Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control
Author: David Merkel
David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does -- on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor's and master's degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth.
Change the phrasing from trading to speculating to be more pointed.
Add more and better criteria to what an investor does.
Added the entire section “What To Do”
Added a picture and more links.? Corrected grammar in a few spots and tightened up some language.
The main reason to edit this article as I did was to give readers more disciplined ideas with respect to buying and selling, and encourage them have rules, and keep a journal of decisions, together with why they bought, and at what point would they sell.? If not, then investors will not take losses when they ought to, and not sell when their thesis is proven false.? That is the way of more and deeper losses.
I published another article at The Balance:?Considering Event-Driven Investing.? This is one place where writing in the third person leaves a lot out.? I’ve done a lot with some types of event-driven investing.
Speculating on hurricanes — I did that successfully at the hedge fund 2004, 2005 and 2006.? 2006 because I thought the risk of another strong hurricane year was overplayed.? 2004 and 2005 because I had a good idea of who was underreporting claims after disasters.? That was the only time in my life that I went from long a company to short without stopping, and I covered on the day the CEO resigned, and caught the bottom tick.
From the prior article, speculating on Lula’s non-impact on Brazil qualifies as event-driven.
Stock arbitrage — did a lot with it when I was younger.? Didn’t do so well.
Index arbitrage — did a neutral trade where we shorted one company out of the Russell 2000, and bought another one in.? Made no money on the trade.? We had a good fundamental justification for the trade, but it just goes to show you that this isn’t as easy as it looks.
I buy a decent number of spinoffs.? Most succeeded as investments for me.
Now, all that said, most areas where there are simple arbitrages typically boil down to a simple credit risk: will the deal get completed? Will the company not take an action that changes its capital structure in a way that hurts me?
Since these are relatively simple trades, the returns are relatively low like that on a short-term junk bond — at present, like the yield on T-bills plus 2-3%.? It’s not very compelling given the risks involved.? Most of the mutual funds that do that type of arbitrage have not done so well.
Thus, aside from spinoffs, at present, I don’t do that much with event-driven investing.? Many of the forms of it are too crowded, and I prefer simplicity in investing.
Active managers as a group are very similar to the index.? That shares move from active to passive managers does not affect their valuation, just as one active manager selling to another does not.
This was rejected at the founding of Social Security because of the socializing of America’s private companies as a result.? Also, given that politicians would never make decision immediately after a crisis, there would be the tendency to buy in when expensive, and becoming the ultimate dumb money of the market.? Assets subject to the whims of politicians rarely get managed well — they are the worst at greed and fear.
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Note: this is the last “Best of Aleph Blog” post for a while.? My policy was don’t decide on what’s best for a year.? As it is, given that my posting rate has slowed, these posts may come even more rarely, because there won’t be enough in some three month windows to justify a post.
It is very difficult to get a high real rate of return over a long time.? This article peels apart the math, and brings out the quantitative factors that play a role in the analysis.
Clarifying the return series that I use for my forecasts of future stock market returns, and is it likely for an investor to earn a 3% real return over a long horizon?
Because of underfunding, there will be more cuts. ?Depend on that happening for the worst funds, and at least run through the risk analysis of what you would do if your pension benefit were cut by 20% for a municipal plan, or to the PBGC limit for a corporate plan. ?Why? ?Because it could happen.
This is an underrated report from the US Government, but even it is forced to downplay how the situation is for Social Security and Medicare.? Things aren’t getting better, and time is running short.? The next time I write about this is when the 2018 report comes out.? Until then remember my more recent piece?Notes from an Unwelcome Future, Part 1.
This is timely.? Are US firms too short-term in their orientation? No.? To be more controversial, if companies in the rest of the world imitate the US, they will be better off.? They don’t push the present hard enough, and the great long-term returns don’t materialize as a result.
This was a fun piece to write.? It is a high quality problem (usually), but the rules are the opposite for firms with undervalued stock, which is more common.
Often it takes time for an investment thesis to work.? Thus, look at old ideas that have gone nowhere… maybe the work is about to pay off.? Also, other ways to find ideas to buy.
How to think about asset credit risk for financial institutions.? Also, why a “brain dead” 10% leverage proposal for banks is a bad idea, and really not a conservative idea at all.
Supposedly Hank Greenberg said that to Warren Buffett at one point.? This was written when BRK wrote a huge retroactive cover for AIG, capping prior bad underwriting decisions.
Why the main municipal pension fund in South Carolina ran into troubles, and what lessons we can learn from that.? (Put on your peril-sensitive sunglasses before reading this…)
Fertility doesn?t turn on a dime. ?When women conclude that the rewards of society (money, power, approval of peers) go to those with fewer children, that?s a tough cultural idea to overcome. ?I would conclude that it will take a lot longer than a single five-year plan to turn around birthrates in China? if they can be turned around at all. ?All across Asia, marriages happen at lesser rates, happen later, and produce fewer children. ?China is one of the more notable examples.
A lot of people got skinned by the bankruptcy of Horsehead Holdings, which was unfair to stockholders, but sadly, legal.? That said, those that owned the company missed several significant points regarding risk control, and that is why they lost.
On a rare time that I agree with Paul McCulley — we both think the Fed in general should not invert the yield curve.? Also, how the Fed could be genuinely independent, unlike their “independence” that they talk of presently.
It ain’t all dirty, and it ain’t all clean.? Sometimes non-GAAP is a correction, and sometimes it is abusive of economic reality.? You have to analyze it carefully.
Remember, earnings estimates are off of non-GAAP earnings.? Do not confuse them with prior GAAP earnings for making an estimate of the growth in the value of corporations.
“What municipalities lose businesses and people? ?Those that treat them like milk cows. ?Take a look at the states, counties and cities that have lost vitality, and will find that is one of the two factors in play, the other being a concentrated industry mix in where the dominant industry is in decline.
The more a municipality tries to milk its businesses and people, the more the businesses begin to hit their flinch point, and look for greener pastures. ?With the loss of businesses and people, they may try to raise taxes to compensate, leading to a self-reinforcing cycle that eventually leads to insolvency.”
“Money does not flow into or out of assets. ?When a stock trade happens, shares flow?from one account to another, and money flows the opposite direction, with the brokers raking off a tiny amount of cash in the process. ?Prices of assets change based on the relative desire of buyers and sellers to buy or sell shares near the existing prior price level. ?In a nutshell, that is how secondary markets work.”
For about two months, I wondered when I would write this.? Now I know… I’m writing it now.? To all my readers, I am letting you know that Aleph Blog is not ending, but it is changing.? I accepted a writing assignment with The Balance.? I am going to write 4-5 articles for them per month, and correct some old articles as well.? I will publish links to them here.? Like Aleph Blog, The Balance is free, so you don’t have to do anything more than click on the article link here to read it.
Why did I do this?? I felt I was getting stale in my writing.? I was a little bored; that’s why I wasn’t writing so much.? I had completed all of my main goals for the blog in 2014, and slowly lost the will to keep cranking it out.
The deal with The Balance is like theStreet.com in that I get compensated.? It is not like theStreet.com in three ways.
I write primarily in the third person, like a journalist.
They don’t want any stock picks.
They assign me topics to write on, and I pitch ideas to them, which they must approve before I write.
I like it.? It forces me to learn new things and write in a new way outside of my comfort zone.? It is a challenge.
I will still write some pieces natively for Aleph Blog, but most of what you will see here will be lead-ins to my articles at The Balance.? I will personalize them here, and say things that I can’t say there, because here I don’t have to be neutral.
Let me simply say here that I am not crazy about Private Activity Bonds [PABs], and municipal bonds generally.? If you have a long enough time horizon to buy and hold a muni bond 20-30 years, then you may as well own stocks.? Aside from that, these aren’t municipalities paying on the PABs — these are private corporations.? It is a “heads they win, tails you lose” situation in many cases.? The credit risk level is higher than an equivalently rated muni.? So, buyer beware, and stick to investments that are simple, because complexity favors the financial structurer, not the buyer of the note that is a part of the financial structure.
But maybe I am wrong.? If you think I missed something, let me know in the comments.
In general, I think there is?no?value in preparing for the ?total disaster? scenario if you live in the developed world. ?No one wants to poison their own prosperity, and so the?rich and powerful?hold back from being too rapacious.
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The sun will rise tomorrow, Lord helping us? so?diversify and take moderate risks most of time.
After a certain point, additional risk reduces returns, because average people cannot stomach making the tough decisions when things are too good, or things are too bad.
My modified “Fed Model” as a measure of the equity premium inherent in the well-known Dividend Discount Model applied to the market as a whole.? Then I break the equity premium apart into three concepts that are simpler to understand.
My take on the Brexit, before and after the vote.? It is still my opinion that Britain is better off outside the EU, and that the worries regarding it remain overblown.
On another type of charlatans, the political sorts.? Two of the few things I had to say prior to the elections in 2016 — the first one about how the problems were bigger than the government could solve, yet the politicians would still promise solutions.? The second was in the same vein, but at greater length.
Last set of charlatans, the ones at the Fed.? Using money finance has always led to bad results.? Much as I think the Fed talks about monetary policy lags, and then acts like they don’t believe that, that is a small error compared to helicopter money.? (This one got me a 15-minute interview on an English-speaking financial radio in Seoul, Korea.)
Two real long-term problems that our world will have to face.? High private and governmental debt around the world, which may lead to some weak nations defaulting on dollar-denominated debt.? “Weak parts of the Eurozone and Japan are possibilities, along with a number of emerging markets.”? Pensions are another issue, and most of the news globally is depressing.? So much for not having children and not saving.
Though I always consider illiquidity to be a risk factor, for the economy as a whole, liquidity is overrated.? Public policy should not be geared to making all/more assets tradable.? Things that are genuinely illiquid should remain so, lest you have financial crises like the recent housing bubble, where too much money was lent against illiquid assets.
Actual asset performance is more important than liquidity. Analyze your investment selections carefully.
The first two articles on The Economic Philosopher’s stock valuation model that I have written.? As an update, the market is currently priced for a 3.8%/year return over the next ten years, not adjusted for inflation.? This is the best model available on future returns, bar none.
“My advice to you tonight is simple. ?Be skeptical of complex approaches that worked well in the past and are portrayed as new ideas for making money in the markets. ?These ideas quickly outgrow the carrying capacity of the markets, and choke on their own success.”
It is possible to over-save, and underspend.? You should leave some inheritance for your heirs, but don’t deprive yourself of the benefits that having some assets provides.
In general it is better to take payments over time than to receive it as a lump sum.? If you do have a lump sum that comes to you, take care not to spend it too rapidly.
How would you live if you were trapped in Venezuela, Turkey, Zimbabwe, or some other badly run country with high inflation.? Here are a few bits of advice.
Truly gruesome.? What’s the difference between what a buy-and-hold investor earned on Ken Heebner’s main fund versus what the average investor earned on the fund?? Really, it’s astounding.
Over time, all classes of risky assets tend to become correlated with each other.? This is because investors naively diversify their risky assets across these classes, and then engage in panic selling behavior with all of these classes as a group.
As the yield curve steepens, more investment opportunities become uneconomic.? Don’t say that monetary policy is accommodative when you are tightening.
At Christmas, the Wall Street Journal republishes a vacuous opinion piece by Vermont Royster that is little better than liberation theology for conservatives.? He twists Scripture out its contexts to make it mean what is never meant.? Bogus beyond measure.
