David Merkel – Page 269 – The Aleph Blog

Eleven Notes on our Cantankerous Credit Markets

Posted on 5 April 2008 by David Merkel

1) Note to small investors seeking income: when someone friendly from Wall Street shows up with an income vehicle, keep your hand on your wallet.? One of the oldest tricks in the game is to offer a high current yield, where the yield can get curtailed through early prepayment (typically in low interest rate environments), or some negative event that forces the security to change its form, such as when a stock price falls with reverse convertibles.? Wall Street only gives you a high yield when they possess an option that you have sold them that enables them to give you the short end of the stick when the markets get ugly.

2) When times get tough, the tough resort to legal action.? Financial Guarantee Insurance contracts are complicated, and the guarantors will do anything they can to wriggle off the hook, particularly when the losses will be stiff.

3)? The loss of confidence in financial guarantors has not changed the operations of many muni bond funds much.? With less trustworthy AAA paper around, many muni managers have decided that holding AA and single-A rated muni bonds isn’t so bad after all.? Less business for the surviving guarantors, it would seem.

4) Jefferson County, Alabama.? Too smart for their own good.?? So long as auction rate securities continued to reprice at low rates, they maintained low “fixed” funding costs from their swapped auction rate securities.? But when the auctions failed, the whole thing blew up.? There will probably be a restructuring here, and not a bankruptcy, but this is just another argument for simplicity in investment matters.? Complexity can hide significant problems.

5) Spreads were wide one week ago, even among European government bonds, and last week, as these two posts from Accrued Interest point out,? we had a significant rally in spread terms last week.? Now, credit can be whippy during times of stress, and there are often many false V-like bottoms, before the real bottom arrives.? Be selective in where you lend, and if the sharp rally persists for another few weeks, I would lighten up.? That said, an investor buying and holding would see spreads as attractive here.? When spreads are so far above actuarial default rates, it is usually a good time to buy.? I would not commit my full credit allocation here, but half of full at present.

6)? I don’t fear ratings changes, if that is the only thing going on, and there is no incremental credit degradation, or increased capital requirements.? But many investors don’t think that way, and have investment guidelines that can force sales off of downgrades that are severe enough.? Personally, I think Fitch is best served being as accurate as possible here; they don’t have as large of a base to defend, as do S&P and Moody’s.? So, if downgrades are warranted, do them, and then make the other rating agencies justify their views.

7) I have not been a fan of the ABX indices, and I thought it was good that an ABX index for auto ABS did not come into existence.

8) So what is a auction rate security worth if it is failing?? Par?? I guess it depends on how high the coupon can rise, and the debtor’s ability to pay.? It was quite a statement when UBS began reducing the prices on some auction rate securities.? Personally, I think they did the right thing, but I understand why many were angry.? A complex pseudo-cash security is not the same thing as owning short-term high-quality debt.

9) Then again, there are difficulties for the issuers as well, particularly in student loans.? Not only are costs increased, but it is hard to get new deals done.

10)? GM just can’t seem to shake Delphi.? In an environment like this, where liquidity is scarce, marginal deals blow apart with ease, and even good deals have a difficult time getting done.

11)? Regular readers know that I am not a fan of most complex risk control models that rely on market prices as inputs. My view is that risk managers should examine the likely cash flows from an asset, together with the likelihood of the payoff happening.? With respect to bank risk models, they were too credulous about benefits of diversification, as well as what happens when everyone uses the same model.? Good businessmen of all stripes focus on not losing money on any transaction; every transaction should stand on its own, with diversification as an enhancer in the process.

Dropping Subscriptions

Posted on 5 April 200822 June 2017 by David Merkel

When I was younger, twenty years younger, I subscribed to the WSJ, Forbes and Barrons.? Though I am retaining my subscription to the WSJ (my wife wants it for one of my older sons), I am letting my subscriptions to Forbes and Barrons lapse.? What good that they do, I can get online.? (I will probably keep my Barrons Online, but dump WSJ Online.)

I just don’t get enough from Forbes to justify reading it anymore.? Their lists are a convenient way to fill space, and the advertising to articles ratio is high.? I like Barron’s, but I can read it online.? As for the Wall Street Journal Online, it may already be free.

I learned a lot from all of these publications when I was younger, but time is shorter now, and I get more information from online sources at present.

Shelter Fallout

Posted on 4 April 2008 by David Merkel

Though sometimes I do posts that are a melange of different items that have caught my attention, I do try when possible to gang them up under a common theme.I try not to do “linkfests” because I want my readers to get a little bit of interpretation from me, which they can then consider whether I know what I’m talking about or not. Anyway, tonight’s topic is housing. I didn’t get to my monetary policy 101 post this week — maybe next week. I do have three posts coming on Fed policy, credit markets, and international politics/economics. (As time permits, and ugh, I have to get my taxes done…. 🙁 )

1) The big question is how much further will housing prices fall, and when will the turn come. My guess is 2010 for the bottom, and a further compression of prices of 15% on average. Now there are views more pessimistic than that, but I can’t imagine that a 50% decline from the peak would not result in a depression-type scenario. (In that article, the UCLA projections are largely consistent with my views.) It is possible that we could overshoot to the downside. Markets do overshoot. At some level though, foreigners will find US housing attractive as vacation/flight homes. After all, with the declining dollar, it is even cheaper to them. Businesses will buy up homes as rentals, only to sell them late, during the next boom.
2) But, the reconciliation process goes on, and with it, losses have to go somewhere. In some cases, the banks in foreclosure refuse to take the title. Wow, I guess the municipality auctions it off in that case, but I could be wrong. Or, they let the non-paying borrowers stay. I guess the banks do triage, and decide what offers the most value to act on first, given constraints in the courts, and constraints in their own resources. Then again, developers can reconcile the prices of the land that they speculated on to acquire. In this case, cash is king, and the servant is the one that needs cash. I just wonder what it implies for the major homebuilders, with their incredible shrinking book values. Forget the minor homebuilders… Can one be worse off? Supposedly my father-in-law’s father lost it all in the great depression because he was doing home equity lending. There are wipeouts happening there today as well. Add in the articles about unused HELOC capacity getting terminated (happened to two friends of mine recently), and you can see how second-lien lending is shrinking at just the point that many would want it.

3) The reconciliation process goes on in other ways also. Consider PennyMac, as they look to acquire mortgage loans cheaply, restructure, and service them. Or, consider Fannie and Freddie, who are likely to raise more capital, and expand their market share (assuming guarantees don’t get the better of them). Or, consider the Fed, which has tilted the playing field against savers, and in favor of borrowers, particularly those with adjustable rate loans. No guarantee that the Fed can control LIBOR, though…

4) The reconciliation process steamrollers on. We’ve seen Bear Stearns get flattened trying to pick up one more nickel, and maybe Countrywide will get bought by Bank of America, but you also have banks with relatively large mortgage-lending platforms up for sale as well, like National City. Keycorp might bite, but I’ve seen Fifth Third rumors as well. Then there is UBS writing down their Alt-A book, along with a lot of other things.

5) A moment of silence for Triad Guaranty. A friend of mine said that they were the worst underwriter of the mortgage insurers. Seems that way now. Another friend of mine suggested that MGIC would survive off of their current capital raise. They stand a better chance than the others, but who can really tell, particularly if housing prices drop another 15%.

6) Beyond that, the financial guarantors have their problems. FGIC goes to junk at S&P. MBIA goes to AA at the operating companies, and single-A at the holding company at Fitch. I personally think that both MBIA and Ambac will get downgraded to AA by S&P and Moody’s. I also think that the market will live with it and not panic over it. That said, BHAC (Berky), Assured Guaranty, and FSA (Dexia) will get to write the new business, while the others are in semi-runoff.

7) Now for the cheap stuff. Amazing to see vacancy rates on office space in San Diego rising. I think it is a harbinger for the rest of the US.

8 ) Buy the home, take the copper, abandon the home, make a profit. Or, just steal the copper.

9) Bill Gross. A great bond manager, but overrated as a policy wonk. Many would like to see home prices rise, but others would like to buy a home at the right price. How do we justify discriminating against those who would like to buy a cheap house?

10) “The prudent will have to pay for the profligate.”? Well, yeah, that is much of life, in the short run.? In the long run, the prudent do better, absent aggressive socialism.? The habits of each lead to their rewards, and the ants eventually triumph over the grasshoppers.

Why I Don’t Think the Troubles in Financials are Over Yet

Posted on 4 April 20084 April 2008 by David Merkel

When I was a investment grade corporate bond manager back in 2002, there were three “false starts” before the recovery began in earnest. The market started rallies in December 2001, August 2002, and October 2002. I remember them vividly, and I behaved like the estimable Doug Kass during that period, buying the dips, and selling the rips.

In this bear market for the financials, we are only through the first leg down. Here is what remains to be reconciled:

Residential housing prices are still too high by 10-20% across the US on average.
The same is true of much of commercial real estate.
The mortgage insurers have not failed yet. Triad Guaranty is close, but at least two of them need to fail.
There is still too much implicit leverage within the derivative books of the investment banks.
Too many credit hedge funds and mortgage REITs are left standing.

I have tried to avoid being a pest on issues like these, but the overage of leverage has not been squeezed out yet.

Feeding on Fed Funds

Posted on 3 April 200822 June 2017 by David Merkel

One of my Finacorp colleagues pointed me to some Fed funds data yesterday, and it made me want to write an article. He pointed out something that looked anomalous about the way Fed funds is trading, namely, that on many days in the last month, that some trades are going on where some banks out there are accepting almost zero for the rate on investing excess reserves.

Let me back up. We talk about Fed funds all the time, but we don’t often stop to talk about what it means. Banks and thrifts have to keep non-interest bearing reserve funds at the Fed. Those funds can be deposited by the depositary institution at the Fed, or, they can borrow the funds from another institution that has excess funds deposited at the Fed. Thus there is an active lending market between banks for reserves deposited at the Fed. The weighted average rate at which these overnight loans get done is called the effective federal funds rate.

The Fed influences where Fed funds trades through open market operations, where they lower the Fed funds rate by increasing the supply of reserves to the system through temporary repurchase transactions, and outright purchases of securities through the creation of new credit, thus expanding its balance sheet (a permanent injection of liquidity). The Fed raises the Fed funds rate by decreasing the supply of reserves to the system through temporary reverse repurchase transactions, and outright purchases of securities which reduces credit, and shrinks the balance sheet of the Fed (a permanent reduction of liquidity — rare).

All the guessing games that go on around FOMC meetings today, revolve around the Fed funds target rate. That’s the rate the the Fed in the short run says that it will try to keep the effective Fed funds rate at, primarily through temporary measures using repurchase and reverse repurchase transactions.

Back to the Present

Since August 1993, the high and low transaction yields for Fed funds each day have been recorded. The following graph shows the high, low, and effective Fed funds rate from then until the present.

As you can see, the difference between the high and low for Fed funds on a given day can be substantial.? Most commonly the big ranges happen near the end of accounting periods, or at minor financial panics, whether for legitimate reasons (LTCM, 9/11), or dubious reasons (Y2K).? In any case, there can be a scramble for overnight fed funds, leading to a very large high rate for the day.? Conversely, there can be a very small low rate for the day when enough institutions have significant excess funds to lend at Fed funds, and few takers at some point during the day.

That range between high and low Fed funds can be quite large, as you can see in the following graph.? In order to show the persistence of the range, to flatten out the influence of disasters, and quarter- and year-ends, I threw in a 22-day moving average, which is meant to approximate the rolling monthly average.

In this present environment, I am most concerned with how low Fed funds trades on a daily basis.? Since that is a noisy figure as well, I applied a 22-day moving average there.

The range for Fed funds trading is high on a monthly average basis, butnot as high as it was at points back in the mid-90s. Short-term interest rates were higher then, so there was more room on the downside for the range to expand, which is not possible today.? What is unusual now is that the low trade for Fed funds is averaging near the levels achieved during the wondrous 1%-1.25% Fed funds rate policy that the Greenspan Fed instituted from late 2002 to mid-2004.

In the midst of a period where liquidity is so scarce, we have a situation where some banks are having a hard time getting a good yield from Fed funds.? To summarize the situation, look at my final graph:

This is a scatterplot to show how the moving averages for low Fed funds varies against the range for Fed funds.? The diagonal line is there for convenience to show where the moving averages for the range and the low would be equal.? Back during the 2002-2004 era, though rates were low, Fed funds traded in a tight band.? In the mid-90s, rates were higher, but we had occasional periods where the range would explode for accounting or crisis reasons.

Now we are in a period where we have a volatile range for Fed funds amid low rates.? This is unusual.? I’m open to new ideas here, but it seems that the liquidity situation in Fed funds is volatile enough that some banks end up snapping at low yields at some point each day.? Just another piece in a difficult policy period for the banks and the Fed.? If I have to speculate, it indicates that some banks are already awash in liquidity, and aren’t sure what to do with it.

The Economics of SFAS 157

Posted on 2 April 20082 April 2008 by David Merkel

I’m not crazy about flexible accounting standards because they destroy comparability across companies, with perhaps a gain in accuracy within companies. We’ve had a lot of noise in the blogosphere recently regarding the SEC allowing companies to ignore prices if they are the result of forced sales or tax-loss selling. You might expect me to say that the SEC is nuts again. You would be wrong.

I am aware of reasons there are economic for one party to sell, that do not appeal to the bulk of investors, and I have seen forced sales for tax and other reasons. Even with those sales, the market is thin. Almost every transaction is special; trades are by appointment only, unless someone offers a humongous bargain for immediate liquidity. I have seen this in the market myself, and seen management teams struggle with how to price an illiquid bond when tax loss sellers bomb the market at the end of a year

So, when I read facile pieces suggesting that FAS 157 has been gutted, (and here) I just groan. With level 3 assets, the markets must be very thin, not nonexistent. Prices in a thin market rarely represent the net present value of the future cash flows to the average market participant.

Also, one should realize that SFAS 157 merely cleans up the rules for how assets are to be valued under SFAS 133. Calculating “fair value” is often hard, though unscrupulous managements will take advantage of that flexibility. At least we have rules to determine when we use market prices, figures that derive directly from other market prices, and figures where a discounted cash flow analysis, or something like it must be employed.

Was the move of the SEC a big help? A help, yes, but a wee one. Companies could already under SFAS 157 make the argument that the SEC blessed. The SEC simply makes that argument easier.

All that said, I don’t think that SFAS 157 has that much economic impact, compared to the way firms finance themselves. A loss of liquidity does far more damage than volatility in earnings results, unless there are debt covenant violations.

In the end, I am saying that there is an issue here, but it is not a big one. Better that companies in trouble would lower their leverage, and finance long-term, which costs more in the short run but preserves the company to fight another day.

Seven Notes on Equity Investing

Posted on 1 April 2008 by David Merkel

1) A lament for Bill Miller.? Owning Bear Stearns on top of it all is adding insult to injury.? Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.? I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.? During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.? When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.? What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.? The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)? Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.? Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.? What a concept amid falling housing and equity prices.? Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.? My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.? I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.? When there are problems, major economic actors are not passive; they look for solutions.? That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.? It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.? Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.? These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.? They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.? They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.? When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.? But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.? Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.? Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.? But without fully invested conventional wisdom, contrarianism has little to fight.

Federal Office for Oversight of Leverage [FOOL]

Posted on 1 April 20081 April 2008 by David Merkel

I want to go back to an article that I wrote early in the history of this blog, when nobody read me except a few RealMoney diehard fans — Regulating Systemic Risk From Hedge Funds.? It was a critique of the ?Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.?? Yes, the “shadowy” President?s Working Group on Financial Markets.? Some will call it the “Plunge Protection Team.”? Well, if they are that, they are certainly not playing up to their billing.? As an aside, I tend not to believe in conspiracy theories, because most bad plans of our government don’t require them.? As Chuck Colson pointed out regarding the Nixon Administration and Watergate leaks — he felt that information tightness in the Nixon White House was so effective, that if a conspiracy could work, it would have worked there.? (Since it didn’t work, and the information leaked out, it had a surprising effect on Colson’s life, as he concluded that the disciples of Jesus (Y’Shua) could not have conspired to steal the dead body, hide it, and fake a resurrection.? But that’s another story.)?? Suffice it to say that I don’t think the government intervenes in the major financial markets of our country — there would be too many accounting entries to hide, and someone would have a real incentive to leak the information, or write a book about it.

Going back to my article, I tried to point out the difficulty of gathering data and analyzing it.? It was also somewhat prescient as I said, “Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won?t do them; they are friends with too many people who benefit from the current setup. If they won?t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.”

There is another reason why they would not act then, as I had pointed out at RealMoney over the years.? Bureaucrats are resistant to offering changes where if thy would get harmed if the changes led to a market panic.? Once the market panic starts, they can move with greater freedom, because no one will be able to tell whether changes imposed during the panic intensified the panic or not.

So, color me skeptical on efforts to monitor and control systemic risk.? It would be very hard to do effectively, and there are too many powerful interests against it.? Also, it would be difficult to get the gross exposure data necessary for inhibiting crisis, because many financial instruments would have to be split in two or more pieces.

As to the articles I have read on Treasury Secretary Paulson’s plan, they divide into credulous (one, two), mixed, and skeptical/hostile (one, two).? Let me simply observe that any plan for the control of systemic risk has to overcome:

Political opposition
Lack of effective data
Lack of an effective model
Lack of willingness to implement the conclusions generated by the staff/modeling
Inter- and Intra-agency disagreements
Data and action lags

If it is already difficult for the Fed to implement contracyclical monetary policy, just imagine how difficult it will be for them to deal with a problem that is far more tricky because of its multivariate nature.? Imagine them trying to analyze the effects from currencies, commodities, operating businesses, credit, ABS, RMBS, CMBS, equity-related businesses, counterparty risk, etc.? This is not trivial, and Paulson I suspect knows it all too well, which has led him to make a modest proposal that will likely not be effective, but will likely run out the shot clock for the Bush administration, leaving the issue for the next President to deal with.

The Fed is not by nature an activist institution, and it would have to become far more activist in order to effectively regulate the bulk of all financial institutions in the US.? I don’t see it happening.

As an aside, I am ambivalent about Federal regulation of insurance, and this RealMoney article of mine still expresses my views adequately.? Still, it would make sense to hand over oversight of financially sensitive insurers, such as the financial guarantee insurers and the mortgage insurers to the Feds, together with whoever oversees the ratings agencies.? An integrated solution is preferable.? (I still like my proposed name for the new regulator, “Federal Insurance Bureau” [FIB… well, it can’t be the FBI].

As for some of the fog that a regulator of investment banks would exist in, consider these two articles on hedge fund distress.? What affects the hedge funds, affects the investment banks.? They are symbiotic.

As a joke, given that it is the first of April, if we do get a regulator for overall financial solvency and systemic risk, I believe it should be called the Federal Office for Oversight of Leverage [FOOL].? After all, I think it is taking on a fool’s bargain.

Two Monetary Policy Graphs for the Evening

Posted on 29 March 200830 March 2008 by David Merkel

A few notes before I begin this evening. I tried posting twice, but my system failed twice, and the auto-save did not do its job faithfully. So, one reduced post, if I can get it out. Next week, I should publish a small primer on how monetary policy works. Also coming up is my next portfolio reshaping.

Well, there is certainly no more stigma in borrowing directly from the Fed. Just look at the discount window:

That’s a new record since the beginning of my data (1980), and more than doubles the last peak in 2001.

The following graph (look at the lower green graph) is the ratio of my M3 proxy (Total Bank Liabilities) to high-powered money (Total Fed Credit, the Monetary Base).

This ratio measures the willingness of the Fed to allow the banking system to lever up their deposit base relative to the size of the Fed’s own balance sheet. The data only goes back to 1980, but we are knocking at the door of a new high. The recent move up began in earnest at the beginning of the last tightening cycle, but has persisted into the loosening cycle, as the FOMC has not let the monetary base grow, but has permitted the banks to continue to gather deposits (banking, savings, CDs, money market funds). Some capital requirements have been loosened, and I suspect the bank examiners are not playing hardball at present, at least compared to the attitude 18 months ago.

After all, the banks don’t have to pay much interest to those who deposit money with them with a curve this low and steep, and many people are afraid of the equity markets, and are letting balances at the banks grow. The banks get cheap funding, and they use it to buy short-duration agency RMBS yielding 3-4%, which is a winner, at least for now.

Book Review: 7 Commandments of Stock Investing

Posted on 28 March 200812 February 2011 by David Merkel

For those that read my book reviews, let me simply say that unless I say that I skimmed a book, I read every book that I review, and I don’t use the publishers notes to aid me, as many other reviewers do. I just give you my opinion straight, even if I didn’t like it, realizing that there will be no commissions at my Amazon Store from that review. And that is fine with me. I review new and old books — I just want to point my readers to what I think is good, and away from the bad stuff.

I would also add that my Amazon Store is my equivalent of the tip jar. If you value my writing, when you need to buy a book from Amazon, simply start by clicking on a book on my leftbar, and buy the books that you would buy anyway. It doesn’t increase your costs at all, and I get a small commission.

Anyway, onto tonight’s book review. I am genuinely not sure what to conclude on “7 Commandments of Stock Investing.”? There was much that I liked, and much I did not.? I know that Mr. Marcial wrote a column for Business Week for many years, but that was not something I followed closely.? This is my first real introduction to his thought.

Let me take his seven principles, and go in order:

Buy Panic –? Hey, I can go for that.? The difficulty for average investors, and even many seasoned investors is that they buy too soon in a panic.? One also has to focus on companies that are high credit quality in order to avoid big losses.? That got some attention in the book, but not enough for me.

Concentrate, Diversify Not — Ugh, I like having 35 companies in my portfolio, because I concentrate industries.? To the extent that you concentrate, you must have superior knowledge of the companies that you own.? Without that knowledge, the average investor should diversify more, and investors with no special knowledge should buy index funds.

Buy the Losers –? Again, I can go for this, but it takes a special person to separate out the companies that will crater from the companies that have a sustainable business model and will bounce.? Buying quality companies is a must here, or else you can lose a lot.

Forget Timing — I agree.? I keep roughly the same equity exposure all the time, and my rebalancing discipline helps protect me as well.

Follow the Insider –? That’s a good principle, but I’m not sure that it should rank so highly in a set of stock picking rules. Insiders do do better than the market as a whole, but using insider purchase and sale data takes discretion to interpret.

Don’t Fear the Unknown –? By this he means have some foreign equity exposure and biotechnology investments.? One of my rules is, “If you can’t understand it, you won’t know how to buy and sell it.”? Getting comfortable with any area of the market that is volatile takes study and effort.? This is not trivial.? As for biotech in particular, that takes a lot of incremental skill that I don’t have.? After reading what Mr. Marcial wrote, I would not feel confident investing there.

Always Invest for the Long Term: Seven Stocks for the Next Seven Years — He employs a multi-year holding period, like I do, and then points out seven stocks that he thinks will do well.? I’m not going to spoil that part of the book by mentioning any of the seven, but none of them interest me.? (Well, maybe one or two at the right level.)? All of them are large caps, and are quality companies.

Quibbles

Under his first principle, he recommends buying the stock of the company that you work for when it gets hammered down (page 8).? Unless you are an industry expert here, be careful… you are compounding your risks, because your wage income derives from the health of the firm.? Don’t put your savings there too, unless you are dead certain.? (Full confession: I put one-third of my net worth on the line on my employer, The St. Paul, in March of 2000, selling in August of 2000.? Great trade, but no one else knew in the firm did it.)

On page 62, calling Primerica the predecessor firm to Citigroup is a bit of a stretch.? Yes, I know how the case could be made, but there were links in the chain where the smaller company was acquired by a larger one, and the smaller company came to dominate the management of the combined firm.

Under his third principle, he favored GM and Ford.? I can’t support buying such credit quality impaired investments under the rubric of “Buy the Losers.”? These are two companies that will have a hard time surviving in their present forms.? Motorola would be another example… a pity there is such a lag between writing and publication.

Summary

The book is intelligently written, and is short enough for an average person to read in 4 hours (188? pages).? He gives plenty of examples to illustrate his points.? I wasn’t usually enthused by the companies that he chose — I prefer to go further off the beaten path, and buy them cheaper.

His basic principles are good principals to follow, but they need to be tempered by a focus on risk control.? It’s one thing to serve up investment ideas as a writer — you can throw out a lot of promising ideas, and do it well.? What is tough is owning the companies, and trading through their troubles.? That’s a dirtier business; one where average investors will be more prone to fear and greed, and may not do so well, just because they can’t stomach the risks.

He also does not make clear how the seven principles work together. Need you follow all seven on every investment?? I think that’s what he is saying.

Away from that, you can’t use his principles on low quality stocks; that would be a recipe for regular large losses.? Buying panic, buying weakness, and concentrating requires a high quality approach to investing.

With that, I recommend the book to those that have enough maturity to know that they will have to bring their own risk control models to the game.? His methods presuppose a degree of ability in interpreting the fundamentals of companies, so I do not recommend this book to beginners; it would be a dangerous way to start out in investing.? Better to start with Ben Graham.

Full disclosure: If you buy this book, or any other book through the links on this page, then I get a small commission.