The Aleph Blog

My Time on RT America’s Boom Bust

You can never quite tell where blogging may take you.  I know that if I lived near New York City, some opportunities would open up that presently aren’t likely.  Living near Baltimore/DC has had its share of opportunities, though.

In general, if I get asked to appear somewhere, I’ll try to make time on my schedule for doing so, whether it is:

  • Internet TV
  • Internet Radio
  • Local Radio
  • Fox Business News (with Cody Willard)
  • Speaking at a local High School
  • Speaking to a local College
  • Speaking to meetings of the Society of Actuaries, local Actuarial Societies, local CFA Societies, etc.
  • Talking to the staff at SIGTARP, giving a lesson on how insurance companies work
  • And more… if someone had told me all of the things that I would do as a result of saying “yes” to Jim Cramer’s invitation to write for RealMoney.com eleven years ago, I would have been surprised.  The thing I would have been most surprised at would have been the total amount of words that I have written.  I viewed myself eleven years ago as a mathematical businessman, but not a writer.

About five days ago, I was invited to appear on RT America’s show Boom Bust.  What I did not know at the time was that Ed Harrison of Credit Writedowns was behind getting me onto the show.  I’ve known Ed for some time — he was one of the original attendees at the only Aleph Blog Lunch.

I also didn’t know what I would be talking about on the show, so when I got pulled into the makeup room (me?) ten minutes prior to airtime, I was saying to myself, “I guess I have to ‘wing it.'”  Then Ed popped his head through the door and said “Hi,” and explained everything to me.  What a relief!  I went back to the Green Room, scribbled out a few notes — not that I could take it with me, but just to get my mind in order for what I *might* be asked about.

As it was, it went fast, like every other time that I have been on live TV or radio.  What was eight or so minutes felt like two.  Are there things I would have said differently with more composure?  Yes.  But that’s part of the fun of it: thinking on your feet, because I knew little about what the actual questions would be.

If you want to, enjoy watching the video of RT America Boom Bust.  My particular portion is on from 3:30 to 12:00 or so.  Ed Harrison is on at the end.  I stayed to watch that segment live, and talk with Ed and the charming host Erin Ade afterwards.  It was a fun end to my workday.

Q&A with Guy Spier of Aquamarine Capital

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In the near future, I will be writing a a review of Guy Spier’s The Education of a Value Investor, which will be released next week.  Until then, to whet your appetite, here is an 11 question Q&A that I did with Guy, for which I give him thanks, because his time is valuable.

  1. What company have you owned the past that was the most surprising to you? (In prospect or in retrospect)

I think that many have surprised me in one direction or another, but one of the more memorable was Duff and Phelps Credit rating – which I purchased in the mid-1990’s at a 7 Price to Earnings ratio. The company proceeded to increase in value by seven times over 2-3 years before being purchased by Fimalac, the owner of Fitch. I had expected the stock to double, but I did not understand that I had purchased a super high quality business with a manager who was committed to devoting every cent of free cash, which was in excess of reported earnings, to repurchasing shares.

  1. Which rule(s) of your checklist would surprise average investors the most, if any?

I actually think that none of them would. They are common sense items that anyone would look over and say, “yes – that makes obvious sense”. What is key is not that they are surprising, but that in the wrong state of mind, I might easily skip over a particular factor in evaluating an investment.

  1. Would you advise young people to get a CFA charter or an MBA or is there a better way to become an investor?

I don’t think that either is necessary in order to become a good investor. Attending the Berkshire Hathaway meetings, studying Warren Buffett and reading the Berkshire Annual Reports, along with Poor Charlie’s Almanack are an absolute necessity, in my view.

  1. Would you ever consider setting up your own holding company like Buffett did? (Permanent capital has its attractions…)

Yes. It’s a no brainer to do it if you have the skills. I hope that I have the skills, but I don’t think that the time has been ripe for me. Mohnish Pabrai has recently launched Dhandho Holdings which I think will be an extraordinarily successful enterprise over the years. It’s one to watch.

  1. What would you say is the most common mistake that value investors make? Does this matter if the value investor is amateur or professional?

I think that all-too-often, we feel like we are forced to take a decision. Warren Buffett has often said that, unlike baseball, there are no “called strikes” in investing. That is a truism, but the point is that too many of use act like it is not true. Amateur investors, investing their own money, have a huge advantage in this over the professionals. When you are a professional, there is a whole system of oversight that is constantly saying, “What have you done for me lately!” or in baseball terminology, “Swing you fool!”

 Amateur investors who are investing unlevered funds that they don’t need any time soon have no such pressures.

  1. Financial companies are usually a big part of the portfolio of value investors, because they seem cheap to industrials and utilities. But every now and then financials wipe out in a credit crisis. Why don’t many value investors pay attention to credit conditions?

Yes, that’s absolutely true. Many value investors love the financial industry: Probably because, in a certain way, we are in it ourselves. And yes, value investors probably pay far too little attention to the credit cycle. In my case, I think that I was utterly convinced that my stocks were sufficiently cheap, such that I could invest without regard to financial cycles. But I learned my lesson big time in 2008 when I was down a lot. I now subscribe to Grant’s Interest Rate Observer so as to help me track the credit cycle.

  1. Are your wife and children happier as a result of the changes to your life since becoming a value investor in the style of Warren Buffett?

Absolutely. I spend more time with them. I am simply around more, although that can come with its own irritations. You might have to ask them.

  1. I appreciate your “investing tools,” and I do things mostly like that, but isn’t the main goal of them to be reasoned, dispassionate, independent-minded, etc.? The actual form of the rules is less important than the effect it has on our personalities in making decisions rationally, yes?

Yes – I 100% agree and thus a different personality might have a very different set of rules to guide them. That’s why the book is about my education as a value investor. It’s personal and idiosyncratic. I would fully expect someone else to come up with different rules of behavior.  I do hope though that it will allow people to see that getting to a reasoned, dispassionate, independent minded state is a struggle for this investor, at least and that thinking about our meta environment and making good decisions about that is just as, if not more important than the actual investment decisions.

  1. How do you balance keeping an independent view versus interacting with respected professional friends who have their views?

I try to switch off, or distance myself from people who I think communicate in a way that is not productive for me. The key is to have the kind of discourse that allows other people to come to their own conclusion. Asking open ended questions and not telling someone what to do are important aspects of that. When I come across people who do that, I try to build closer relationships with them. If they don’t I might still keep them in my circle, but I would not allow myself to interact with them too often – because I don’t want to be swayed.

  1. How do you feel about those who use 13F filings to generate ideas?

Mohnish Pabrai taught me to be a cloner. In the academic world, plagiarism is a sin. In business, copying other people’s best ideas is a virtue, and it is no different in investing. I would go further. In the same way that if I wanted to improve my chess, I would study the moves of the grandmasters, if I want to improve my investing, I need to study the moves of the great investors. 13F’s are a great way to do that.

  1. How do you feel about quantitative value investors?

I am not sure that I understand the way that you are using the term. If you mean to use statistical methods to uncover value, Ben Graham style, then I’m all for it. That is what I did when I created my Japan basket. That said, I found it hard and monotonous work. Monotonous because, in the case of Japan it did not lead to greater knowledge or wisdom about the world, because there was a limit on the degree to which I could drill down. But that said, I do run screens for value on S&P CapitalIQ from time to time, and then drill down on some of what comes up.

Again, thanks to Guy Spier for taking time to answer some questions for us… his book is being released on September 9th.  Look for it.

Full disclosure: The Author and some PR flack asked me if I would like a copy and I said “yes.”

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.

Book Review: Deep Value

deep-value-front-coverThis is a book that starts with a simple premise: buy stocks at a fraction of the per share intrinsic value of the company, conservatively calculated.  Neat idea, huh, and it is called value investing.

The author starts by giving a preview of where he will end — with Carl Icahn when he was much younger, where he was buying closed-end funds at large discounts, and pressuring managers to liquidate the fund.  Eventually he started doing the same with overcapitalized companies trading a discount to the net worth of the company.

Then the author takes us on a trip through history, starting with Ben Graham buying the shares of companies at prices lower than the net liquid assets of the company, net of the debt.  It was easy money while it lasted, but eventually many of those companies were bought up and liquidated, and many of the rest had the stock price bid up until the value was no longer compelling.

Then we get to travel along with Warren Buffett and Charlie Munger, who note that the easy pickings are gone, and begin investing in companies that are inexpensive relative to their growth prospects.  This is more complicated, because these companies must have an advantage that will sustain their effort versus their competition.

Then we visit Joel Greenblatt, where he analyzes buying good companies at cheap prices, analyzing them the way an acquirer might do, but also looking for high returns on invested capital.  Lo, but it works, and furthers the efforts of those trying to obtain excess returns.

Then the book gets gritty, and looks at mean reversion of companies that have done poorly over the last four years.  Surprise! The worst tend to do quite well on average.  Also, raw application of simple valuation ratios tend to work on average in stock selection.  People undervalue the boring crud of the market, and overvalue the glamorous stocks, leaving an investment opportunity.

Then it tells a story that is personal to me, that of Litton Industries.  Litton Industries was one of two stocks I owned as a boy — gifts from relatives.  Litton Industries was a company that in the ’50s and ’60s used its highly valued stock to buy up companies that were not highly valued, and made Litton look like its earnings were growing rapidly, which propelled the value of Litton stock still higher.  So long as Litton could keep acquiring cheap-ish companies, the idea kept working, but eventually that ended, and the stock price crashed.  When did my relatives buy me shares of Litton?  Near the end, natch, when everyone know how wonderful it was.

Quite a lesson for an eight year old to see the stock price down by 80% in a year.  The other stock, Magnavox, did that also, so it is a testimony to my mother’s own clever investing that I ended up in this business… my story aside, the point of the Litton chapter was to point out that not all earnings growth is real, and that it is far better to focus on boring companies than what seems glamorous and successful.  Untempered optimism tends not to be rewarded.

The book then moves onto investors large enough to effect change outright, buying enough of a company to force change in a management team that is lazy, incompetent, or overly conservative.  The book goes through the experiences of Ronald Brierly, T. Boone Pickens, and Carl Icahn.  The art of spotting an undervalued company, and gaining enough influence to buy the company and fix it, or see the company sold to another company that will fix it, can lead to great gains.

Here the trail ends.  It started with Ben Graham buying companies that would be good investments regardless, moves to companies that will be good investments if you analyze them more closely, and ends with companies that good be good investments if you could influence a change in corporate behavior.  The same principles are being applied, but with much more analysis and potentially threat of a takeover.

In closing, the book talks about what can be a way of measuring moats, which is gross profits as percentage of assets.  It also reviews what factors activist investors look for when they invest, which may give the clever a guide into what stocks to pursue.

Quibbles

I liked the book, and I recommend it, but in one sense the book is a  statement of how tough the value investing game has become.  Ben Graham could sit back and do simple analyses, pursuing artistic endeavors and the good life in his spare time.  We have to analyze far more closely, and be aware of whether what companies larger activist players may consider.  Value investing still has punch for amateurs, but there is a lot more work and analysis to do.

Summary

This book would be good for investors looking to understand value investing better, and how it has changed over the years.  It would not likely be good for novices.  If you still want to buy it, you can buy it here: Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance).

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

Using Mean Reversion and Momentum for Possible Advantage

One of the challenges of fundamental investing is trying to find decent ideas that are off the radar. There are a number of ways to try to do that by looking at:

  • smaller foreign companies
  • companies that have made some significant losses.
  • companies where the relative performance is so awful that no manager benchmarked to an index would dare touch the company.
  • small companies with modest insider buying.
  • companies in boring industries that you know can’t have any significant growth.  (This excludes “buggy whip” industries.)
  • companies where insiders own so much of the company, that it can’t easily be taken over.
  • complex companies that are difficult to understand.

Okay, tall order.  That said, I’ll do a few articles over the next two months that try to unearth companies that might be suitable candidates for analysis.  Tonight’s article follows up on what I wrote in my last article, where I said:

Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year.  This can point out areas that are still ignored by most of the market, but where trend may have shifted.  I’ll post that screen after my software has its weekly update on Saturday.

I’m going to show you the list, with some additional data to give some context, but remember this: the only reason these stocks are here is that they underperformed the market massively for the last four years, and have had a turn in performance in the last year.  Anyway, here is the list:

 

 

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I’ve been analyzing stocks for over 20 years… out of the 49 companies listed here, I recognize 24 of them.  I own none of them at present, though I have owned four of them in the past [AKS, DYN, TNP & YRCW].  That said, four years of lousy relative performance likely means that few are actively looking at these companies.

As with any analysis on the internet, purchasing or selling shares of companies like this is at your own risk.  I’m planning on looking through this list for ideas, and if I find one good enough to buy for my clients and me, I will do a write-up after we have established our position.

In order to get there, I would have to be satisfied about a number of things regarding any one of these companies:

  • What went wrong over the last four years?
  • Has management fixed what was wrong?  (Or, is there a new management with better ideas?)
  • Is the business adequately capitalized?
  • Is the accounting likely honest/conservative?
  • Do they have a large area where they can earn money sustainably, or are they up against stronger competition almost everywhere?
  • If they are in a tough industry, are they one of the few that could survive if conditions got markedly worse?
  • Does management seem intelligent in using excess cash?

The question is to look for a margin of safety, and then see whether the company will earn a return on its business that is attractive at your entry price.  This is a challenge, but maybe one or two companies out of 49 could make it.

Or not.  Be careful.

 

Two Portfolios. Pick One.

I’m going to show you two portfolios — I’m not initially going to tell you much about either one, but then you can consider which one you might like better.  Here’s portfolio A:

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And here is portfolio B:

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There is one obvious difference in the two portfolios: portfolio B has gone up more than portfolio A in the past year.  But the hidden story is that portfolio A’s stocks have had price returns of -85% or worse over the past four years, whereas portfolio B’s stocks have has price returns of 1000% or better.  They are the only stocks with current market caps of over $100 million that meet those criteria.

Now, which one would you choose, if you had to hold one portfolio for the next year? The next four years?

Oddly, the right answer might be portfolio A.  Currently, I am reading through a book called Deep Value, which I will review in a week or two, and they cite in Chapter 5 some research by Thaler and De Bondt which indicates that portfolios that have gone through extreme failure tend to outperform portfolios that have gone through extreme success.

Though the momentum anomaly (weak as it has been recently) usually favors portfolios with stronger price momentum, the relationship breaks down over longer periods of time, and more severe moves, where mean-reversion tends to take over.  One thing that I can tell looking at the two portfolios — the expectations are a lot, lot higher for portfolio B than portfolio A.  Things only have to stop getting worse for there to some positive price action there.

Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year.  This can point out areas that are still ignored by most of the market, but where trend may have shifted.  I’ll post that screen after my software has its weekly update on Saturday.  Until then.

PS — as an aside, it will be fun to review the relative performance of these portfolios.

The Art of Extracting Large Commissions From Investors

The dirty truth is that some investments in this life are sold, and not bought.  The prime reason for this is that many people are not willing to learn enough to save and invest on their own.  Instead, they rely on others to corral them and say, “You ought to be saving and investing.  Hey, I’ve got just the thing for you!”

That thing could be:

  • Life Insurance
  • Annuities
  • Front-end loaded mutual funds
  • Illiquid securities like Private REITs, LPs, some Structured Notes
  • Etc.

Perhaps the minimal effort necessary to avoid this is to seek out a fee-only financial planner, and ask him to set up a plan for you.  Problem solved, unless…

Unless the amount you have is so small that when look at the size of the financial planner’s fee, you say, “That doesn’t work for me.”

But if you won’t do it yourself, and you can’t find something affordable, then the only one that will help you (in his own way) is a commissioned salesman.

Now, to generate any significant commission off of a financial product, there have to be two factors in place: 1) the product must be long duration, and 2) it must be illiquid.  By illiquid, I mean that either you can’t easily trade it, or there is some surrender charge that gets taken out if the contract is cashed out early.

The long duration of the contract allows the issuer of the contract the ability to take a portion of its gross margins over life of the contract, and pay a large one-time commission to the salesman.  The issuer takes no loss as it pays the commission, because they spread the acquisition cost over the life of the contract.  The issuer can do it because it has set up ways of recovering the acquisition cost in almost all circumstances.

Now in some cases, the statements that the investor will get will explicitly reveal the commission, but that is rare.  Nonetheless, to the extent that it is required, the first statement will reveal how much the contractholder would lose if he tries to cash out early.  (I think this happens most of the time now, but it would not surprise me to find some contract where that does not apply.)

Now the product may or may not be what the person buying it needed, but that’s what he gets for not taking control of his own finances.  I don’t begrudge the salesman his commission, but I do want to encourage readers to put their own best interests first and either:

  • Learn enough so that you can take care of your own finances, or
  • Hire a fee-only planner to build a financial plan for you.

That will immunize you from financial salesmen, unless you eventually become rich enough to use life insurance, trusts, and other instruments to limit your taxation in life and death.

Now, I left out one thing — there are still brokers out there that make their money through lots of smallish commissions by trading a brokerage account of yours aggressively, or try to sell you some of the above products.  Avoid them, and let your fee-only planner set up a portfolio of low cost ETFs for you.  It’s not sexy, but it will do better than aggressive trading.  After all, you don’t make money while you trade; you make it while you wait.

If you don’t have a fee only planner and still want to index — use half SPY and half AGG, and add funds periodically to keep the positions equal sized.  It will never be the best portfolio, but over time it will do better than the average account.

One final note before I go: with insurance, if you want to keep your costs down, keep your products simple — use term insurance for protection, and simple deferred annuities for saving (though I would buy a bond ETF rather than insurance in most cases).  Commissions go up with product complexity, and so do expenses.  Simple products are easy to compare, so that you know that you are getting the best deal.  Unless you are wealthy, and are trying to achieve tax savings via the complexity, opt for simple insurance products that will cover basic needs.  (Also avoid product riders — they are really expensive, even though the additional premiums are low, the likely benefits paid are lower still.)

Return to Behemoth Stocks

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Photo Credit: Benh LIEU SONG

Somewhat less than three years ago, I wrote two articles on Behemoth stocks [one, two], which I define as stocks with over $100 Billion of market cap.  Today I want to revisit those stocks, and those that have joined them.  The last time I wrote, there were 39 of them actively trading on US Exchanges.  Now there are 61, for a difference of 22.  24 stocks are new, and two have dropped out.  Let start with those two:

  • Vodapone plc [VOD] sold off its interest in Verizon Wireless to Verizon, creating a lot of value, and returned a lot of capital to shareholders.  For those of us who were shareholders, I can only say, great job.  You made Verizon pay up, and you didn’t blow all of the new free capital on suboptimal projects.
  • The stock price of Vale, SA [VALE] has gone down considerably (~40%).  China is no longer a giant vacuum cleaner for minerals The pace of China’s expansion has slowed, and that has had an impact on base metals producers like Vale.

This highlights three things:

  • In a bull market, once you are big, you tend to stay there.
  • If you want to create value for shareholders as a behemoth, you need to take radical actions that sell off parts of the company, and return capital to shareholders.  Managements should think, “How can we reorganize the company such that each component part will be better managed, and lines that we aren’t so good at are sold off.”
  • In general, these companies are too large to be taken over; change must come from within.  Activists will only succeed if the managements let them.

Now let’s look at the new companies, which fall into six main groups: Consumer Oriented, Banks, Pharmaceuticals, Information Technology,  Industrials, and  Internet.

Consumer Oriented

  • Anheuser Busch Inbev SA (ADR) [BUD]
  • British American Tobacco PLC [BTI]
  • Comcast Corporation [CMCSA]
  • Home Depot, Inc. [HD]
  • Visa Inc [V]
  • Walt Disney Company [DIS]

Banks

  • Banco Santander, S.A. (ADR) [SAN]
  • Bank of America Corp [BAC]
  • Citigroup Inc [C]
  • Royal Bank of Canada [RY]
  • Westpac Banking Corp (ADR) [WBK]

Pharmaceuticals

  • Amgen, Inc. [AMGN]
  • Bayer AG (ADR) [BAYRY]
  • Gilead Sciences, Inc. [GILD]
  • Sanofi SA (ADR) [SNY]

Information Technology

  • Cisco Systems, Inc. [CSCO]
  • QUALCOMM, Inc. [QCOM]
  • Taiwan Semiconductor Mfg. Co. [TSM]

Industrials

  • Siemens AG (ADR) [SIEGY]
  • United Technologies Corp [UTX]
  • Volkswagen AG (ADR) [VLKAY]

 Internet

  • Amazon.com, Inc. [AMZN]
  • Facebook Inc [FB]

 Energy

  • China Petroleum & Chemical Corp [SNP]

Most of these stocks have become Behemoths as a result of rising earnings and expanding P/E multiples amid the bull market.  A few, like Facebook and Amazon don’t require much in the way of earnings to support their stock price versus something like an Apple or a Google.  But let me show you my summary graph regarding now and three years ago for Behemoth stocks:

BEHEMOTH 8-2014_11021_image001

 

Three years ago, 2011-13 earnings were estimated, versus 2014-16 earnings today.  If you look at 2008-10, you can see the impact of the new stocks on the median P/E of the group as a whole.  In general, the P/Es of the new Behemoth stocks were higher than those that were already Behemoths three years ago, pulling the median at least one multiple turn higher.

And looking at 2011-13 estimated versus the actual, you can see how much valuations have increased over that period.  It didn’t happen all at once, but the S&P 500 is ~60% higher now than when I wrote the first two pieces (not counting dividends).

In December 2011 you could consider getting 9-10% earnings yields out of the Behemoths.  Today, you’re looking at 7%.  Quite a difference.  Some of it could be attributed to tighter yield spreads, but not to changes in Treasury yields, which are actually higher now than they were in December 2011.

You aren’t as well-compensated today relative to BBB corporate yields to play in the Behemoth stocks today.  Now, the Behemoths may be safer than many other stocks in the market, and are priced at a discount to the market averages, but your absolute margin of safety is lower.

What Can Behemoth Stocks do for You?

  • They can pay you dividends.  They have relatively protected market niches, and they pay above average dividends — 2.9% on average, and that is with seven that have dividends of less than 1%.
  • They can go down less than other stocks whenever the next bear market hits.

What Can’t Behemoth Stocks do for You?

  • They can’t grow as rapidly as smaller companies.
  • They can’t be taken over, so improvements from entrenched management teams must come from sweet reason convincing them, rather than barbarians at the gates.

What Could Behemoth Stocks do for You, if Management Teams were Willing to Take Some Chances?

These ideas aren’t likely, because those that manage Behemoth companies like managing these monstrosities, but if they did consider shareholders first:

  • Energy companies would split into upstream, midstream, refining and retail companies.
  • Conglomerates would divide into more focused companies.
  • Large financial companies would split into companies focused on serving specific markets, realizing that there are few advantages from diversification, and much loss from lack of focus.
  • Companies would segment into slow-growing legacy businesses which can be reliable income vehicles, and the rapidly-growing portions that could be amazing with some focus.
  • Frito-Lay would spin off Pepsi.
  • Procter and Gamble and GE would be even more aggressive about spinning off entities.

The main problem with Behemoths is that they are undermanaged.  There is only so much a single senior management team can do; the incentives of management teams get rather dull with respect to each division.  Even the radical decentralization of Berkshire Hathaway can only do so much; a day will come when they will centralize, reorganize and prune, but not while Warren Buffett still leads.

As for me and my clients, we own six of the cheaper Behemoth stocks, comprising  14% of our holdings, biding our time until I see better opportunities.

Full Disclosure: Long BRK/B, BP, CVX, SNP, TOT, and WFC

Peddling the Credit Cycle

9142514184_9c85b423ae_z Starting again with another letter from a reader, but I will just post his questions in response to this article:

1) How much emphasis do you put on the credit cycle? I guess given your background rather a great deal, although as a fundamentals guy, I imagine you don’t try and make macro calls.

2)  What sources do you look at to make estimates of the credit cycle? Do you look at individual issues, personal models, or are there people like Grant’s you follow?

3) Do you expect the next credit meltdown to come from within the US (as your article suggests is possible) or externally?

4) How do you position yourself to avoid loss / gain from a credit cycle turn? Do you put more emphasis on avoiding loss or looking for profitable speculation (shorts or quality)

1) I put a lot of emphasis on the credit cycle.  I think it is the governing cycle in the overall economic cycle.  When some sector of the economy finds itself under credit stress, it has a large impact on stocks in that sector and related areas.

The problem is magnified when that sector is banks, S&Ls and other lending enterprises.  When that happens, all of the lending-dependent areas of the economy tend to slump, especially those that have had the greatest percentage increase in debt.

There’s a saying among bond managers to avoid the area with the greatest increase in debt.  That would have kept you out of autos in the early 2000s, Telecoms after that, and Banks/Finance heading into the Financial Crisis.  Some suggest that it is telling us to avoid the junior energy names now — those taking on a lot of debt to do fracking… but that’s too small to be a significant crisis.  Question to readers: where do you see debt rising?  I would add the US Government, other governments, and student loans, but where else?

2) I just read.  I look for elements of bad underwriting: loosening credit standards, poor collateral, financial entities focused on growth at all costs.  I try to look at credit spread relationships relative to risks undertaken.  I try to find risks that are under- and over-priced.  If I can’t find any underpriced risks, that tells me that we are in trouble… but it doesn’t tell me when the trouble will hit.

I also try to think through what the Fed is doing, and think what might be harmed in the next tightening cycle.  This is only a guess, but I suspect that emerging markets will get hit again, just not immediately once the FOMC starts tightening.  It may take six months before the pain is felt.  Think of nations that have to float short-term debt to keep things going, particularly if it is dollar-denominated.

I would read Grant’s… I love his writing, but it costs too much for me.  I would rather sit down with my software and try to ferret out what industries are financing with too much debt (putting it on my project list…).

3) At present, I think that an emerging markets crisis is closer than a US-centered crisis.  Maybe the EU, Japan, or China will have a crisis first… the debt levels have certainly been increasing in each of those places.  I think the US is the “least dirty shirt,” but I don’t hold that view strongly, and am willing to be challenged on that.

That last piece on the US was written about the point of the start of the last “bitty panic,” as I called it.  For a full-fledged crisis in US corporates, we need the current high issuance of  corporates to mature for 2-3 years, such that the cash is gone, but the debts remain, which will be hard amid high profit margins.  Unless profit margins fall, a crisis in US corporates will be remote.

4) My goal is not to make money off of the bear phase of the credit cycle, but to lose less.  I do this because this is very hard to time, and I am not good with Tactical Asset Allocation or shorting.  There are a lot of people that wait a long time for the cycle to turn, and lose quite a bit in the process.

Thus, I tend to shift to higher quality companies that can easily survive the credit cycle.  I also avoid industries that have recently taken on a lot of debt.  I also raise cash to a small degree — on stock portfolios, no more than 20%.  On bond portfolios, stay short- to intermediate-term, and high to medium high quality.

In short, that’s how I view the situation, and what I would do.  I am always open to suggestions, particularly in a confusing environment like this.  If you’re not puzzled about the current environment, you’re not thinking hard enough. ;)

Till next time.

Should I Invest in Private Equity?

5882167382_aa2d53e315_oOne of the best things for me regarding blogging are the readers who ask me questions.  When I get a set of them that are general enough, I answer them for all my readers, after stripping out identifying data.  Here is the most recent:

Thank you for your work on your blog which I read with great interest!

I would have a question for you regarding private equity vs. public traded stocks:

– Does a private investor who is investing/saving for retirement need private equity investments?

- Does such an investor make a big mistake if only investing in publicly traded stocks?

- Do you also invest in private equity?

- Is there any evidence that private equity is outperforming simple passive index investing?

 Many thanks for your time and all the best.

Before I answer the questions, let me take a step backward, and be a little more general, asking a few questions of my own:

1) If you wanted to invest in private equity, how would you do it?

2) What are some of the disadvantages and advantages of investing in private equity?

3) Why don’t amateur investors invest in just a few public stocks?

Okay, here goes:

If you wanted to invest in private equity, how would you do it?

There are two ways to do it, and I have done each one in my life:

a) invest in a private equity fund

b) invest in a friend’s business

I’m going to ignore the new phenomenon of crowdsourcing, because it is too new to evaluate.  Wait for it to mature before committing funds.

Now, investing in a private equity fund usually requires being an accredited investor, because the legal form is that of a limited partnership, and those who invest in that are supposed to be sophisticated investors who can afford to lose it all.

Now, in my days of working inside insurance companies, late in the ’90s, it was all the rage for life insurers to invest in private equity funds.  I remember being brought in to vet deals after my boss had informally set his heart on doing them.  As you might guess, I was not too crazy about a tech-heavy fund that was investing in dot-coms, still, we ended up doing it.  I liked better a private equity fund that was investing in small and medium-sized ordinary businesses in the Mid-Atlantic region.

We invested in both of them; neither one ended up returning the capital to the insurance company.  Just because the institution is big enough to be a Qualified Institutional Buyer does not mean that it has the smarts to actually evaluate the risks taken on.  Similarly, just because you are an “Accredited Investor” doesn’t mean you are capable of evaluating the risks you will be taking.  All it means is that the government won’t stand in the way of you losing money that they keep the little guys from losing.

As for investing in a friend’s business, I have done it twice, and so far, seemingly successfully with each: Wright Manufacturing and Scutify.  You don’t have to be accredited to be an angel investor, but it can be a take it as it comes sort of thing if you don’t live in an area where lots of new ventures get created.

In these situations, it is good if you bring more than capital to the table.  Particularly with Wright Manufacturing, I have tried to make my help available when needed when the firm has faced challenges.

What are some of the disadvantages and advantages of investing in private equity?

Disadvantages

  • Illiquid — in a fund, you are locked up for years.  Investing in a friend’s business means you are at the mercy of the firm and other shareholders if you want to buy more or sell some.  If you think bid/ask spreads for illiquid public stocks are wide, they are narrow compared to owning shares in a private business.
  • The management has information advantages, whether it is the fund or the friend’s business.
  • The variability of results is very high, with many investments being total losses.  As true of public equities, don’t invest what you can’t afford to lose.
  • Your friend may try to raise capital at times where you can’t or don’t want to participate.
  • You may not get the same amount of data to analyze as with a public company; then again, you may get the inside scoop.

Advantages

  • The fund could have genuine professionals sourcing business prospects otherwise unavailable to most for investment.
  • Your friend could really be onto something big.
  • There is the remote possibility of hitting a home run and making a return many times greater than your capital.
  • Sometimes there are tax advantages (say, for creating manufacturing jobs in Maryland).
  • Stock prices are not posted for you, and so you don’t panic so easily, and after all, you would have a hard time selling.

Why don’t amateur investors invest in just a few public stocks?

Most amateur investors are not good enough at business to find a few superior businesses and hang onto only those.  Don’t feel bad, though, that’s true of almost all professionals.  Diversification is the only free lunch in the business, because it reduces the variability of returns.  If you think investors do badly panicking with diversified funds as in 2008-9, if they were only holding a few companies, the volatility would be so great that many more would lose confidence.

The upshot here is that the results of own shares in just a few private companies will vary tremendously; most people will not be able to live with that level of variability, lack of liquidity, and lack of control.

So, onto my reader’s questions:

Do you also invest in private equity?

I have done so, as I have said, but most of my investments are in public equities following my own strategies.  My asset allocation would look something like this:

  • Public equities 55%
  • Private equities 15%
  • House 15%
  • Bonds & cash 15%
  • No debt

Does a private investor who is investing/saving for retirement need private equity investments?

Need it? No.  Could you use it if accredited, or investing in the businesses of friends? Yes.

Does such an investor make a big mistake if only investing in publicly traded stocks?

No.  Think of it this way — private equity tends to do about as well as leveraged index funds, on average.  A portfolio of private equity and bonds will do about as well as some equity index funds, on average, with a much wider degree of variation than the index funds.

As an aside, to two private firms in which I hold shares carry little debt.  That lowers my risk.

Is there any evidence that private equity is outperforming simple passive index investing?

It does better in good times on average, and worst in bad times, and is far more variable.  One note, be careful about some of the Internal Rate of Return [IRR] figures that some private equity funds trot out.  The returns are overstated because the capital is drawn on slowly, which inflates the IRR.  That said, investors have to plan for that capital to be drawn, and must have some slack assets earning less to fund the later draws on capital.  If that cost were factored in, the IRR would go down considerably.

In Closing

If I were talking to an amateur investor who wanted to run a concentrated portfolio of value stocks in the public markets, I would say, learn a lot, and put in enough time to make it a second job.  The same would be more true for the fellow attempting to do the same thing in private equity — it is harder.

If I were talking with an amateur investor trying to find a very good mutual fund manager or registered investment adviser [RIA] for his funds, I would tell him to look carefully for active share, is the process sensible and repeatable, etc.  If he were accredited, and wanted to do the same for private equity, I would be inclined to tell him to hire a specialist consultant to find it for him, because the data is not as available, and the games are more opaque.  Add in that the big, respected names stick with institutions as clients — smaller amounts of money will have to find a good manager that is also off the beaten track.

So no, there is no advantage to private equity after taking into account the disadvantages.  Both of my investments have had more than their share of ups and downs; I don’t think the average person is made for that.

Book Review: Investor Behavior

Investor-BehaviorOrdinarily, I read all of the books that I review, but when I don’t, I tell my readers. This book I started to read, but I found it so dry that I started skimming it. It’s not that I don’t know the material; it is that I do know it.

The book covers most areas of behavioral finance, however, it does it in an academic way.  The book would be ideal for academics and those that appreciate an academic approach to finance, that want to have a taste of many different areas of behavioral finance.

There are more engaging books for practitioners and average investors to read — you would even do better reading articles like this from a leading blogger.  (Those at Amazon, please come to Aleph Blog if you want the links.)

Summary

 When I review books, I try to say who it would be good for — in this case, it is academics.  Let average market participants seek elsewhere for more engaging content.  If you still want to buy it, you can buy it here: Investor Behavior: The Psychology of Financial Planning and Investing.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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