asset classes over 20 years.

9) The one site / Twitter account / newsletter that I can’t do without is _____.

Since you asked twice, the Aleph Blog is one of the best investing blogs on the internet, together with its Twitter feed.  It has written about most of the hard questions on investing in a relatively simple way, and is not generally marketing services to readers.  For the simple stuff, go to the personal finance category at the blog.

10) Any other ETF-related investing tips or advice?

For a fuller view of my ETF-related advice, go to Aleph Blog, and read here.  Briefly, be careful with any ETF that is esoteric, or that you can’t draw a simple diagram to explain how it works.  Also realize that traders of ETFs tend to do worse than those that buy and hold.

 

Photo Credit: Grant || Lotsa zinc there

Photo Credit: Grant || Lotsa zinc there

I haven’t written about promoted penny stocks in a long time.  Tonight I am not writing about promoted stocks, only penny stocks as promoted by a newsletter writer.  He profits from the newsletter.  Ostensibly, he does not front-run his readers.

Before we go on, let me run the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 12/1/15DeclineAnnualizedDead?
GTXO5/27/20082.450.011-99.6%-51.5% 
BONZ10/22/20090.350.000-99.9%-68.5% 
BONU10/22/20090.890.000-100.0%-100.0% 
UTOG3/30/20111.550.000-100.0%-100.0%Dead
OBJE4/29/2011116.000.000-100.0%-100.0%Dead
LSTG10/5/20111.120.004-99.6%-74.2% 
AERN10/5/20110.07700.0001-99.9%-79.8% 
IRYS3/15/20120.2610.000-100.0%-100.0%Dead
RCGP3/22/20121.470.180-87.8%-43.4% 
STVF3/28/20123.240.070-97.8%-64.7% 
CRCL5/1/20122.220.001-99.9%-87.2% 
ORYN5/30/20120.930.001-99.9%-85.4% 
BRFH5/30/20121.161.000-13.8%-4.1% 
LUXR6/12/20121.590.002-99.9%-86.3% 
IMSC7/9/20121.50.495-67.0%-27.9% 
DIDG7/18/20120.650.000-100.0%-100.0% 
GRPH11/30/20120.87150.013-98.5%-75.4% 
IMNG12/4/20120.760.012-98.4%-75.0% 
ECAU1/24/20131.420.000-100.0%-94.9% 
DPHS6/3/20130.590.005-99.2%-85.5% 
POLR6/10/20135.750.005-99.9%-94.2% 
NORX6/11/20130.910.000-100.0%-97.5% 
ARTH7/11/20131.240.245-80.2%-49.3% 
NAMG7/25/20130.850.000-100.0%-100.0% 
MDDD12/9/20130.790.003-99.7%-94.5% 
TGRO12/30/20131.20.012-99.0%-90.9% 
VEND2/4/20144.340.200-95.4%-81.6% 
HTPG3/18/20140.720.003-99.6%-95.9% 
WSTI6/27/20141.350.000-100.0%-99.9% 
APPG8/1/20141.520.000-100.0%-99.8% 
CDNL1/20/20150.350.035-90.0%-93.1% 
12/1/2015Median-99.9%-87.2%

 

If you want to lose money, it is hard to do it more consistently than this.  No winners out of 31, and only one company looks legit at all — Barfresh.

But what of the newsletter writer?  He seems to have a couple of stylized facts that are misapplied.

  1. Every day, around 45 stocks double or more in price.
  2. Some wealthy investors have bought stocks like these.
  3. Wall Street firms own these stocks but never recommend them to ordinary individuals
  4. The media censors price information about these stocks so you never hear about them

Every day, around 45 stocks double or more in price.

That may be true, but most of those that do double or more in price don’t do so for fundamental reasons; they are often manipulated.  Second, the stocks that do double in price can’t be found in advance — i.e., picking the day that the price will explode.  Third, the prices more often fall hard for these tiny stocks.  Of the 30 stocks mentioned above that were not dead at the time of the last article, 10 fell more than 90% over the 10+ month period.  13 fell less than 90%, 1 broke even, and 7 rose in price.  The median stock fell 61%.  This was during a bull market.

Now you might say, “Wait, these are promoted stocks, of course they fell.”  Only the last one was being actively promoted, so that’s not the answer.

My fourth point is for the few that rise a lot, you can’t invest in them.  The stocks that double or more in a day tend to be the smallest of the stocks.  Two of the 30 stocks listed in the scoreboard rose 900% and 7100% in the 10+ month period since my last article.  How much could you have invested in those stocks?  You could have bought both companies for a little more than $10,000 each.  Anyone waving even a couple hundred bucks could make either stock fly.

So, no, these stocks aren’t a road to riches.  Now the ad has stories as to how much money people made at some point buying the penny stocks.  The odds of stringing several of these successful purchases in succession, parlaying the money into bigger and bigger stocks that double is remote at best, and your odds of losing a lot of it is high.

This idea is a less classy version of the idea promoted in the book 100 to 1 in the Stock Market.  If it is difficult to find the 100-baggers 30 years in advance, it is more difficult to find a stock that is going to double or more tomorrow, much less a bunch of them in succession.  You may as well go to Vegas and bet it all on Double Zero on the roulette wheel four times in a row.  The odds are about that bad, as trying to get rich buying penny stocks.

The ad also lists three stock that at some point fit his paradigm — MeetMe [MEET], PlasmaTech Biopharmaceuticals, Inc. (PTBI) which is now called Abeona Therapeutics Inc. (ABEO), and Organovo (ONVO).  All of these are money-losing companies (MeetMe may be breaking into profitability now) that have survived by selling shares to raise cash.  The stocks have generally been poor.  Have they had volatile days where the price doubled?  At some point, probably, but who could have picked the date in advance, and found liquidity to do a quick in-and-out trade?

The author lists five future situations as a “come on” to get people to subscribe.  I find them dubious.

As for wealthy investors, he mentions two: Icahn pulling of a short squeeze on Voltari (difficult to generalize from), and Soros with PlasmaTech Biopharmaceuticals, Inc.  It should be noted that Soros has a big portfolio with many stocks, and that position was far less than 1% of his assets.  In general, the wealthy do not buy penny stocks.

As for brokers and the media not mentioning penny stocks, that is being responsible.  The brokers could get in hot water for recommending or buying penny stocks even under a weak suitability standard.  The media also does not want to be blamed for inciting destructive speculation.  Retail investors lose enough money through uninformed trading, why encourage them to do it where fundamentals are typically quite poor.

I’ve written two other pieces on less liquid stocks to try to explain the market better: On Penny Stocks and Good Over-the-Counter “Pink” Stocks.  It’s not as if there isn’t value in some of the stocks that “fly under the radar.”  That said, you have to be extra careful.

Near the end of the ad, the writer describes how he is being extra careful also.  Many of his rules make a lot of sense.  That said, following those rules will get you boring companies that won’t double or more in a day.  And that’s not a bad thing.  Most significant money is made slowly — it doesn’t come in a year, much less in a day.

That said, I recommend against the newsletter because of the way that it tries to attract people.  The rhetoric is over the top, and appeals to those who sense conspiracies keeping them from riches, so join my club where I hand out my secret knowledge so you can benefit.

In summary, as a first approximation, don’t invest in penny stocks.  The odds are against you.  Fools rush in where angels fear to tread.  Don’t let greed get the better of you — after all, what is being illustrated is an illusion that  retail investors can’t generally achieve.