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: 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…

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.

Photo Credit: Ian Sane || Many ways to supplement retirement income...

Photo Credit: Ian Sane || One of many ways to supplement retirement income…

Investing is difficult. That said, it can be harder still. Let people with little to no training to try to do it for themselves. Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. They get there late, and then their emotions trick them into action. A rational investor would say, “Okay, I missed that move. Where are opportunities now, if there are any at all?”

Investing can be made even more difficult.  Investing reaches its most challenging level when one relies on his investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will say that portfolio decisions are almost always easier when there is more cash flowing in than flowing out.  It means that there is one dominant mode of thought: where to invest new money?  Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing.

What’s tough is trying to meet a cash withdrawal rate that is materially higher than what can safely be achieved over time, and earning enough consistently to do so.  Doing so as an amateur managing a retirement portfolio is a particularly hard version of this problem.  Let me point out some of the areas where it will be hard:

1) The retiree doesn’t know how long he, his spouse, and anyone else relying on him will live.  Averages can be calculated, but particularly with two people, the odds are that at least one will outlive an average life expectancy.  Can they be conservative enough in their withdrawals that they won’t outlive their assets?

It’s tempting to overspend, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs.  It is incredibly difficult to avoid paying for an immediate pressing need, when the soft cost is harming your future.  There is every incentive to say, “We’ll figure it out later.”  The odds on that being true will be low.

2) One conservative estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%.  That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero near the end of a bull market.

That said, most people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets.  At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work.  But if income needs are greater than that, the odds of obtaining those yields over the long haul go down dramatically.

3) How does a retiree deal with bear markets, particularly ones that occur early in retirement?  Can he and will he reduce his expenses to reflect the losses?  On the other side, during bull markets, will he build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.”  Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some similarly bad idea.

Academic risk models typically used by financial planners typically don’t do path-dependent analyses.  The odds of a ruinous situation is far higher than most models estimate because of the need for withdrawals and the autocorrelated nature of returns – good returns begets good, and bad returns beget bad in the intermediate term.  The odds of at least one large bad streak of returns on risky assets during retirement is high, and few retirees will build up a buffer of slack assets to prepare for that.

4) Retirees should avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books.  This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc.  They have no guaranteed return of principal.  On the plus side, they may give capital gains if bought at the right time, when they are out of favor, and reducing exposure when everyone is buying them.  Negatively, all junior debt tends to return worse on average than senior debts.  It is the same for equity-like investments used for income investing.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because many people are buying them as if they are magic.  The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

5) Leaving retirement behind for a moment, consider the asset accumulation process.  Compounding is trickier than it may seem.  Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years).  Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, there is no benefit much from a general rise in values from the stock or bond markets.  The value of a portfolio may have risen, but at the cost of lower future opportunities.  This is more ironclad in the bond market, where the cash flow streams are fixed.  With stocks and other risky investments, there may be some ways to do better.

Retirees should be aware that the actions taken by one member of a large cohort of retirees will be taken by many of them.  This makes risk control more difficult, because many of the assets and services that one would like to buy get bid up because they are scarce.  Often it may be that those that act earliest will do best, and those arriving last will do worst, but that is common to investing in many circumstances.  As Buffett has said, “What a wise man does in the beginning a fool does in the end.”

6) Retirement investors should avoid taking too much or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree.  If a person can do that successfully, he is rare.

What is achievable by many is to maintain a constant risk posture.  Don’t panic; don’t get greedy — stick to a moderate asset allocation through the cycles of the markets.

7) With asset allocation, retirees should overweight out-of-favor asset classes that offer above average cashflow yields.  Estimates on these can be found at GMO or Research Affiliates.  They should rebalance into new asset classes when they become cheap.

Another way retirees can succeed would be investing in growth at a reasonable price – stocks that offer capital growth opportunities at an inexpensive price and a margin of safety.  These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into.  This is harder to do than it looks.  More companies look promising and do not perform well than those that do perform well.

Yet another way to enhance returns is value investing: find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that.  After the companies do well, reinvest in new possibilities that have better appreciation potential.

 

8 ) Many say that the first rule of markets is to avoid losses.  Here are some methods to remember:

  • Always seek a margin of safety.  Look for valuable assets well in excess of debts, governed by the rule of law, and purchased at a bargain price.
  • For assets that have fallen in price, don’t try to time the bottom — buy the asset when it rises above its 200-day moving average. This can limit risk, potentially buying when the worst is truly past.
  • Conservative investors avoid the areas where the hot money is buying and own assets being acquired by patient investors.

9) As assets shrink, what should be liquidated?  Asset allocation is more difficult than it is described in the textbooks, or in the syllabuses for the CFA Institute or for CFPs.  It is a blend of two things — when does the investor need the money, and what asset classes offer decent risk adjusted returns looking forward?  The best strategy is forward-looking, and liquidates what has the lowest risk-adjusted future return.  What is easy is selling assets off from everything proportionally, taking account of tax issues where needed.

Here’s another strategy that’s gotten a little attention lately: stocks are longer assets than bonds, so use bonds to pay for your spending in the early years of your retirement, and initially don’t sell the stocks.  Once the bonds run out, then start selling stocks if the dividend income isn’t enough to live on.

This idea is weak.  If a person followed this in 1997 with a 10-year horizon, their stocks would be worth less in 2008-9, even if they rocket back out to 2014.

Remember again:

You don’t benefit much from a general rise in values from the stock or bond markets.  The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income.  If interest rates are low, as they are now, safe income will be low.  The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income.  Look instead at the underlying economics of the business, and how it grows value.  It is far better to have a growing income stream than a high income stream with low growth potential.

Deciding what to sell is an exercise in asset-liability management.  Keep the assets that offer the best return over the period that they are there to fund future expenses.

10) Will Social Security take a hit out around 2026?  One interpretation of the law says that once the trust fund gets down to one year’s worth of payments, future payments may get reduced to the level sustainable by expected future contributions, which is 73% of expected levels.  Expect a political firestorm if this becomes a live issue, say for the 2024 Presidential election.  There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

Even if benefits last at projected levels longer than 2026, the risk remains that there will be some compromise in the future that might reduce benefits because taxes will not be raised.  This is not as secure as a government bond.

11) Be wary of inflation, but don’t overdo it.  The retirement of so many people may be deflationary — after all, look at Japan and Europe so far.  Economies also work better when there is net growth in the number of workers.  It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

Also consider other risks, and how assets may fare.  Retirees should analyze what exposure they have to:

  • Deflation and a credit crisis
  • Expropriation
  • Regulatory change
  • Trade wars
  • Changes in taxes
  • Asset illiquidity
  • Reductions in reimbursement from government programs like Medicare, Medicaid, etc.
  • And more…

12) Retirees need a defender of two against slick guys who will try to cheat them when they are older.  Those who have assets are a prime target for scams.  Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make assets stretch further.  But there are other scams as well — retirees should run everything significant past a smart younger person who is skeptical, and knows how to say no when it is necessary.

Conclusion

Some will think this is unduly dour, but this is realistic.  There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping, retirees need to be ready for the hard choices that will come up. They should think through them earlier rather than later, and take some actions that will lower future risks.

The basic idea of retirement investing is how to convert present excess income into a robust income stream in retirement.  Managing a pile of assets for income to live off of is a challenge, and one that most people are not geared up for, because poor planning and emotional decisions lead to subpar results.

Retirees should aim for the best future investment opportunities with a margin of safety, and let the retirement income take care of itself.  After all, they can’t rely on the markets or the policymakers to make income opportunities easy.

I have my list of concerns for the economy and the markets:

  1. Unexpected Global Macroeconomic Surprises, including more from China
  2. Student Loans, Agricultural Loans, Auto Loans — too much
  3. Exchange Traded Products — the tail is wagging the dog in some places, and ETPs are very liquid, but at a cost of reducing liquidity to the rest of the market
  4. Low risk margins — valuations for equity and debt are high-ish
  5. Demographics — mostly negative as populations across the globe age
  6. Wages in the “developed world” are getting pushed to the levels of the “developing world,” largely due to the influence of information technology.  Also, technology is temporarily displacing people from current careers.

But now I have one more:

7)  Nonfinancial corporations, once the best part of the debt markets, are beginning to get overlevered.

This is worth watching.  It seems like there isn’t that much advantage to corporate borrowing now — the arbitrage of borrowing to buy back stock seems thin, as does borrowing to buy up competitors.  That doesn’t mean it is not being done — people imitate the recent past as a useful shortcut to avoid thinking.  Momentum carries markets beyond equilibrium as a result.

If the Federal Reserve stimulates by duping getting economic actors to accelerate current growth by taking on more debt, it has worked here.  Now where is leverage low?  Across the board, debt levels aren’t far from where they were in 2008:

As such, I’m not sure where we go from here, but I would suggest the following:

  • Start lightening up on bonds and stocks that would concern you if it were difficult to get financing.  How well would they do if they had to self-finance for three years?
  • With so much debt, monetary policy should remain ineffective.  Don’t expect them to move soon or aggressively.
  • Fiscal policy will remain riven by disagreements, and hamstrung by rising entitlement spending.
  • Long Treasuries don’t look bad with inflation so low.
  • Leave a little liquidity on the side in case of a negative surprise.  When everyone else has high debt levels, it is time to reduce leverage.

Better safe than sorry.  This isn’t saying that the equity markets can’t go higher from here, that corporate issuance can’t grow, or that corporate spreads can’t tighten.  This is saying that in 2004-2006, a lot of the troubles that were going to come were already baked into the cake.  Consider your current positions carefully, and develop your plan for your future portfolio defense.

100 to 1 in the Stock Market

100 to 1 in the Stock Market

 

How can a book be largely true, but not be a good book?  By offering people a way to make a lot of money that is hard to do, but portraying it as easy.  It can be done, and a tiny number succeed at it, but most of the rest lose money or don’t make much in the process.  This is such a book.

Let me illustrate my point with an example.  Toward the end of every real estate bull market, books come out on how easy it is to make money flipping homes.  The books must sell to some degree or the publishers wouldn’t publish them.  Few actually succeed at it because:

  • It’s a lot of work
  • It’s competitive
  • It only works well when you have a bunch of people who are uneducated about the value of their homes and are willing to sell them to you cheap, and/or offer you cheap financing while you reposition it.
  • Transaction costs are significant, and improvements don’t always pay back what you put in.

You could make a lot of money at it, but it is unlikely.  Now with this book, “100 to 1 in the Stock Market,” the value proposition is a little different:

  • Find one company that will experience stunning compound growth over 20-30+ years.
  • Invest heavily in it, and don’t diversify into a lot of other stocks, because that will dilute your returns.
  • Hold onto it, and don’t sell any ever, ever, ever!  (Forget Lord Rothschild, who said the secret to his wealth was that he always sold too soon.)
  • Learn to mention the company name idly in passing, and happily live off of the dividends, should there be any. 😉

Here are the problems.  First, identifying the stock will be tough.  Less than 1% of all stocks do that.  Are you feeling lucky?  How lucky?  That lucky?  Wow.

Second, most people will pick a dog of a stock, and lose a lot of money.  If you aren’t aware, more than half of all stocks lose money if held for a long time.  Most of the rest perform meh.  Even if you pick a stock you think has a lot of growth potential, there is often a lot of competition.  Will this be the one to survive?  Will some new technology obsolete this?  Will financing be adequate to let the plan get to fruition without a lot of dilution of value to stockholders.

Third, most people can’t buy and hold a single stock, even if it is doing really well.  Most succumb to the temptation to take profits, especially when the company hits a rough patch, and all companies hit rough patches, non excepted.

Fourth, when you do tell friends about how smart you are, they will try to dissuade you from your position.  So will the financial media, even me sometimes.  As Cramer says, “the bear case always sounds more intelligent.”  Beyond that, never underestimate envy. :(

But suppose even after reading this, you still want to be a home run hitter, and will settle for nothing less.  Is this the book for you?  Yes.  it will tell you what sorts of stocks appreciate by 100 times or more, even if finding them will still be rough.

This book was written in 1972, so it did not have the benefit of Charlie Munger’s insights into the “Lollapalooza” effect.  What does it take for a stock to compound so much?

  • It needs a sustainable competitive advantage.  The company has to have something critical that would be almost impossible for another firm to replicate or obsolete.
  • It needs a very competent management team that is honest, and shareholder oriented, not self-oriented.
  • They have to have a balance sheet capable of funding growth, and avoiding crashing in downturns, while rarely issuing additional shares.
  • It has to earn a high return on capital deployed.
  • It has to be able to reinvest earnings such that they earn a high return in the business over a long period of time.
  • That means the opportunity has to be big, and can spread like wildfire.
  • Finally, it implies that not a lot of cash flow needs to be used to maintain the investments that the company makes, leaving more money to invest in new assets.

You would need most if not all of these in order to compound capital 100 times.  That’s hard.  Very hard.

Now if you want a lighter version of this, a reasonable alternative, look at some of the books that Peter Lynch wrote, where he looked to compound investments 10 times or more.  Ten-baggers, he called them.  Same principles apply, but he did it in the context of a diversified portfolio.  That is still very tough to do, but something that mere mortals could try, and even if you don’t succeed, you won’t lose a ton in the process.

Quibbles

Already given.

Summary / Who Would Benefit from this Book

You can buy this book to enjoy the good writing, and learn about past investments that did incredibly well.  You can buy it to try to hit a home run against a major league pitcher, and you only get one trip to the plate.  (Good luck, you will need it.)

But otherwise don’t buy the book, it is not realistic for the average person to apply in investing.  if you still want to buy it, you can buy it here: 100 to 1 in the Stock Market.

Full disclosure: I bought it with my own money.  May all my losses be so small.

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.

Photo Credit: Tony Webster || Bridges can collapse -- so can leverage...

Photo Credit: Tony Webster || Bridges can collapse — so can leverage…

This is the last article in this series… for now.  The advantages of the modern era… I went back through my taxes over the last eleven years through a series of PDF files and pulled out all of the remaining companies where I lost more than half of the value of what I invested, 2004-2014.  Here’s the list:

  1. Avon Products [AVP]
  2. Avnet [AVT]
  3. Charlotte Russe [Formerly CHIC — Bought out by Advent International]
  4. Cimarex Energy [XEC]
  5. Devon Energy [DVN]
  6. Deerfield Triarc [formerly DFR, now merged with Commercial Industrial Finance Corp]
  7. Jones Apparel Group [formerly JNY — Bought out by Sycamore Partners]
  8. Valero Enery [VLO]
  9. Vishay Intertechnology [VSH]
  10. YRC Worldwide [YRCW]

The Collapse of Leverage

Take a look of the last nine of those companies.  My losses all happened during the financial crisis.  Here I was, writing for RealMoney.com, starting this blog, focused on risk control, and talking often about rising financial leverage and overvalued housing.  Well, goes to show you that I needed to take more of my own medicine.  Doctor David, heal yourself?

Sigh.  My portfolios typically hold 30-40 stocks.  You think you’ve screened out every weak balance sheet or too much operating leverage, but a few slip through… I mean, over the last 15 years running this strategy, I’ve owned over 200 stocks.

The really bad collapses happen when there is too much debt and operations fall apart — Deerfield Triarc was the worst of the bunch.  Too much debt and assets with poor quality and/or repayment terms that could be adjusted in a negative way.  YRC Worldwide — collapsing freight rates into a slowing economy with too much debt.  (An investment is not safe if it has already fallen 80%.)

Energy prices fell at the same time as the economy slowed, and as debt came under pressure — thus the problems with Cimarex, Devon, and to a lesser extent Valero.  Apparel concepts are fickle for women.  Charlotte Russe and Jones Apparel executed badly in a bad stock market environment.  That leaves Avnet and Vishay — too much debt, and falling business prospect along with the rest of the tech sector.  Double trouble.

Really messed up badly on each one of them, not realizing that a weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times.  As such, if you are worried about a crushing market environment in the future, you will need to stress-test to a much higher degree than looking at financial leverage only.  Look for companies where the pricing of the product or service can reprice down — commodity prices, things that people really don’t need in the short run, intermediate goods where purchases can be delayed for a while, and anyplace where high fixed investment needs strong volumes to keep costs per unit low.

One final note — Avon calling!  Ding-dong.  This was a 2015 issue.  Really felt that management would see the writing on the wall, and change its overall strategy.  What seemed to have stopped falling had only caught its breath for the next dive.  Again, an investment is not safe if it has already fallen 80%.

There is something to remembering rule number 1 — Don’t Lose Money.  And rule 2 reminds us — Don’t forget rule number 1.  That said, I have some things to say on the positive side of all of this.

The Bright Side

A) I did have a diversified portfolio — I still do, and I had companies that did not do badly as well as the minority of big losers.  I also had a decent amount of cash, no debt, and other investments that were not doing so badly.

B) I used the tax losses to allow a greater degree of flexibility in investing.  I don’t pay too much attention to tax consequences, but all concerns over taking gains went away until 2011.

C) I reinvested in better companies, and made the losses back in reasonably short order, once again getting to pay some taxes in the process by 2011.  Important to note: losses did not make me give up.  I came back with vigor.

D) I learned valuable lessons in the process, which you now get to absorb for free.  We call it market tuition, but it is a lot cheaper to learn from the mistakes of others.

Thus in closing — don’t give up.  There will be losses.  You will make mistakes, and you might kick yourself.  Kick yourself a little, but only a little — it drives the lessons home, and then get up and try again, doing better.

 

Full disclosure: long VLO — made those losses back and then some.

diy-financial-advisor-3842593-f00

I am generally not a fan of formulaic books on investing, and this is particularly true of books that take unusual approaches to investing. This book is an exception because it does nothing unusual, and follows what all good quantitative investors know have worked in the past.  The past is not a guarantee of the future, but if the theories derived from past data make sense from what we know about human nature, that’s about as good as we can get.

The book begins with a critique of the abilities of financial advisors — their fees, asset allocation, and security selection.  It then shows how models of financial markets outperform most financial advisors.

Then, to live up to its title , the book gives simple versions of models that can be applied by individuals that would have outperformed the markets in the past.  You can beat the markets, lower risk, and “Do It Yourself [DIY].”  It provides models for asset allocation, stock selection, and risk control, simple enough that a motivated person with math skills equal to the first half of Algebra 1 could apply them in a moderate amount of time per month.  It also provides a simpler version of the full model that omits the security selection for stocks.

The book closes by offering three reasons why people won’t follow the book and do it themselves: fear of failure, inertia, and not wanting to give up an advisor who is a friend.  It also offers three risks for the DIY investor — overconfidence, the desire to be a hero (seems to overlap with overconfidence), and that the theories may be insufficient for future market behavior.

This is where I have the greatest disagreement with the book.  I interact with a lot of people.  Most of them have no interest in learning the slightest bit about investing.  Some have some inclination to learn about investing, but even the simple models of the book would make their heads spin, or they just wouldn’t want to take the time to do it.  Some of it is similar to seeing a Youtube video on draining and refilling your automatic transmission fluid.  You might watch it, and say “I think I get it,” but the costs of making a mistake are sufficiently severe that you might not want to do it without an expert by your side.  Most will take it to the repair garage and pay up.

I put a knife to my own throat as I write this, as I am an investment advisor, but there is more specialized knowledge in the hands of an auto mechanic than in an investment advisor, and the risk of loss is lower to manage your own money than to fix your own brakes.  That said, enough people after reading the book will say to themselves, “This is just one author, and I barely understand the performance tables in the book — if right, am I capable of doing this?  Or, could it be wrong?  I can’t verify it myself.”

The book isn’t wrong.  If you are willing to put in the time to follow the instructions of the authors, I think you will do better than most.  My sense is that the grand majority people are not willing to do that.  They don’t have the time or inclination.

 

Quibbles

The book could have been clearer on the ROBUST method for risk control.  It took me a bit of effort to figure out that the two submodels share half of the weight, so that when submodels A & B flash green — 100% weight, one green and one red — 50% weight, both red — 0% weight.

Also, the book is enhanced by the security selection model for stocks, but how many people would have the assets to assemble and maintain a portfolio with sufficient diversification?  The book might have been cleaner and simpler to leave that out.  The last models of the book don’t use it anyway.

Summary / Who Would Benefit from this Book

I liked this book, and I recommend it for those who are willing to put in the time to implement its ideas.  This is not a book for beginners, and you have to be comfortable with the small amount of math and the tables of financial statistics, unless you are willing to trust them blindly.  (Or trust me when I say that they are likely accurate.)

But with the caveats listed above, it is a good book for people who are motivated to do better with their investments.  If you want to buy it, you can buy it here: DIY Financial Advisor.

Full disclosure: I received a copy from one of the authors, a guy for whom I have respect.

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.