The offering of liquidity through limit orders is a real service to the market, and on average gets rewarded in lower overall execution costs.  In choppy markets, it can really add value.

I urge all investors to place limit orders as a normal practice.  Better not to get filled on a few orders every now and then, than to get ripped off by market makers when a market order hits a thin market and you end up with a lousy fill.

Patience is a virtue in trading.  Don’t insist that you will get a full position on a stock you you want to own.  Rather, have multiple companies that you might want to own at their respective prices, and own the ones that the market is willing to sell to you.

When you think about “flash crashes” and what drove them, there are many factors involved, but one thing is clear: someone placed a market order at the wrong time, asking to buy or sell, no matter what.

Personally, anytime I place orders that are large relative to the ordinary volume of the market, and/or where the bid/ask spread is wide, I use discretionary reserve orders.  Say the bid is 20.50 for 200 shares, and the ask is 21.31 for 300 shares, and I am looking to buy. I would place a discretionary reserve order showing 100 shares at 20.49, but offer 41 cents of latitude, but with 2000 shares available to be bought.  In doing this, the bid/ask does not change, but if a program trade sweeps through the market seeking to sell at less than 20.90, my trade executes, and some will wonder, “Where did that come from?”

My view is that with high frequency trading, managers must adopt tactics, particularly on less liquid stocks, that we become invisible liquidity providers.  We match stealth with stealth, but look to get good fills on solid companies at very good prices.  We become market makers in a sense, up to the level of our price limits.

If I have done my fundamental homework right, putting out limit orders, even those that are “good till cancelled” offer value to me and my clients, because we get shares at prices that offer good value, and and sell shares at prices that represent full value or more.

Before I start this evening’s book review, I would like to ask a favor of my readers.  If you like my reviews, maybe you can say that they are helpful at Amazon.  I rank in the 2000s at present, which was a challenge to get to, because not many reviewers of finance, investing, and economics books get to levels like that.  So, to the degree that you like my reviews, and have extra time to do this, I appreciate it.  If not, no worries — I’ve well exceeded my expectations; I appreciate that you read me.

I have never taken a course in accounting.  But I have had to do accounting for most of my working life, including doing financial reporting inside life insurers, which is the most complex industry for accounting. I have even opined on 10+ financial accounting standards over time.  And Aleph Blog is a leading accounting website as a user of accounting. (Dubious distinction, I know, but when you are a blogger, you take what you can get. )

As a value investor, I have taken a skeptical view toward the accounting of the companies that I invest in.  Cash entries can be trusted; accrual entries are less trustworthy in proportion to the length of time and uncertainty to the collection of cash.

This book relates accounting principles to value investing principles, and it is uncanny as to how they overlap.  It also attempts to connect it to Modern Portfolio Theory [MPT] concepts where it makes sense, but with less success. (No surprise, because value investing has a decent theory behind it and MPT doesn’t.)

The cornerstone of this book is return on net operating assets [RNOA].  The idea is to split the company in two, and separate operating results from financing results.  Give little value to financing results, which are likely no repeatable, and give significant value to operating results.

Note: this means that there is no way of evaluating financial companies under this rubric, but that’s a common problem.  Financial companies are a bag of accruals; value is difficult to discern.  That is why I spend most of my time analyzing the management teams of financial companies to see if they are conservative or not.

The book offers two measures of accounting quality, the Q-score and the S-score.  You would have to do more digging to make these practical, but at least you get some direction in the matter.

There are two simple prizes that the book gives to readers:

1) Profit results mean-revert; don’t trust strong or weak current ROEs. (or RNOAs)

2) Stocks with low P/Es and P/Bs do well.  Each works well, but they work better together.  Maybe if Ben Graham were still alive, he would not have been dismissive of his life’s work at the end, value works.  It’s an ugly brain dead strategy, but it works.

Quibbles

None.

Who would benefit from this book: Those who want to improve their perception of investment value would benefit from this book.  If you want to, you can buy it here: Accounting for Value (Columbia Business School Publishing).

Full disclosure: The publisher asked me if I wanted the book, so I asked for the book and he sent it to me.

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.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

P&C Insurers and Reinsurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.  Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.  Would I increase the overweight here?  Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.  Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.

Central Banking

• Norway Faces Housing Bubble as Krone Steals Policy Agenda http://t.co/15hzb0So By cheapening the currency Norway gets an asset bubble $$ Mar 17, 2012
• Unintended Consequences http://t.co/eLrKtCJc Sprott suggests that the financial system has a chemical dependency on the Central Banks. $$ Mar 17, 2012
• Is the bond market tightening for the Fed? http://t.co/iRSerA8X The bond market is larger than the Fed; they can’t control the curve $$ Mar 17, 2012
• Germany Turns Up Pressure on ECB http://t.co/w2yyfvU1 Difficult to see how the liquidity drains out of the ECB ~3 years from now $$ Mar 13, 2012
• China central bank news conference on policy, yuan http://t.co/w8cy5K1Z & http://t.co/XcIFAbvb Japan buys Yuan, don’t think it means much Mar 13, 2012
• Bond market certainly did not like the FOMC statement. “Don’t worry about energy prices, we got it all under control.” $$ #fuelinginfltion Mar 13, 2012

Investment Banking

• Why banks will continue to rip off clients http://t.co/oTT9fd2i Conflicts on Wall Street, especially at $GS. Big guys know that. So what? Mar 17, 2012
• Goldman Sachs’s long history of duping its clients http://t.co/2sXmKl0D Tells the story of how $GS foxed its way out of Penn Central CP $$ Mar 17, 2012
• The CMBS maturity wall is here http://t.co/GrcEm1KO I remember buying CMBS deals 11-12 years ago. Bullet loans weak if can’t refinance $$ Mar 17, 2012
• Goldman Roiled by Op-Ed Loses $2.2B for Shareholders http://t.co/yz0f0oLy A passing matter; of course IBs have conflicts of interest #duh Mar 17, 2012

China

• Bo’s Ides of March http://t.co/mnKFU8Zx Not so much a move to the right as a statement against being flashy and self-promoting $$ Mar 17, 2012
• Chinese Economy Already in ‘Hard Landing,’ JPMorgan’s Mowat Says http://t.co/kwFW2Ty6 Cyclical industries will produce less in China 2012. Mar 17, 2012
• China’s official admission of slowing commerce activities http://t.co/br7H4D2o When a long trend changes, often moves further than expected Mar 17, 2012
• China’s fixed asset investment growth moderating http://t.co/CEl5mZTc “Growth in real estate and manufacturing projects remains steady.” $$ Mar 13, 2012
• GMO: Something’s Fishy in China http://t.co/DO8v4w8p Goes through the 10 signs of a bubble; finds that Chinese economy has most of them $$ Mar 13, 2012
• US and Europe Move on China Minerals http://t.co/xyGsdkDq WTO ruled against China in January, pressing similar case 17 rare-earth metals Mar 13, 2012
• Another call for an end to China driven industrial commodities “super-cycle” http://t.co/VAd5gR0D Investment is way too high & unproductive Mar 13, 2012

Rest of the World

• Sarkozy’s Yield Drop at Risk With Hollande Victory http://t.co/ti25ozdq Surprise, if Hollande cares for poor in France, E-Zone suffers $$ Mar 17, 2012
• Saudi Arabia Lifts Curtain on Diplomacy as Syria Killings Spur King to Act http://t.co/H8g8D5nG Favors 85% Sunnis over ruling 15% Alawites Mar 13, 2012
• How about those Japanese net-net’s? http://t.co/SAZEcofy Making money in very ill-known small companies in Japan $$ Mar 13, 2012
• The Islamic World’s Quiet Revolution http://t.co/ChNksuFm They’re having fewer children, which I already noted here: http://t.co/KnOGFeOA $$ Mar 13, 2012
• Portugal Yield at 13% Says Greek Deal Not Unique http://t.co/bPBconfk After Greece, the next places to watch are Portugal & Spain. $$ Mar 13, 2012
• Iran-Israel History Suggests a Different Future http://t.co/M1IzxuuB I never knew that Israel sold weapons to Iran in the ’80s. $$ Mar 13, 2012

Financial Sector

• MetLife CEO’s Stress Test http://t.co/YaVV4GMp $MET doesn’t deserve to be treated as a systemically risky firm. Long liabilities protect Mar 17, 2012
• Assurant Falls as California Seeks Rate Cuts http://t.co/d0OcDS09 FD: long $AIZ; this is overrated; ability of the commissioner limited $$ Mar 17, 2012
• Felix Salmon At Columbia Journalism School: Don’t Blame Journalists For Failing To Prevent Financial Crisis http://t.co/0LrCwisB true, but Mar 13, 2012
• Journalists, even if they understood what was going on in the finl mkts would face a tough time writing warnings in the midst of boom $$ Mar 13, 2012
• US Government Agencies Comparing Notes On Algo Feeds http://t.co/15oAxpn9 Little speed advantages w/econ data can lead to big profits #SEC Mar 13, 2012
• Marketview:Point of Reference http://t.co/Xlp5jczH “4 the 1st time this yr I can feel the true bullish sentiment among the investing public” Mar 13, 2012
• Banks foreclosing on churches in record numbers http://t.co/fR3Ro9CJ Frankly, I am surprised that banks lend to some churches. $$ Mar 13, 2012
• Banks Buy Treasuries at Seven Times Pace in 2011 http://t.co/SDKsJIUB What else to do with all the excess liquidity & weak borrowing $$ Mar 13, 2012

US Government-Related

• Pension Benefit Costs Cut by Record 43 States, Study Says http://t.co/B8ZRg4gZ State take actions to reduce benefits to active employees Mar 17, 2012
• Best Treasury Forecaster Says 10-Year Yield to Drop From Highs http://t.co/ma8YoN4u Don’t be too sure about Treasury rates rising $$ Mar 17, 2012
• International Demand for U.S. Assets Rises http://t.co/FwdXqrWH As the E-Zone gets worse, demand for US debt improves. $$ Mar 17, 2012

Investing

• Temporary Hedges eventually force Deleveraging http://t.co/0jVSWRzw On Energy Future Holdings, & why predicting the future is tough $$ Mar 17, 2012
• Cyclicals persistent underperformance http://t.co/KkJ2q05p Cyclicals started underperforming in August. Relatively they never recovered. $$ Mar 17, 2012
• Magnetic Fields http://t.co/S6VYIe5Y Good post. This graph is worth a look: http://t.co/EBhPh6ZN May help explain recent lost decade $$ Mar 13, 2012
• Stock Compensation, Tax Law, Financial Reporting and Facebook’s IPO http://t.co/ULyVLNkr Future dilution may pressure $FB shares $$ Mar 13, 2012
• A Value Investor’s Take on Shorting http://t.co/cZYueqGH Tactical discipline, not structural, b/c market can go nuts. Can help hedge $$ Mar 13, 2012

Miscellaneous

• Considering Bankruptcy? Head to the Mall http://t.co/UvgEArMj Legal services offered for simple situations in mall locations. $$ Mar 13, 2012

How does one write a review for a book when it has been praised by Jack Bogle, Jeremy Grantham, Joel Greenblatt, Seth Klarman, and Warren Buffett?  I am a midget among giants.  I can’t write this, but I am going to try.

Being a teensy part of the investment fraternity that calls itself value investors, I do have some perspective on this book.  The joke of sorts is that there are many things that are “the most important thing.”  But I think the point of the author is that what is most important shifts, depending on the market environment.

But all of “the most important things” can be boiled down to four main concepts:

• Margin of Safety
• Buy it Cheap; Valuation
• Contrarianism
• Think beyond the initial effects to secondary effects.  Think holistically.

By margin of safety, there are many things implied — a strong balance sheet, strong cash flows, conservative accounting, and/or protected market position.  The important thing is to prevent a large loss.  If you can prevent large losses, the gains will come eventually.

Buying it cheap is also a simple concept, though hard to implement well.  What metric to use?  Price to Earnings, Cash Flow, Book, Free Cash Flow, EBITDA?  Where to look in the capital structure for value?  The equity may be too risky, but maybe the preferred stock or bonds might be interesting.

Contrarianism means looking for what others rely on that may not work, and investing against it, whether positively or negatively.  It can’t be mere opinion; the other side has to be invested, and relying on their hypothesis to succeed.  That is the situation where investing contrary to the consensus can succeed.

Thinking holistically comes from being a bright student whether in the sciences or the liberal arts.  It comes from being a life-long learner, and applying oneself to the problem until it yields at least a hint of an answer.  Where it doesn’t, cutting losses pays off.

I recommend this book to all who aspire after value investing.

Quibbles

None.

Who would benefit from this book: All value investors, and those who want to be value investors can benefit from this book.  Those that want to understand how the economy really works will benefit as well.  If you want to, you can buy it here: The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

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.

This period of the Aleph Blog covers May through July of 2010.  The one big series that I started in that era was “The Education of a Corporate Bond Manager” series.  The idea was to describe how a neophyte was thrust into an unusual position and thrived, after some difficulties.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

Then there was the continuation of “The Rules” series:

The Rules, Part XIII, subpart A

On the biases the come from yield-seeking.

The Rules, Part XIII, subpart B

Repeat after me, “Yield is not free.”

The Rules, Part XIII, subpart C

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.  It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

The Rules, Part XV

Securitization segments a security into liquid and illiquid components.

The Rules, Part XVI

“Governments are smaller than markets; markets are smaller than cultures.“

A fundamental rule of mine, but one with a lot of punch.

The Rules, Part XVII

On the differences between panics and booms.

The Journal of Failed Finance Research

Much research fails quietly, but other researchers don’t learn about the dead ends.  Better that they should learn of the failures, and avoid the dead ends.

How I Minimize Taxes on my Stock Investing

Sell low tax cost lots and donate appreciated stock to charities.

Place Political Limits on Overly Compliant Central Banks

Gives a simple rule to control central banks so that they avoid the present troubles.

Yield, the Oldest Scam in the Books

Yes, offering yield is the oldest way to trick people into handing over their money.

A Summary of my Writings on Analyzing Insurance Stocks

A good place to get started if one wants to get up to speed on insurance stocks, but there is a lot there.

Economics is Hard; the Bad Assumptions of Economists Makes it Harder

Going over Kartik Athreya’s letter criticizing nonprofessional economics bloggers.  Why the math behind macroeconomics and microeconomics doesn’t work.

Why Are We The Lucky Ones?

When you are a part of a small broker-dealer, all manner of harebrained deals get offered to you.  This explores three of them.  Note: management did not ask my opinion on the fourth deal, and that is a large part of why they no longer exist.

One more note: the guy who was going to pledge $5 million of stock in example 2 for a $1 million loan?  The stock is worth $7,000 today.

Watch the State of the States

The economics of the states tells us a lot more about the national health because they can’t print money to buy national debts.  (Though they can can raid accrual accounts…)

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

My view is that neoclassical economists are wrong.  Aggregate demand has failed for four reasons:

1. Overleveraged consumers will not readily buy.
2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
3. Aggregate demand is mean-reverting.  It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.  The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
4. When the financial system is in trouble, people get skittish.

The Market Goes to the Dogs, Which Chase Their Tail Risk

Complex and expensive hedging solutions, many of which embed some credit risk, can be less effective than lowering leverage, and (horrors) holding some cash.

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

This one had its detractors, because I believe the paradox of thrift is wrong.  Too much aggregation, and it does not allow the dynamism of the economy to adjust over time, even from severe conditions.

When I wrote my piece last night, I did not write it to say one ought to buy and never sell.  In investing, I encourage the concept that one must look to relative valuations and trade assets that are worth less for those that are worth more.  In doing so, one maintains exposure to the overall risk of the markets, but shifts to more promising areas.

But what if valuations get so strained that future returns from most risk assets are tepid?  At that point, buy-and-hold turns into sell-and-wait.  It’s like being a bond manager — if the excess returns are small from taking additional risk, you don’t take additional risk.

I tend to turn over my portfolio once every three years.  That to me is a good tradeoff between holding for a long time and recognizing that opportunity changes over time.  But my trading is driven by analyzing relative opportunity, selling what I think are lower future cash flow streams for larger cash flow streams.  Do I have a crystal ball to tell me which is better?  No, just business judgment.  As Buffett says, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”

My business judgment has done well for me over my career, but I don’t pretend that it is infallible, because I make significant mistakes.  Humility is an asset to the investor, because we don’t always know the right course.  That said, let diversification handle uncertainty, and within risky assets trade away less promising assets for those with more promise.

A reader wrote me, one who works for a prestigious university and he said:

Since 1926, the minimum inflation-adjusted total return of the S&P 500 (or its predecessor index) has been over 4%, annualized, over every 40-year rolling period.  For 20-year periods, the returns are typically either high (say 9%) or low (say 2%).  Thus, the buy-and-hold investor is best off with the 4-decade hold time.  Fortunately, 40 years matches the typical work life of a person, so workers ought to be shoveling retirement money into equities, and leaving there when they retire, if history is any guide.

 Your thoughts?

Yes, so long as your government holds together, over longer periods of time we do better.  But the tough part for retirees is “What is my situation like when I retire?  Yes, I built up a pot of assets, but what will that buy in terms of continuing income, and will that do well against declining purchasing power?”

There is no magic bullet.  I try to solve this by shifting industries over time, aiming at the most promising current opportunities, but not leaving the market in entire.  I limit cash to 20% of the portfolio when valuations are strained for he market as a whole.

Back to the question, yes, I think most people should buy-and-hold, if they can’t analyze the asset markets.  That’s like the Biblical proverb that a fool is counted wise if he is silent.  But for businessmen/investors there are often relative opportunities to do better.  Analyze those opportunities and take the best of them.

Yes, have some exposure to risky assets for your career, but vary the amount of exposure, and where it goes relative to likely opportunity.

I appreciated Jonathan Burton’s piece Speed kills, but so does complacency.  Like me, he is trying to strike a balance between hyper-trading and permafrost.

My mother is a good example here, though she does things differently than I do.  She holds stocks for a decade or so on average, and analyzes to see whether they have long-term prospects.   She buys, holds, and occasionally adjusts.  She spends more time painting, for which she has a degree of reputation.  She beats average asset mangers regularly.

The main idea should be one of relative value: trade to improve.  Look at the underlying cash flow streams if you can, and trade smaller for larger.

Here’s one more tool to help you.  When the amount of money into an asset goes parabolic, it time to leave.  It is rare that large amounts of additional money will yield excess returns.  This simply admits that there are times when it is wise to reduce exposure to risky assets.  just as bond managers look at yield spreads to commit capital, so should investors in risky assets aim for a margin of safety in what they invest.

As a final note, buy-and-hold is a fundamental strategy in investing.  It presumes that you spent the time analyzing whether this asset was undervalued.  If it becomes overvalued, it does not mean you should hold it.  Always look for better relative value.  In the end that leads to better portfolio performance.

There’s this mistaken idea trotting around in the popular media, which usually only shows its face in bear or sideways markets: buy-and-hold investing is dead. This is wrong in several ways:

1) The average investor is horrible at market timing.  They buy high and sell low.  The more volatile the asset subclass the more pronounced this behavior is.  I have witnessed this personally while analyzing the return differences for Bill Miller, Bruce Berkowitz, and the S&P 500 Spider.  There is a profound difference between the returns that a buy-and-hold investor receives, and that which the average investor receives.  The buy-and-hold investor almost always does better; the only exception that may exist are value investors who have learned to resist price trends, painful as that may be.

2) The assets of the market are far less volatile than those that trade them.  Bonds are issued, the grand majority of them mature (pay off).  Stocks are issued, and they pay dividends, get bought out, fail, spin off another company, etc.  Trading activity usually far exceeds the need for financing assets; it becomes a game unto itself, and a zero-to-negative-sum game at that.  When you are playing a game that is overall negative-sum, i.e., the brokers suck cash out of the game proportionate to trading, the better players look for quality assets, and trade less.

3) When a sustained bull market arrives, the other mistake will show up, “Buy-and-hold is the only way to go.”  Risky assets have periods of protracted increases in valuation.  Certainty in the continuation of the process grows as it gets closer to the end of the cycle, when the cash flows of the assets cannot support the cash flows of those who borrowed to buy them.

4) Longer-term investors are often the key to a turnaround in the price of an asset.  Asset prices bottom when longer-term investors see value, and buy-and-hold, waiting out the volatility.  Asset prices crest when long-term investors decide to sell-and-wait, because the prospective returns to a buy-and-hold investor are poor.

This is why the perspective of a value investor can be valuable in approaching markets… are you willing to do a cold hard analysis of the likely cash flows?  You know that it gets harder to maintain high returns on equity [ROEs] as time goes on, and the same for low ROEs — new management arrives, and there is mean-reversion.

Conclusion

Yes, there are clever traders, but by necessity they are few in the market ecosystem, and repeatability is uncertain.  There are far more dumb traders, and repeatability is only limited by their declining capital.  Then there are the value-oriented infrequent traders.  They do best, but second to them are those that buy-and-hold.

In general, the economy rewards those who bear risk over long periods of time.  Thus buy-and-hold does well, usually, over long periods of time.  That time period may be 30-40 years, and may not do well with respect to your retirement date, so take caution, and don’t trust in long-term investing as if it is the force of gravity.  It is more akin to one who realizes the bean farming has become unpopular, and so, he decides to plant beans.  It might not work immediately, but it stands a better chance of working than those who are chasing the current farming fad.

Yesterday I was a judge (one of five) for the Washington/Baltimore Investment Research Challenge.  Five teams from local colleges participated to analyze a prominent local company, Under Armour.  (My kids love the stuff, I hate to pay the price.)

I have to say that I admire all of the young men and women who presented to us.  It takes a lot of guts to present to people 30 years older then you.  The experience differential is considerable.

One practical difference is that the students apply many methods from Modern Portfolio Theory that are roundly ignored by most investment managers.  Few investment managers apply Discounted Cash Flows [DCF], because it is too flexible, with too many parameters that are hard to calculate.  Some apply reverse DCF, attempting to estimate the rate of return of companies at their current price… same problems exist, though the comparability of results is simpler.

My advice to future contestants would be to spend more time on qualitative issues, and less on quantitative.  Regarding quantitative issues, I would encourage abandoning DCF in favor of simpler valuation methodologies.

Also, I would discourage using regression unless you really understand what it means.  It’s easy to teach people to use advanced statistical methods, but tough to teach them the limitations of where the methods get abused, or don’t work.  As I have often said, I rarely see advanced statistics used properly by Wall Street, and yesterday was no exception.

But all that said, there are a lot of bright people entering the talent pool for investing; for investment firms in a given region, going to an event like this could be a good recruiting tool.

PS — make sure you understand the liability structure in full, also…

We would all like our practical decisions to go easily, and bear quick positive results.  That’s not reality.  As for me, I needed to decide whether I would:

• borrow against my home at 3% for 15 years.
• liquidate a portion of my taxable brokerage account
• liquidate shares in best private manufacturer of commercial lawn mowers in the world.

I decided on the flexible and probably low-cost solution, selling some of the taxable brokerage account.  I have two accounts, an IRA and the taxable account.  They were invested differently, but my investors get a blend of the two accounts.  I used to put the higher income names into the IRA, while the taxable account would take the lower income names.

That has been changed. Both portfolios have the same proportion of names (companies). In the process, gains have been realized, but not so much as overwhelm the deferred losses of the past.

But for this exercise, one salient result was that both portfolios, which are the model portfolio in aggregate, would become like the model portfolio.   They are now clones of each other, as is true of all client portfolios that I manage.  My promise to clients is that they get what I get, so I create a clone of my portfolio for each client.  It certainly aligns my incentives with theirs.  Even after today, my next-largest client is 20% of my aggregate portfolio.  So, yes, I eat my own cooking, and in general, my cooking has been tasty over the last twelve years, even though the last year has been less than inspiring.

On the bright side, with the market up, it has allowed me to harvest an amount that will take care of my family for a year, while leaving my portfolio up considerably from one year ago.  That helps a lot when revenues from managing money are still light.

Hopefully, within a year, I will have enough clients that my revenues support my family.   We’ll see; but if that doesn’t happen I know there are a number of firms that would like to employ me, so my downside is limited.

One final note: one reason why this was a difficult decision was that the low rates for mortgaging my home were more difficult to obtain while self-employed.  Aside from my investments, I am not earning as much as I used to.  The fixed costs of liquidating part of my portfolio were 6% of the fixed costs of obtaining the mortgage.  Beyond that the question remains as to how well equities will do in the future, a question for which I have no good answer.

I think I made the right move here; I usually do, generally, but we will see whether this was the right decision over the next few years.