Book Review: The Dao of Capital

Posted on 11 December 2013 by David Merkel

Have I said this before: this is a tough book to review.? Much as I am in sympathy with Austrian Economics, I am not in sympathy with Daoism.

When I came to Christ at age 16, the major rival for my heart was Daoism, not the Catholicism that I grew up with.? My main difficulty was that Catholicism did not speak with a single voice on critical matters — one priest would say this, another that.

Daoism has an advantage in some ways because it seems to describe the world; the world is cyclical, and often a condition gives way to its opposite.

But Daoism, though descriptive of what happens, is amoral, as is much of radical libertarian thought.? A system without rules is no system.? There have to be rules for a good nation to exist.? On economics, there have to be ways to prosecute fraud.? There have to be ways to protect property rights.? That can’t happen without a strong, if limited, government.

Capitalism does not derive from Daoism, but from the laws of Moses, and the words of Jesus.? “Thou shalt not steal.” has impact, because it implies property rights.? 70% of the parables of Jesus involved money, and assumed that people were free to do with their resources as they saw fit.

Daoism did not develop capitalism.? It was a creation of the Christian West.? Was everything perfect in the way it was worked out?? No.? There were many mistakes, and much dispropriation of cultures that had no concept of private property.

Other Problems

The book would have been better without the constant repetition of foreign words.? It is pretentious to make readers learn a bevy of foreign words.

Minsky is better than the author makes him out to be.? At least Minsky sees how financing gets warped through the boom-bust cycle.

I believe that most financial crises occur because of government interference, but not all of them.? Men are greedy/envious/fearful enough to create self reinforcing cycles in the absence of government interference.? Look at the Creation more generally.? There are many species that ceased to exist long before Mankind became dominant.? In the same way, there have been many crises that have occurred in the absence of government interference.? “Man is born to trouble, as the sparks fly upward.”

Practical Upshot

In the last two chapters, he comes out in favor of the Q-ratio and the price-to-book style of value investing, plus quality.?? Both good ideas, but both require patience, which is in short supply among aging baby boomers.? The question to the reader is how long you are willing to wait.? That is the big question of much investing, and how to answer the question — the book says wait.? I agree, but it is tough to hold a lot in cash in a bull market.

Who would benefit from this book: It is a good book, though I doubt that many can follow the advice.? If you want to, you can buy it here: The Dao of Capital: Austrian Investing in a Distorted World.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

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.

Three Dimensions, and Printed, but not Real

Posted on 10 December 2013 by David Merkel

Okay, let’s run the promoted stocks scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 12/9/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.014	-99.4%	-60.9%
BONZ	10/22/2009	0.35	0.001	-99.6%	-74.2%
BONU	10/22/2009	0.89	0.001	-99.9%	-79.4%
UTOG	3/30/2011	1.55	0.001	-99.9%	-93.0%
OBJE	4/29/2011	116.00	0.350	-99.7%	-89.1%	1:40
LSTG	10/5/2011	1.12	0.015	-98.7%	-86.2%
AERN	10/5/2011	0.0770	0.0001	-99.9%	-95.3%
IRYS	3/15/2012	0.261	0.000	-100.0%	-100.0%	Dead
RCGP	3/22/2012	1.47	0.300	-79.6%	-60.4%
STVF	3/28/2012	3.24	0.490	-84.9%	-67.1%
CRCL	5/1/2012	2.22	0.028	-98.8%	-93.5%
ORYN	5/30/2012	0.93	0.038	-95.9%	-87.6%
BRFH	5/30/2012	1.16	0.420	-63.8%	-48.6%
LUXR	6/12/2012	1.59	0.015	-99.1%	-95.6%
IMSC	7/9/2012	1.5	0.800	-46.7%	-35.8%
DIDG	7/18/2012	0.65	0.049	-92.5%	-84.4%
GRPH	11/30/2012	0.8715	0.053	-93.9%	-93.5%
IMNG	12/4/2012	0.76	0.063	-91.7%	-91.4%
ECAU	1/24/2013	1.42	0.330	-76.8%	-81.2%
DPHS	6/3/2013	0.59	0.007	-98.8%	-100.0%
POLR	6/10/2013	5.75	0.090	-98.4%	-100.0%
NORX	6/11/2013	0.91	0.160	-82.4%	-97.0%
ARTH	7/11/2013	1.24	0.182	-85.3%	-99.0%
NAMG	7/25/2013	0.85	0.785	-7.6%	-19.1%

	12/9/2013		Median	-97.2%	-88.4%

Market regularities are heartening.? It’s astounding how regular the losses are from promoted stocks.

On to tonight’s loser-in-waiting, Makism 3D Corp [MDDD].? This is another company with no revenues, has never earned a dime, etc.? It used to be a company that supposedly was trying to improve cellular telephony, but never earned a dime doing so.? So they bought a UK company that was supposedly working on 3D printing, and surrendered the company to them.

It would be incredibly surprising that a company of three people would be able to overthrow the 3D leaders — DDD and SSYS.? They have invested a lot of time, money, and effort to improve 3D printing, and a startup can beat them with less than a million bucks, and less than a year, with a young undifferentiated staff?? I don’t think so.? Or, as an old-style pinball machine might say, “TILT!”

I don’t buy it, and you should not either.? As with all promoted stock scams, the hard part is identifying who benefits.? My guess is affiliates of the guy who wrote the glowing report.? The company has disclaimed ay responsibility.

In any case, avoid promoted stocks.? Do your own research, and buy stocks that you find attractive.? Don’t buy anything that another is trying to pitch you.

Two zeroes merge, and should we expect a positive result?? I think not.

Book Review: Bonds are not Forever

Posted on 8 December 2013 by David Merkel

This is a good book, it is not a great book like The Hedge Fund Mirage.? Why?

There are a few reasons.?? First, the book on hedge funds contradicted the conventional wisdom.? This book confirms the conventional wisdom that interest rates have to rise.

We all have to be wary of the conventional wisdom in economics.? Economics is a social science, but I mean it not in the sense that we study society, but that economists toe the line as to what is acceptable to publish.? This is guarded by peer review, which ensures that no new idea that might be correct gets published.? (This is true of most of the “sciences” because many “scientists” are not neutral observers — they have axes to grind.)

This book assumes that the US will inflate its way out of this crisis.? In the? Great Depression, it did not work that way, though many thought it would.

The book correctly calls out all of the ways that Wall Street cheats individual bondholders, particularly structured notes, and the illiquidity of muni bonds.

He does not get how muni bond ladders are durable investments, being a good compromise on how to avoid interest rate risk.? Further, he never mentions how the TRACE system of FINRA reports all trades.? The system is not that opaque.

This is a good book, but not a great book.? Yes, I think inflation is more likely than deflation, but I don’t think inflation is a slam-dunk.? We haven’t had it yet amid many predictions for it.

Quibbles

Already expressed.

Who would benefit from this book: It is a good book, though I doubt that the theory is certain.? If you want to, you can buy it here: Bonds Are Not Forever: The Crisis Facing Fixed Income Investors.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

Sorted Weekly Tweets

Posted on 7 December 2013 by David Merkel

Rest of the World

Ghana Farms Miss Out on Oil-Fueled Middle Class Food Demand http://t.co/IwEsoXVy20 Middle classes introduce changes into societies $$ $SPY Dec 07, 2013
Are the Baltic Dry Index Telling Us to Expect a Stronger Economic Activity? http://t.co/aqnFaUuGkg Could be, but only in exports $$ Dec 07, 2013
Yuan Passes Euro as 2nd-Most Used Trade-Finance Currency http://t.co/yeNQzNYLWD If China’s banks were exposed 2 market, would b impressed $$ Dec 07, 2013
Big Oil to Get Brazil-Like Terms in Plan to End Mexico Monopoly http://t.co/SWqSEyVnU0 Maybe Mexico can gain the technical help it needs $$ Dec 07, 2013
Panasonic in Deal Talks With Auto Parts Makers for Expansion http://t.co/vjECK9hnD5 Desperation drives the company 2 seek more markets $$ Dec 07, 2013
Pirates Wielding Grenades Spur Japan to Ease Samurai-Era Gun Ban http://t.co/jsOtaI0J7c Force must b opposed by force; no other way $$ $SPY Dec 07, 2013
Rich Kazakhs Revive Polygamy as Women Seek Poverty Escape http://t.co/vTn2h9eSZx Young Kazakh women would rather b second wives than poor $$ Dec 07, 2013
Iran Wants US Companies to Develop Oil Fields http://t.co/E1NUUEo5t4 The Great Satan is quite useful under the right conditions $$ $SPY $TLT Dec 07, 2013
China Cinda Attracts $65B in Orders for Up to $2.5B IPO http://t.co/6i5nvsWhSD Those are bubbly conditions; 2 much $$ 2 put 2 work $SPY $TLT Dec 07, 2013
Wrong: OECD Warns Riksbank Against Obsessing Over Record Debt http://t.co/fYu3CcY31M OECD should learn excessive debt harms $$ $TLT $SPY Dec 07, 2013
Banks in Safest Euro Nation See Credit Drought as Finns Save http://t.co/HZ6IDctQzk Many want to save; few want to borrow. Rational $$ Dec 07, 2013
Spain Credit Falls to ?05 Shadow After Price Collapse http://t.co/y9VUnLcszp Even that is too much credit. Wait 4 hard money buyers $$ Dec 06, 2013
China Bans Financial Companies From Bitcoin Transactions http://t.co/i8yhbAcKAW Wealthy Chinese want to get value out of China $$ $SPY $TLT Dec 06, 2013
“Wealthy Chinese could use it to funnel flight capital out of China” ? David_Merkel http://t.co/XRD6rOfsGg How Bitcoin functions in China $$ Dec 02, 2013
China?s Largest Bitcoin Exchange Seeks Recognition for Currency http://t.co/hNtBu9e2MU Communist Party will eventually ban Bitcoin $$ $SPY Dec 02, 2013

PPACA/Obamacare

Obamacare’s New Goal: Stay Alive Until 2015 http://t.co/tJpT20oW6K The idea is 2 survive until 2015, so the law can’t b destroyed in 2017 $$ Dec 07, 2013
How Much More Will Smokers Pay for Obamacare? http://t.co/Rd3eWeVynR Answer: not much more & no, it will have little effect on quitting $$ Dec 04, 2013
Obamacare Website Repair Goals Reached, Administration Says http://t.co/PfJ5tgLrSu Big Problem: the insurers are not getting the data $$ Dec 03, 2013
Deep Inside The Hot Mess Called Obamacare: It’s Time For Honesty http://t.co/uY6P8JnakO Sophomoric, doing a dumb thing, calling it wise $$ Dec 01, 2013
Obamacare Payment System to Insurers Changed in Setback http://t.co/0d26PCyQh6 Complex law, difficult to change w/o affecting other parts $$ Nov 30, 2013
Inside the Company That Bungled Obamacare http://t.co/EbcR6VQ3rs B wary of companies that grow 2 fast w/shaky revenue recognition $$ $GIB Nov 30, 2013

Pensions

Change Illinois’ pension benefits to match the Social Security system http://t.co/LuA3nkw50C The bill passed will harm Illinois long-run $$ Dec 07, 2013
The Best and Worst Run States in America: A Survey of All 50 ? http://t.co/Kq5ElC567u You might be surprised by the rankings $$ $SPY $TLT Dec 07, 2013
Pension Threats in Illinois, Detroit Rattle Government Workers http://t.co/t2rqvoK3cl If the local government can’t pay, it won’t $$ Dec 07, 2013
Pension Threats in Illinois, Detroit Rattle Government Workers http://t.co/Hd0Wr0TL0b Blame Union strategy of extracting pension gains $$ Dec 06, 2013
Illinois Passes Pension Overhaul http://t.co/8svwzeiTuK Fake overhaul that leaves Illinois taxpayers worse off, will go to court & die $$ Dec 05, 2013
Detroit Retirees Got Extra Interest After Guaranteed 7.9% http://t.co/WmvpH4PHWI What Detroit did w/”excess” pension earnings was evil $$ Dec 03, 2013
Illinois Legislative Leaders Try to Sell Pension Agreement http://t.co/vU1O1qKSO6 Dreamland vs Hard Choices. So far Dreamland is winning $$ Nov 30, 2013

US Politics & Policy

Gun Patents Set 35-Year Record as Limits on Sales Fail http://t.co/lZKuBqkheu When GOP has Presidency sales will fall $$ Dec 07, 2013
What You Don?t Know About Mortgages http://t.co/dmKPgFMAqL! Mortgage documents don’t reflect the full cost of getting the mortgage $$ $TLT Dec 07, 2013
Obama war chiefs widen drone death zones http://t.co/E47ZKFgBex If we want to make the US odious to the rest of the world, use drones $$ Dec 07, 2013
Paul Krugman Consigns To Hell An Economic Slump Of His Own Devise http://t.co/qgrKFSBG8W We have 2 turn the lights off near Krugman $$ Dec 07, 2013
The Fed Must Inflate http://t.co/nBKutizEDw I think this is the most likely conclusion, but not certain $$ Dec 07, 2013
Is the Fed increasingly monetizing government debt? http://t.co/1I3twSCfaY Yes, Fed is monetizing government debt, get ready 4 inflation $$ Dec 07, 2013
Angry Self-Insured Voters Dim Democratic Takeover Plans http://t.co/MMjVZi16LU Many feel robbed by the loss of choice in healthcare $$ $SPY Dec 06, 2013
Henninger: Obama’s Red-Line Presidency http://t.co/tOjc5UV88s What doe the US stand for? What will we defend? Who r our allies? Confusing $$ Dec 06, 2013
“You can’t regulate what you don’t understand. The SEC looked in on it several times, with more?” ? David_Merkel http://t.co/g9jqwD0En1 $$ Dec 03, 2013
Uninsured-Driver Dilemma http://t.co/DSBWcNLyMk Have Assurant track non-payment at the insurers, & inform the MVAs of lapsation $$ $AIZ Dec 03, 2013
Magic Johnson, Tom Hanks Join Obama on Cash-Grabbing Trip http://t.co/z2AOd9C8yC Cash works in the short run, voters decide the long run $$ Dec 03, 2013

Financial Sector

Why FDIC is Running Out of Time for Resolution Planning http://t.co/5PTdNU6LPb As w/all complex laws, things move slowly, no surprise. $$ Dec 07, 2013
Why Capital Is Key Battleground in GSE Reform Debate http://t.co/21pFcfRhfU Appropriate capital 4 new system:a political &technical issue $$ Dec 07, 2013
Penny Pricing for US Stocks Said to Get Scrutinized http://t.co/grStNTieJR I don’t think this is a big problem, helps small investors $$ Dec 07, 2013
Examiners-in-Residence Should Be Pulled Out of Megabanks: OCC Report http://t.co/QGyvc9RkDz Familiarity breeds acquiescence, not contempt $$ Dec 07, 2013
Buyers Give Up Their Names to Seal Merger Deals http://t.co/zmAgQ2J5Zo Who cares what a bank is named, so long as you have control? $$ $FXF Dec 07, 2013
Volcker Rule to Force Banks to Comply With Five Regimes http://t.co/7H0s7dhCnm Recipe 4 disaster. When many r responsible, no one is $$ Dec 07, 2013
Slate Writer Is Dead Wrong to Root Against Community Banks http://t.co/TAL566KB0n Getting banks is tough 4 neophytes like Matty Yglesias $$ Dec 06, 2013
Private equity firms brace for ?mafia? style scrutiny http://t.co/dRaXIvfztv This looks a lot more difficult than the article indicates $$ Dec 03, 2013
Fed Eyes Financial System’s Weak Link http://t.co/ShsZIBcWT4 Solution is simple; bifurcate repo acctg 4 statutory cash flow testing $$ $XLF Dec 03, 2013
Creating a Black Swan http://t.co/wMnfc81Ai0 Attempts 2 explain how negative black swan events get created in financial markets $$ $SPY $TLT Nov 30, 2013
The Black Swan http://t.co/IBQL7AG4XJ A good piece that explains positive & negative “Black Swan” events, & how 2 thus position for them $$ Nov 30, 2013

Companies & Industries

Crude Oil Refiners Are In A Sweet Spot | Commodities http://t.co/HjtUJOe0gZ Because crude oil can’t b exported, refiners benefit $$ $SPY Dec 07, 2013
Retailers Are in a Deflated Holiday Mood http://t.co/Rd7JLXlRj8 One reason why I rarely invest in retailers, aside from grocery $$ $SPY $TLT Dec 07, 2013
Heavy Inventories Threaten to Squeeze Clothing Stores http://t.co/t542Zlltcf That said, clothing is dirt cheap, so why worry much? $$ $SPY Dec 07, 2013
Hidden U-Haul Billionaire Emerges With Storage Empire http://t.co/YRE2pc6Tf4 Fascinating tale of how brothers rescued the family business $$ Dec 06, 2013
UnitedHealth Projects 2014 Results Below Analysts’ Estimates http://t.co/c9fGK1QUzp Health Insurers take one for Obama’s errors $$ #FTL Dec 03, 2013
Olin Corporation Common Stock up 9% today http://t.co/HwlrL4TD9z Something is happening w/OLN today. Anyone know what? FD: + $OLN $$ $SPY Dec 02, 2013
Microsoft, Yahoo Upgrades Shows Snowden Won, Obama Failed http://t.co/sqzBmoIY8n Encryption keys double, squaring time needed to crack $$ Nov 30, 2013
Fair-Weather Friends or Raining on Your Parade http://t.co/uVksfLp84u Good snarky post. Time to lighten up on property-centric reinsurers $$ Nov 30, 2013

Market Dynamics

Gen Re?s Gilbert Says Fed Sets Up Stocks for a Decline http://t.co/o28udyUMGC The Fed will learn the limits of its power in a few years $$ Dec 07, 2013
The Blessing of a Declining Stock Price http://t.co/Ta2eE12QW7 This is how I do it; I buy companies that have moved against me $$ $SPY $TLT Dec 07, 2013
The Stock Market Is ‘Shrinking,’ Despite Record-High Indexes http://t.co/cj6YcrhBYL Interesting argument of stock scarcity pushing prices $$ Dec 07, 2013
Buffett’s Alpha http://t.co/D3UrTxePlp Finally a paper from academics that gives Buffett the credit he deserves. Efficient markets? No. $$ Dec 07, 2013
Gross to Run Pimco Unconstrained as Dialynas Takes Leave http://t.co/rgLxxVp3Xj Unconstrained is no guarantee of good performance $$ $TLT Dec 06, 2013
?Quant? hedge funds: Computer says no http://t.co/ZCXplVsnnA Runs in cycles as more or less focus on anomalies in investing $$ $SPY $TLT Dec 01, 2013
Don?t Ignore Doctor Copper http://t.co/JYw6XNcR5z Copper is indicating a punk economy $$ $SPY $TLT Dec 01, 2013
Howard Marks: Too Cute for His own Good? http://t.co/BWZ2bDD0xP Unfair. Marks says that the opportunity set is small, get it? $$ $SPY $TLT Dec 01, 2013

Other

Fixing What’s Wrong With Economics 101 http://t.co/BR8Lt8Z19H We need 2 scrap neoclassical economics, and move economics away from math $$ Dec 07, 2013
Madoff Behaved Like a Lunatic Over Fund Probe, Jury Told http://t.co/CUfV17a9tA Seems like Madoff employees kept their heads down $$ Dec 07, 2013
CS50, a computer science course, breaks stereotypes and fills halls at Harvard http://t.co/wnc2WYQbpo Making IT relevant across cultures $$ Dec 01, 2013
Caveat Emptor: Lovers of Latin Try to Sell a Dead Tongue http://t.co/d5YuHQQZtd Looks like wishful thinking 2me. Esperanto, anyone? $$ Nov 30, 2013
Why Taylor Swift Is the Reigning Queen of Pop http://t.co/sTEJPtyp66 Swift’s popularity secret? My take:she appears more humble than most $$ Nov 30, 2013
Build a Better Turkey Sandwich http://t.co/mM42sClsuL Thanksgiving keeps on giving in six inspired takes on the leftover-turkey sandwich $$ Nov 30, 2013

Classic: Become a Smarter Seller, Part 2

Posted on 7 December 2013 by David Merkel

The following was published at RealMoney, but I don’t know when, but I do know that this is the first draft, not the finished product — my editor did not want me to mention that I was unemployed.

?I always sell too soon.” ? Baron Rothschild

In 2003, when I was briefly unemployed, I noticed that my personal account was starting to underperform.? Partly to give myself more confidence at interviews, and partly to get rid of a distraction, I went over my portfolio to tune it up.

I started out by ranking my portfolio from top to bottom in terms of expected returns.? Nothing complex ? I just went my price targets and compared them to current prices.? Highest percentages are at the top; lowest are at the bottom.? My next step was to do the same for a list of replacement candidates.? I then looked at the second list, and found that my top three replacement candidates beat the expected returns for the median company in my portfolio.? I bought those three companies for my portfolio, and funded it by selling the four stocks in my portfolio with the lowest expected returns.? At the same time, I added a small amount to two underperforming names in my portfolio.? Here were my actions, and the results through 7/14/03, the date that I sold Pechiney:

Action	Size	Name	Ticker	7-Mar	14-Jul	Return	Average Return
Sell	100%	Adtran	ADTN	30.46	58.52	92%
	100%	Am Power Conversion	APCC	14.66	17.11	17%
	100%	Texas Instruments	TXN	16.26	19.12	18%
	100%	Bank of Montreal	BMO	27.94	31.91	14%	35%
Buy	100%	Precision Castparts	PCP	22.59	33.00	46%
	100%	Nucor	NUE	38.70	48.81	26%
	100%	Pechiney	PY	11.60	24.61	112%
	25%	Petrobras	PBR	13.60	20.80	53%
	25%	Dycom Inds.	DY	9.50	17.92	89%	63%

With the exceptions of Pechiney and Nucor, I still hold positions in all of the purchases.? When Pechiney hired the investment bankers, I tossed in the towel; I thought they were fighting for their cushy jobs, not enhancing shareholder value.? I was surprised to see them sell out to Alcan.? I sold Nucor in late 2003, over the rise in scrap steel prices; even though Nucor can raise its own prices, its profits will not increase as much as other steel firms.? I also goofed in my evaluation of Adtran.? It had much better prospects than I thought.

There were other companies on my purchase candidate list with expected returns that beat the expected returns of companies remaining in my portfolio, but did not beat the median expected return.? I set the bar at the median in order to avoid excessive turnover.

The price return on the purchases versus the sales was better by more than I would ordinarily expect, and faster as well ? I look for returns on my portfolio to beat the S&P 500.? This series of trades certainly helped.

Rebalancing

The two smaller purchases were done for a different reason than the other trades.? PBR and DY were already in my portfolio, but had been performing badly.? The weight that each had in my portfolio had shrunk to be the smallest in my portfolio.? After a review of the fundamentals, I did what I call a rebalancing trade.

When I was interviewing managers at Provident Mutual, another question that we would ask managers is how they would rebalance positions in response to market movements.? Many of them would do nothing; others had no fixed strategy.? A few had really worked on this aspect of portfolio management, and to my surprise, their strategies on this topic were similar, even though other aspects of their portfolio management styles were different.? One was value, one was growth, one was core, but they each had evidence that their approach improved their returns by a couple percent per year.

There is a growing academic literature on market microstructure; one thing it addresses is measurement of the total costs of trading.? One of the costs of trading comes from whether a trade demands or supplies liquidity to the market.? When a trader posts a limit order, he offers other market participants an option to exchange shares for liquidity at a known price.? In offering liquidity, the trader hopes to get an execution at a favorable price.

The approach that the three managers use, and I employ in my personal account, is as follows:

Define a series of fixed weights for the stocks in the portfolio.
Do a rebalancing trade when any position gets more than 20% away from its target weight.? Use this time as an opportunity to re-evaluate the thesis on the stock.
If the rebalancing trade generates cash, invest the cash in the stocks that are the most below their target weights, to bring them up to target weight.
If the rebalancing trade requires cash, generate the cash from stocks that are the most below their target weights, to bring them down to target weight.

This discipline forces you to buy low and sell high, and also, to reevaluate your holdings after significant relative market movement.? This method works best with companies that possess low total leverage relative to others in their industries.? This helps avoid the problem of averaging down to a huge loss.? This also works best for diversified portfolios with 20-50 stocks, with reasonable even weights.? In my portfolio, the weights range from 2 to 7.5%, with 33 companies altogether.

The 20% figure is arbitrary, but in my opinion, it strikes a balance between excessive trading, and capturing reasonable trading profits, by providing shares and liquidity to the market when it wants them.? The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low, and sells high.

Long DY, PBR, PCP (at that time, at present [2013] I have no positions in companies mentioned)

What is Liquidity? (Part VI)

Posted on 6 December 20134 July 2014 by David Merkel

Here are the predecessor posts in this series:

This series has been very irregular.? But it does include the first real post at this blog.? It is something that I think about frequently, and my best summary for what liquidity means is:

What does it cost to enter or exit fixed commitments?

Tonight I want to take a slightly different approach, and talk about two aspects of liquidity: assets and liabilities.

On the liability side, we can look at publicly traded assets and say that they are liquid, though many may only be fungible.? When I was a bond manager there were some trades that took days or weeks to set up.? Some were public bonds coming to market that were complex, others were asset- and mortgage-backed bonds that took some time to research.? Some were pure privates where you were trading the whole chunk or nothing — it was not far distant from being a bank.

With many investments, there is a liability structure.? Yearly, quarterly, monthly, daily liquidity.? Funds are locked up for three or five years.? Funds are locked up until assets are liquidated, and you might be paid in kind, not cash.

The ability to get cash is an important aspect of liquidity.? But so is the ability to preserve value, and that is the asset side of the question.? After all, liquidity means that you have assets that preserve value, such that you can liquidate and spend it.

From an asset standpoint, stocks are liquid as far as trading goes, but not liquid in terms of preserving value in the short-to-intermediate run.? Equity is illiquid, whether public or private.? It offers no protection of value.? Think of it this way: if you were going to buy a house in a few months, would you invest your down payment in stocks?? It would not be wise to do that.

There are various ways of owning equities, and other investments.? It is more important to understand the riskiness of the assets, than the shell in which the assets are held.? The shell may offer liquidity at intervals, but that has no effect on the underlying value of the assets.

Thus I will say it it is far more important to focus on the value of the assets, than on when cash will be released to you.? As one of my bosses said to me:

Liquidity follows quality.? The better the asset is, the more liquid it becomes.

As a result, those wanting to do best in investment management should keep a supply of short-to-intermediate high-quality debt as the performance of risk assets may vary considerably, which will affect the ability to achieve fixed commitments.

Liquidity is the ability to preserve value for near-term spending.? Thus both asset and liability aspects of investments have to be considered when considering liquidity — it is not only ability to liquidate, but to receive value back in real terms.

Classic: Become a Smarter Seller, Part 1

Posted on 5 December 20135 December 2013 by David Merkel

The following was published at RealMoney, but I don’t know the date.

?I can always find good stocks to buy, but figuring out when to sell is harder.?? (My Mom, when I was much younger.)

In some ways, my career in investing has been a happy accident.? Much of my career has been in the insurance industry, working as an actuary.? Being a generalist, with a focus on investments, this helped me to learn a great deal about institutional investing, before doing it myself.

At Provident Mutual, now a part of Nationwide Financial Services [NFS], I was the one financial analyst on a committee that chose the managers for a series of multiple manager funds for our pension clients.? I ended up interviewing 30-40 top money managers over a three-year period.? The similarities and differences were interesting.? Two areas that we would always ask about would be their buy and sell disciplines.

On buy disciplines, the answers varied considerably.? But sell disciplines were usually pretty similar, falling into three groups:

Price target met
Failure of momentum
Fundamentals deteriorate

The last of these is squishy, and I would usually ask, ?How can you detect fundamentals deteriorating ahead of everyone else??? This would usually elicit the intelligent equivalent of a mumble.

There were a few of the better managers who used what I later called ?The Economic Sell Rule.?? The economic sell rule says that if a manager finds an asset that he likes better than one that he presently holds, he should swap.? That means the manager either intuitively knows what he likes better, or estimates the anticipated rate of return (adjusted for risk tolerance) over the time horizon that he manages, to appraise the desirability of new assets.

I ended up calling it the economic sell rule, because each of three rules listed above had problems of their own.? In a market where valuations are crazy, like the late 90s, many price targets get hit.? If the manager is a ?long only? manager, and has to stay fully invested, he can begin to run out of ideas on where to put money to work.? For managers that can go both long and short, there is the problem that as price targets get hit on the long and short side in a sustained market rally, the portfolio gets shorter and shorter.? And in a sustained decline, the portfolio gets longer and longer.

This is an implicit bet on mean-reversion, which no doubt happens, but often not soon enough for the clients of the manager, who can lose assets under management as underperformance persists.

Failure of momentum could take two forms: valuation-driven managers with price declines below original cost, and momentum-driven managers that would sell when relative strength weakened.? Some valuation-driven managers would often sell any stock that declined more than a threshold percentage, whereas others would do a review at such times to check their investment thesis.? After all, if a manager liked the company before, certainly he should like to buy it cheaper, no?? Unfortunately, the pressure for instant results, measured on a monthly or quarterly basis, can force decisions that are less than fully rational.

As one manager said to me, ?If it goes down more than 20% from where we bought it, we obviously didn?t get the story right, so we sell it and move on.?? This is a recipe for turnover and underperformance.? It is normal for stocks that are good long run performers to have 20% drawdowns once a year or so.? Even with good research analysts, the odds of a 20% drawdown are decent, even immediately after a recommendation.? In my own portfolio, after reviewing my thesis, I view 20% drops as buying opportunities.

Because I don?t manage money that way, I can?t comment as competently on the momentum-driven managers.? I will only note that they have high turnover rates, and that their trading tends to demand liquidity, rather than supply it.? In future articles, I will comment on the tendency for those who supply liquidity to be rewarded for it.

Though I never heard a good explanation for having a competitive edge in detecting deteriorating fundamentals, following the fundamentals is the most useful way for developing a sell discipline.? Absent surprises, companies and industries perform better or worse as investors change their estimates.? As the forward-looking estimate of future returns for a company falls below that of prospective purchase candidates, it is time to swap out.? As the forward-looking estimate of future returns for a company rises compared to other companies in a manager?s portfolio, it is time to buy more.

Consider when a ?surprise? happens to a company.? Surprises can be positive (e.g., possible takeover, good earnings), or negative (e.g., bad earnings).? After a surprise, is it time to sell, buy more, or wait?? It boils down to how much the surprise affects the manager?s estimate of value for the stock.? (And to some degree, how much it has affected the estimates of others.)? How much has the long-run earning power been affected?? For how much could the company be sold off?

Answering questions like these will lead to the estimates of value that can properly inform sell decisions in volatile times.? Using a discipline like this forces a manager to re-estimate a forward-looking estimate of return, rather than let greed or regret drive decision-making.

In my next article, I will show how this process has worked in practice for me, together with another technique that some managers use to pick up some incremental return, and reduce risk.

Book Review: Retirement GPS

Posted on 4 December 2013 by David Merkel

This book encourages you to invest most of your savings abroad, away from the imperfect but good protections offered by US law.? I wrote a piece on this idea a few years ago that pointed out the problems with this idea.? (Note to those reading this at Amazon.com, Google “Aleph In Defense of Home Bias” and you will find my article.)

Now don’t get me wrong — I invest in foreign companies.? One-third of the assets that I run are invested abroad, in both developed and emerging markets.? International investment is good, but it is not a panacea.? There is no inherent advantage to investing abroad versus investing in the US.? Even if emerging markets are growing more rapidly, that doesn’t mean they are better to buy. because valuations are higher, and government policies are more fickle.

This book is rather facile about problems in emerging markets.? Problems with Brazil led me to sell my stocks when Dilma Rousseff was elected President.? Lula promoted markets, Dilma did not.

I found this book to be long on cliches, and short on sharp ideas.? If you try to take the advice as an amateur, you will have a hard time doing it.? If you decide to hire an advisor other then the authors, you won’t get what the book offers.? Thus I can tell you that the book is merely a marketing pitch for their services, and so I tell you to avoid it.

Quibbles

Already expressed, though I would also add that the book didn’t feel right.? Too casual in the way that it treated topics.

Who would benefit from this book: Few would benefit from the book; the theory is flawed.? If you want to, you can buy it here: Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

Book Review: Why Stocks Go Up and Down, Fourth Edition

Posted on 3 December 20133 December 2013 by David Merkel

This is a good book to help the inexperienced learn about investing.? It begins by teaching the rudiments of accounting through the adventures of a man and his company who have built a better mousetrap.

He starts the business on his own, but needs more capital.? In the process of growing, he taps bank loans, private investors, public investors, bonded debt, and preferred stock.? All of this is done with simple explanations in a step-by-step manner.

The book then explains bonds and preferred stocks.? At first I was a little skeptical, because this is supposed to be a book about stocks, and the authors made a small initial error in that section.? That was the last error they made.? I became impressed with their ability to explain corporate bonds and preferred stocks, even some arcane structures like trust preferred securities, and other types of hybrid debt.

Now, if I were trying to shorten the book, a lot of those sections would have been cut.? For those that do want to learn about bonds in the midst of a stock book, you get a free bonus.? If you don’t want to spend the time on bonds, you can skip those sections with little effect on your ability to understand the rest of the book.

Then the book turns to trickier aspects of accounting, explaining cash flow from operations, and free cash flow.? It’s all good stuff, but here is my first problem with the book: what is the most common way of giving a distorted picture of earnings?? Revenue recognition policies.? The book does not talk about revenue recognition, and the most basic idea of Generally Accepted Accounting Principles [GAAP], which is revenue gets taken into earnings proportionate to the delivery of goods and services.? With financial companies, revenues are earned proportionate to release from risk.

That brings up another point.? The book is very good for describing the analysis of an industrial company, but does little to describe how to deal with financial companies.? Financial companies are different, because most of the cash flow statement has no meaning.

Then the book moves on to valuation of common stocks, and that is where I have my biggest problem with the book.? Though they mention other means of valuing stocks, their main valuation method is earnings.? The book does not mention price-to-book as a metric, which is a considerable fault.? Price-to-book is the main way to value financials versus ROE, while price-to-sales is a very good way to measure industrials relative to relative to profit margins.

Further, it suggests that P/E multiples should remain constant as a company grows.? I’m sorry, but P/E multiples tend to shrink as a company grows.? This is because the highest margin opportunities are exploited first, and then lesser opportunities.? For the P/E to remain constant, or even expand means that new opportunities are being exploited that have higher margins.? Investors should not count on that.

These mistakes are minor, though, compared to the good that the book does for an inexperienced investor.

Quibbles

Already expressed.

Who would benefit from this book: This is a classic book that will aid inexperienced investors to learn the basics.? Just remember, it is only the basics, and it covers most things, but not all things. It would be an excellent book for one of your relatives or friends that think they know what they are talking about in investing, but really doesn’t know.? If you want to, you can buy it here: Why Stocks Go Up and Down.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

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