The Rules – Page 5 – The Aleph Blog

The Rules, Part XXVII, and, Seeming Cheapness vs Margin of Safety

Posted on 29 December 201129 December 2011 by David Merkel

The market takes action against firms that carry positions bigger than their funding base can handle.? Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.? After that happens, valuation-motivated sellers appear to offer more at those prices.? The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.? As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”? The short-term proclivities of investors usually have no effect on the long run value of companies.? Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.? One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.? And often, they invested in financials that looked cheap, but took too much credit risk.? Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.? Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.? Every time I read something by him or see a video with him, I think, “Bright guy.”? But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.? Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.? From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.? And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.? Are the assets and liabilities properly stated?? Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

Company size (the ability of management to make sure values are accurate or conservative declines with size)
Rapidity of the company’s growth
Length of the asset or liability
Uncertainty over when the asset will pay out, or when the liability will require cash
Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”? It is also a question of whether the company will have adequate financing to hold those assets in all environments.? For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”? All financial asset values are relative to the financing environment that they are in.? Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.? Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.? Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.? (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.? Do they try to grow rapidly?? That’s a danger sign.? There is always the tradeoff between quality, quantity, and price.? In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.? Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?? How much do they explain away one-time events?? Are they raising leverage to boost ROE, or are they trying to improve operations?? Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?? Even with good financial companies there are disappointments.? With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.? They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.? What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.? Even the others of his top 10 have not done well, and the fund as? a whole has suffered.? Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.? And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

A 9.9% return from inception to 5/31/2011 is hot stuff, and,
A 6.0% dollar-weighted return is very good as well.? Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”? Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.? The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.? It can be a negative self-reinforcing cycle for some time.? My one bit of advice would be: focus on margin of safety.? If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

The Rules, Part XXVI (Efficiency vs Stability)

Posted on 27 August 201120 June 2017 by David Merkel

T+1 will raise volatility.? Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

There was an effort in the early 2000s to make almost all securities settle as a rule in one day.? Three days was the rule for most markets then, as it is now.? Government bonds settle differently, and some other securities as well.? The effort to settle transactions more quickly failed, and we still settle trades in three days.

I was glad when the move to T+1 failed.? There were efforts to move to T+0 behind it.? Not that I had many trades that I needed to break as a bond manager (I had one, the phone call to do so made me ill), but I knew there were settlement failures even at T+3, and the stress on the back office would be considerable.? Better to go slower, and have fewer failures.

I prefer stability over efficiency.? Efficient systems tend to require high attention.? Stable systems have redundancy.? Not everything has to go right for the system to work.? In my example above, T+1 required a lot more accuracy, and T+0 would be unimaginable.? We would need angels to clear trades.

That’s one reason why I am not crazy about market efficiency.? Yes, efficiency is a good thing as far as it goes, but when it begins to impact stability I part ways with efficiency.

-=-==-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

It is inefficient to have a balance sheet.? All of the slack capital that you don’t need all of the time.? Far better to be a trader with no significant balance sheet, the profits will be greater.

I disagree.? Though this is an extreme example, look at Buffett with his purchase of Bank of America preferred stock with warrants.? In a single stroke, he protected the downside, and allowed for the participation in the upside.? He probably understands that his credibility can move markets.? The preferred stock can be stuffed inside an insurance entity with little capital cost, while the warrants can be held at the holding company.

Bank of America entered into expensive financing with Buffett who had cash at a critical moment.? Give the Buffster props for his cleverness in the tub — he understood their need of capital, and gave it to them in away where they could deny the need for new capital.? Brilliance.

Brilliance, so long as the losses never reach down into the preferred equity portion of their balance sheet.

=-=-=-=-=-=-=-=-=-==–=-=-===-=-=-

Having a balance sheet allows for modest losses to occur and the system does not fail.? But it means that some capital is not deployed; it is there in reserve for disasters.

That is why financial systems with excess capital survive better.? Yes, it is inefficient to carry capital that does not earn much, but it is more inefficient to fail.? Think of the Baumol model, where there is an economic order quantity.? The same can be applied to finance, where the is a level of efficiency below which we should not go, because of ordinary volatility.

Volatile markets require intermediaries, or at least, systems that slow settlement.?? Slack in the system is not wasted, but is there to protect against catastrophes.? That is a benefit to all, even those that seek to make markets more efficient.

The Rules, Part XXIV

Posted on 13 August 201114 August 2011 by David Merkel

Every excess eventually unwinds.? When an excess unwinds, the fall gets exacerbated by trend-followers blowing out of mutual and other pooled funds with lousy relative performance.

If you had a list of who owned a given publicly-traded asset, and when they bought it, you would know a lot about how patient, intelligent, indebted, etc., the holders of the assets are.? That would give some insight into how they might behave if the asset’s price began to fall.? Would they buy more as it went down, or would they sell in a panic?

Now no one has this data, but some approximate the data by a variety of measures.? Dollar volume traded as a fraction of market capitalization is a measure of speculative activity, though truly, I suspect that the holders of most stocks fall into two camps — long-term (years), and short-term (days to months).? Short-term has gotten shorter as computer power has democratized trading.

We can also read the lists of holders from 13F data.? Managers are pretty consistent.? If they are low turnover, they tend to stay that way.? The same for high turnover.

The holders of mutual funds tend to be late to the news.? There are two reasons for this:

They aren’t paying close attention because the results of mutual funds give slow and unclear signals, which only become clear when the quarterly statement arrives.
Because of loads, and brokers who sold the investors on the funds, regret causes reactions to be slow.

But these holders are late liquidators, and cause funds with bad investment strategies to sell some of their favorite wrong investments, which drives the prices of the investments down further.? This can cause assets to overshoot below their fair value, which value investors quietly accumulate.

=–==-=-=-=–==-=-=-=–==-=-=–==-=–=-==-=-=-=-=-=-=-=-=-=-=-=-

Long horizon investors tend to resist momentum.? Short horizon investors tend to follow momentum.? Long horizon investors tend to have little short-term need for results.? Short-horizon investors want/need results soon.? At bottoms, long-term investors dominate.? At tops, short-term investors dominate.

Mutual funds are in general short term investors, but the few that try to educate their investors that they are long term value investors do get more patient holders, which gets reinforced if the returns are good over a long period.

The Rules, Part XXIII

Posted on 2 August 20112 August 2011 by David Merkel

A Ponzi scheme needs an ever-increasing flow of money to survive.? Same for a market bubble.? When the flow?s growth begins to slow, the bubble will wobble.? When it stops, it will pop.? When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)? – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.? But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.? Also, at very high levels, the authorities take interest.? At very low levels, the Ponzi dies.? Part of the evil genius of Madoff was striking the balance.? He also did four other things:

Soft-peddled the marketing so that it was like joining an exclusive club.
Discouraged withdrawals by saying you would not get back in (for some).
Deluding regulators into thinking that it was a front-running scam.
He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.? All Ponzi schemes eventually fail. So how does this relate to market bubbles?? With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.? This could be due to a number of factors:

Players see that borrowing to chase a rising asset is a winner.
Promoters make it easy to do for inexperienced investors.
An easy monetary policy lowers financing costs, aiding bubble financing.
Players seek stock gains, and disdain debt claims.
At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.? Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the? investment environment is.

The Rules, Part XXII

Posted on 7 June 2011 by David Merkel

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.? Perhaps another possibility is when a country?s currency is being used more and more as a shadow currency, like the US in the Third World.? But even that will come home someday.

I wrote this sometime prior to 2003.? But can it be more relevant than today, aside from my comment about being a shadow currency?? Alas, the US Dollar is not a store of value anymore.? It is only a unit of exchange, like trading cigarettes in a prison camp.

The Federal Reserve may pretend that it is the guardian of stability, but it is not so with respect to asset values.? The Fed stays within its mandates: labor unemployment and goods price inflation.? Those are not much affected by Fed policy at present.? But asset values are inflated.

What should we expect of monetary policy?? Additional creation of money or credit should affect the prices of something.? If the Fed does not intend on affecting a price somewhere, what is it up to?? The economy is prices.? What is the Fed if it does not affect prices?? Next press conference, ask Ben what set of prices he is trying to affect.? If he mumbles, as he usually does, you can know that he is without knowledge, or lying.? All monetary policy affects prices, and it is either dishonest or stupid to say otherwise.

That’s all for now.? We are in a rough situation because of errors in government and central bank policy, as well as cultural errors that have favored spending over saving.? Ignore the idiots who talk of the paradox of thrift.? They rely on short-term models which are not relevant in the real economy.? Saving is a good thing, but maybe save in currencies that are not subject to government discretion, like gold.

The Rules, Part XXI

Posted on 28 May 201129 May 2011 by David Merkel

Before I start this evening, I have a request for readers, and a comment for new readers.? (Note: if you are reading this anywhere but directly at my blog, please realize that you have to come to my blog for me to hear what you are saying.? I do not read comments anywhere else but at Aleph Blog.)? First the request: I would like to test the robustness of the Impossible Dream TAA model on another country.? If any of you have data on any non-US market, which would require the following:

Index price series
Earnings series
Dividends series
And a fixed income return or yield series

Contact me, and we can discuss whether you should send me the data or not.? Monthly data would probably work best, but I am open to other periodicities.

Second, for new readers, welcome to my blog.? Why do I write this after 4 1/4 years of blogging?? May 2011 is my biggest month ever, largely because of the “Impossible Dream” pieces.

For new readers, here is what you have to understand about me: I write about a lot of different things.? I have lots of interests.? I almost named this blog “The Investment Omnivore” but didn’t, because I planned on creating a firm called Aleph Investments back in 1996.? It eventually happened — 14 years later.

So, if I don’t always write about investment strategy, or any other single topic (all crisis, all the time) please don’t get disappointed.? I write in proportion to what is of current interest, and what discoveries I have been making.

So, travel with me on this trail where I cover everything from the global macroeconomy to personal finance issues.? My goal is to help you learn to think about economic/finance/investment issues, and help you see the interconnections between markets, so that you can develop your own perspective on the markets, and not just parrot me.? (Not that many do… 😉 )

-=-==-=-=-=-=–==–==-=-=–==-=–=-=-=-==-=-=-=-=–==-=–==-=-=-=-

All assets represent future goods.? The prices of assets represent the trade-off between present goods and assets.

I wrote a piece recently called Inflation Speculation.? The idea was to explain how it is difficult to save for the future in a way that will transfer today’s purchasing power to the future without diminution, particularly when you have a central bank trying to stimulate the economy through the creation of credit, and the nation as a whole is overindebted.

So, if the Fed is patting itself on the back for:

lowering corporate yield spreads
rising stock market prices

I would tell them: it is easy to change the discount rate, but hard to change the cash flows.? Yes, as you flooded the market with credit, the values of risky assets rose.? Big deal.? Most executives are smart — they still see that demand is punk, and won’t do any real creation of plant and equipment that they weren’t already planning to do.? Little new investment took place, the value of existing assets got revalued up.

When asset prices are high, it means that money today will not buy a lot of future goods.? High P/Es, low interest rates tell us that new investments will have low yields, absent some amazing transforming technology that improves productivity dramatically.

Some people will say to me, “I need more yield today.? Yields are so low.”? I say, “When yields are so low, it is time? to avoid yield and preserve capital.? The time to seek yield is when yields are high, and no one wants to part with money to lend to them.

In March of 2009, I helped to rescue the firm of a friend.? He needed cash in the midst of the crisis, and a few of us lent to him at rates exceeding 10%, with warrants, realizing that he might be bankrupt in short order.? But things turned, and not only did he survive but he thrived.? I am still receiving interest, but will likely be redeemed soon.

Maybe that’s not such a good example.? I put 40% of my congregation’s building fund into high yield and low investment grade debt in late 2008 — made up for a lot of 2008 losses.

=–=-==-=–=-==-=–==–==–==-=-=–==–==–=-=

Think of it a different way: shares in corporations are a proxy for the future well being of the country.? When P/Es are low, the potential for capital gains is large, as is the ability to keep up with inflation.? When P/Es are high, the potential for capital gains is small, as is the ability to keep up with inflation.? Same for bond yields — better to be aggressive when rates and spreads are high, and defensive when they are low.

Thus I would tell Ben Bernanke to lay off the quantitative easing.? It has not helped.? Yes, you have pushed asset prices up, and interest rates down, but has not created any significant new economic activity.? And why should it?? Consumers are still overindebted, and 30% of those with mortgages will lose money on a sale.? The real problem was the debt overhang, and you did nothing to to address that, not that you could, or should.

Buffett once said that most people should not be glad when they see asset prices rising, because they will need to invest more in the future, and will now have to pay higher prices.? Thus times like September 2008 offer the future at a discount to those who have ready liquidity, whereas 2007 offers the future at a premium price.

To the extent that you can, commit capital when it is most needed, and avoid chasing markets up.

The Rules, Part XX

Posted on 26 October 2010 by David Merkel

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

I have been scratching my head over all the problems in the residential mortgage market.? How can foreclosure take place, when there is no note, properly endorsed, to display?? How can certificate holders of securitizations be comfortable when the transfer of ownership interests in mortgages was never completed.

But, I’m not all that worried.? In one sense, the bigger the problem, the easier it is to solve.? Why?? Because the political systems that surround the economic systems tend to focus better on big problems than little problems.

As in Cordwainer Smith’s “The Instrumentality of Man,” the first priority of any government is to survive.? This is one reason why it is easier for them to survive large crises than small problems.? That’s why I give Rudy Giuliani relatively little credit for what he did on 9/11, but give him more credit for what he dealt with on budget issues.

In large crises, the range of options becomes limited.? Also, it becomes easier to see which option is the best one.

So, given the systematic and severe errors that occurred in residential mortgage securitization, shouldn’t there be an obvious answer to what must be done now?? Yes, but a solution here will take time.? Banks will have to make the effort to secure the notes that allow them to foreclose.? And then, they will foreclose.? Will that mean a lot of upset for the residential property market in the short run?? Yes.? Will the residential property market survive this?? Yes.

Foreclosures will take place.? But the legal niceties that protect our property rights in other areas must be observed by the banks.? Courts should not give in to pressure that they must do something to preserve the proper functioning of the market.? Yo, courts.? The markets will survive even if you delay.? Take your time and do it right. Yo, lenders; delay is the price for not having done it right in the first place.

As for the securitization certificateholders, let me remind you of the investment banks and AIG.? AIG absorbed subprime mortgage risk from all of the investment banks.? The investment banks thought they were pretty clever, until they realized that they all had taken advantage of AIG, and thus, AIG might not be able to make good on all the risks that they had absorbed.

In the same way, if all residential mortgage-backed securitizations are unwound at the same time, the sponsors of the mortgage-backed securitizations will not be able to make good on their obligations.

As I see it, residential mortgage-backed certificate holders have an incentive to work with the sponsors to see how this crisis can be worked through.? And as I see it, perhaps the solution is to pay a consent fee to the certificate holders in exchange for waiving their rights to sue over the malfeasance of not transferring the notes from the originator all the way to the trust.

=-=-=-=-=-=-==-=-=-=-=-=-

As with other crises, the probability of total failure is remote.? Total failure only occurs when those at the top of the power structure are so self consumed that they do not see the threat to their lives.

That’s why I see a slow but reasonable solution coming through the court system to solve the malfeasance engendered through the sloppy execution of securitizations.? Yes, things are bad.? Yes, our current politicians are clueless.? But there is enough interest in coming to a solution for society as a whole that an equitable solution will be arrived at in the courts ? not through Congress, not through the President.

That doesn’t mean that things won’t be choppy and messy.? Indeed, there will be many ugly times en route to a solution.? But things are not so bad in our judicial systems, as a whole, that we will not come to the correct solution, after exhausting all imaginable alternatives.

The Rules, Part XIX

Posted on 23 October 201023 October 2010 by David Merkel

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

After doing my talk for the Society of Actuaries last Wednesday, I got inspired to write something about modern portfolio theory, the capital asset pricing model, the efficient markets hypothesis, etc.? This particular rule deals with two things:

The same event can have different risk for different individuals.? Risk is unique to each individual.? It cannot be summarized by a single statistic for comparative purposes across individuals.
In general, with a few exceptions, risk is inverse to price.? As the price gets higher, so does risk.? As the price gets lower, so does risk.? The major exception to this rule is when trends are underdiscounted, because estimates of intrinsic value are flawed.

Let’s deal with these issues one at a time.? Start with a simple question.? Why do academics want to have a single measure for risk?? It allows them to write papers, and it keeps the math simple.? That’s why we have concepts like beta and standard deviation of total return.? It’s why we have concepts like the Sharpe ratio and other ratios that purport to measure return versus risk.

If our total planning horizon was similar to the periods that these figures are calculated over, they might have some validity.? But most of the time are planning horizons are longer than the periods that these figures are calculated over.? Even worse, most of these statistics are not stable.? The value calculated today may likely have a statistically significant difference from the value calculated a year ago.

But what is worse still is the idea that by taking more risk you will get more return.? If anything, the empirical research that I’ve been reading, and the value investors that I have talked to, indicate that the less risk you take, the more you’ll make.? A good example of that would be Eric Falkenstein and his book Finding Alpha.? Minimum beta and minimum standard deviation portfolios tend to outperform the market.? Junk grade bonds tend to underperform investment-grade bonds.

If it hurts too much, don’t do what I’m about to say.? Think about Lenny Dykstra.? When he and I were writing at RealMoney.com at the same time, I would often ask him about what his method would be to control risk.? He never gave me a good answer; actually he never ever gave me an answer at all.

My concern was for small investors, dazzled by the celebrity, and the simple approach that he would take that seemingly yielded huge profits, would adopt the approach, and not know what to do when things went wrong.? For Dykstra, who seemingly had a lot of money, losing a little on a deep in the money call trade would not hurt him much.? But to an unfortunate average guy reading Dykstra’s work, a similar sized loss could be very painful.

That said, that greatest risk was in plain view, which Steve Smith, I, and a few others went after — Larry didn’t know what he was talking about.

Risk varies by differences in wealth; risk varies with age.? Risk varies with the level of fixed commitments you have in life.? To give you an example there, when I went to work for a hedge fund, the first thing I did was pay off my mortgage so that I would feel free to take big risks for the hedge fund.? It is far harder to take risk, the higher the level of fixed obligations that one must pay month after month.

To make it more practical, think of all the malarkey that has been spilled talking about ?animal spirits.?? I don’t believe that businessmen are irrational; many Keynesian economists are irrational, but no, not businessmen.? Businessmen will not take risks when they are overleveraged, or, when a broad base of their customers is overleveraged.

Risk is unique to everyone’s individual situation.? Any time you hear someone bring up risk factors that are generic, you can either ignore them, or, more charitably think that they have a proxy that might have something to do with risk, maybe.

Go back to Buffett’s dictum: far better to have a bumpy 15% return than a smooth 12% return.

-==–==-=-=-=-=-=–==-=-=-=-=-=-=-=-

The second part of the rule says that risk models should reflect higher risk as prices rise and lower risks as prices fall.? The implicit idea behind this is that it is possible to calculate the intrinsic value of an asset.? Can I disagree with one of my own rules?? Well, since I do the writing here, I guess I get to make up the rules about the rules.

There are many assets that it is difficult calculate the intrinsic value thereof.? Examples would include commodities, growth stocks, and anything that is highly volatile.

Though I believe my rule is correct most the time, markets are subject to momentum effects.? Often when a stock is at its 52-week high, that’s a good time to buy, because people are slow to react to changes in information.? And, when stock is falling hard, and is at a 52-week low, that is often a good time to not buy the stock, because there are maybe bits of information about the stock, or its holders, that you don’t know.

In general, though, higher prices are more likely to be overpayment and lower prices are more likely to indicate bargains.? Why?? Because returns on equity tend to mean revert.? Companies with poor returns on equity tend to find ways to improve business.? Companies with high returns on equity tend to find increased competition.

Thus, as always, I counsel caution.? Don?t ignore momentum, but also don?t ignore valuation.? Ask yourself how much upside there could reasonably be, and how much downside.? Play where the downside is limited relative to the upside, because the key to investing is margin of safety.? Play to win, yes, but even more, play to survive, so that you can play longer.

The Rules, Part XVIII

Posted on 11 September 201012 September 2010 by David Merkel

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

I have been invited to speak twice in the next two months on the efficient markets hypothesis [EMH].? Once in Denver, once in NYC.? Fortunately for me, the folks in Denver are paying my way, and I will take a regional train to NYC and back.

I grew up on the idea that the EMH in its weak form was true, no doubt.? No one can make money looking at past price movements.? As for the semi-strong form of the EMH, which says that you can’t make money off of any past or present public data, I believed it with some reservations.? My mother was a self-taught investor who regularly beat the markets.? She used a discipline of half utilities (“they are my bonds”) and half “growth at a reasonable price” [GARP] stocks.? She is why I went to Johns Hopkins, rather than the University of Wisconsin.

The EMH in its strong form, that no one can make money off of insider information, was doubted by almost all.? Even today, we track insiders, and there is money to be made by following them.? Even following 13F filings of successful investors is profitable to many.

Yet, the EMH is compromised even in its weak form.? When one reads academic research on the markets, what is the most durable and powerful of all of the anomalies? Price momentum, which violates the weak EMH.? That said, a lot of economic actors know that price momentum works well, and so it gets used.? And overused.

Any strategy can be overused.? Before a strategy peaks, the overuse of a strategy makes the strategy work overly well, as prices for stocks are pushed above equilibrium levels through strategy momentum.

In the long run the stock market is a weighing machine, so the short-term overshoot will correct itself eventually.? But when too many follow momentum, the market goes wild.? Volatility rises; daily moves tend to be up or down a percent or more.? During such a period, price momentum stops working for a time, until enough abandon the strategy.

The same applies to longer term strategies, like value investing, or overweighting small companies, or overweighting companies with sound financials, or low price volatility, etc.? Any one of these can be pursued too much.? When any of them is pursued too much the stocks involved will overshoot and plunge.

There is no magic strategy that works all of the time.? Smart investors have to be aware of almost all of the strategies that exist in the market, and understand when they are underplayed (buy) and overplayed (sell).

Healthy markets have multiple strategies that work.? When the strategy becomes monoculture, e.g. tech stocks, then beware.? When there is only one road to wealth, the market is in a bad place, and smart investors will hold cash, or invest conservatively away from the one thing that is working now.? Broad leadership is needed in a true bull market.? When leadership thins to one idea, it is time to take profits.

Don’t confuse brilliance with a bull market.? Try to understand where you are in the cycle of your stock picking strategy.? It does not work all the time, so when things are at the best that you have seen, wait a bit, and then take two steps back.? When things are horrible, wait a while and redouble your efforts.

Factors in investment returns move in cycles. Be aware of where you are in the cycles, and maybe you can profit from them.

The Rules, Part XVII

Posted on 31 July 20101 August 2010 by David Merkel

In a panic, only two attributes of a financial instrument get priced — liquidity and quality/survivability.

In a panic, all risky assets become highly positively correlated with each other.

Given that correlations tend to rise in a panic, a reasonable measure of sentiment is to measure the average absolute value of 10-day correlations.

Markets cannot survive for long periods of time at high levels of actual or implied volatility.? They eventually revert to normal.

Panics and booms are different — they may be opposites, but they behave differently.? Panics are events, often multiple events, and booms are processes.? The nature of this is best explained through the credit cycle.? The boom phase of the credit cycle involves rising profits of corporations.? Stocks and bonds behave differently here.

Say the expectation of income moves from negative to a low positive figure.? Stocks will rally; bond may rally more, because the threat of bankruptcy is lifted.

Now suppose that the expectation of income moves from a low positive to a normal positive figure.? Stocks will rally a lot, but bonds will rally a little.? The odds of the bonds being paid rise a minuscule amount.? The stocks estimate of future distributable profits rise a great deal.

Now suppose that the expectation of income moves from a normal positive to a high positive figure.? Stocks will rally some, but bonds will not rally much.? The odds of the bonds being paid don’t change.? The stocks estimate of future distributable profits rise, but with a sense of possible mean reversion.

So in a boom, credit spreads [the difference between the yields of corporate bonds and Treasury bonds] tighten quickly, tighten slowly, and then stop tightening, even though things seem to be going great.? The end of the boom, as far as the credit market is concerned, can last a long time.

The end of the boom comes when a significant amount of companies the overextended their balance sheets during the boom find themselves in a compromised condition, and have a hard time gaining financing.? The suspicion of credit troubles travels fast, and all of the companies where investors waved their hands at problems now get a fresh look with a different set of eyes.

The moment incremental financing seems less likely or more expensive, companies that will need financing get re-evaluated by the market — stock prices move down, bond yields go up.? This is when analysis of the balance sheet and the cash flow statement are worth the most, and the income statement is worth the least.? The bull phase of the cycle is all about income statements, and estimating what future income will be.? The bear phase of the cycle is about estimating? cash flows, and the strength of balance sheets, to identify who might not survive the bear phase well.

During the boom phase of the cycle, the degree of correlation of asset returns is low.? There is noise, and not everything does equally well.? There are multiple risk factors and strategies that are working.? But in the bust phase, the acid test of survival dominates.? One factor gets priced, whether an asset is money good or not. [For bonds, “money good” means the par value of the bond will be repaid at maturity.]

But panics don’t last long — usually two years or so.? As the panic drags on three processes take place:

Companies in horrible shape default.
Investors examine companies in okay shape, and find weaknesses.? Some will default, and some will clean their acts up.
Companies clean up their acts, and it becomes obvious that they will survive.

Toward the end of the bust phase, like a fire running out of fuel, there is a moment of clarity where some realize that things aren’t getting worse.? Most companies have cleaned up, and there will be fewer future defaults.? That sets the scene for the next rally.

Through the bust, equity volatility and credit spreads remain high; they are correlated phenomena, but there is a point of exhaustion.? High yields attract needed financing to companies that are mis-financed, rather than insolvent.? Credit spreads can only get so high before money comes in willing to buy no matter what the future may hold.? Equity volatility can only get so high before players begin writing short straddles, knowing that the odds of winning are tipped in their favor.

It pays to watch both the equities and bonds, and other related securities — it gives a richer picture of what is going on.? In particular, when the bull phase has gone on for two full years, watch for equity volatility and credit spreads to stop falling.? That is a sign that the bull market is getting close to the end, and most of the easy gains have been made.? Watch for telltale signs of cashflow shortfalls where banks are less than willing to plug the gap at a price.

Learn this well, and your ability to play the market will improve considerably.