Industry Rotation – Page 15

Dealing with Underperformance

Posted on 7 August 20077 August 2007 by David Merkel

Over the past seven years, my broad market strategy done well against the S&P 500. I reach the seven year anniversary at the end of August, and should business prospects require it, I will get the results audited. But since the start of the quarter, the strategy has not done so well, trailing the S&P by a little less than 4%. Why have the results been so bad?

My portfolio has concentrations in a number of areas. I have a slight overweight in financials (though only one company affected by the current crises), a large overweight in energy, and an overweight in cyclicals, though cyclicals targeted at foreign demand, not US demand. These areas have underperformed, and so have I. Industries are 60% of the performance of the market in my opinion, so when you run a portfolio that concentrates industries, there will be periods of underperformance.

Value is out of favor at present as well. My approach is “all cap” value; I don’t care about the size of companies that I buy. I’m only 2% or so behind the Russell 1000 Value, but I am more than 4% ahead of the Russell 2000 Value. Small cap value has gotten smashed, and I am a partial casualty along with it.
So, maybe I’m not doing that badly. What I do at times like this is to try to identify the factors leading to underperformance and ask whether those factors are likely to persist for a year or more. Let me go through my major exposures, updating what I wrote previously:

Energy ? Integrated, Refining, E&P, Services, Synfuels. I am still a bull here; we aren’t finding enough energy supplies to meet the needs of our growing world. (15%)
Light Cyclicals ? Cement, Trucking, Chemicals, Shipping, Auto Parts. These areas are undervalued, given the way our world is growing. (20%)
Odd financials ? European banks, an odd mortgage REIT [DFR]. Largely insulated from the credit crises, and cheap. (10%)
Insurance — AHL, AIZ, SAFT, and LNC. All of them cheap, and with good earnings prospects. (10%)
Latin America ? SBS, IBA, GMK. All are plays on the growing buying power in Latin America. (8%)
Turnarounds ? SLE, JNY. Give them time; Rome wasn?t burnt in a day. (5%)
Technology ? NTE, VSH. Stuff that is not easily obsoleted. (5%)
Auto Retail ? LAD, GPI. Out of favor. (5%)
Cash (15%) — 5.25%/year is not bad.

That’s 93% of my broad market portfolio. Three other miscellaneous companies make up the rest. You can find the complete portfolio here.
After writing this, my tentative conclusion is that my methods still work, but that I am fighting temporary setbacks from value being out of favor, and from financials getting taken out and shot, even if there is no connection to the current credit crises. Therefore I soldier on, trusting the methods that have brought me this far.

Full disclosure: long LAD GPI NTE VSH SLE JNY SBS IBA GMK AHL AIZ SAFT LNC DFR

Portfolio Notes — July 2007

Posted on 19 July 200720 July 2007 by David Merkel

I have three portfolios that I help manage. They are listed over at Stockpickr.com. The big one is insurance stocks, where I serve as the analyst, and have a lot of influence over what is selected, but don’t make the buy and sell decisions. The second is my broad market fund, over which I have full discretion. The last is my bond fund, which doesn’t have an independent existence, but fills the fixed income role for the two balanced mandates that I run, in which the broad market fund serves as the equity component. I’m going to run through each portfolio, and hit the high points of what I think about my holdings. Here we go:
Bond PortfolioI sold our last corporate loan fund in early June. We made a lot of money off these over the past two years as LIBOR rose, and the discounts to NAV turned into premiums. New issuance of corporate loans has been more poorly underwritten. I’m not coming back to the corporate loan funds until I see high single digit discounts to NAV, and signs that credit quality is flattening from its recent decline.

The portfolio is clearly geared toward preservation of purchasing power. We have TIPS and funds that invest in inflation-sensitive bonds [TIP, IMF]. We have foreign bonds [FXC, FXF, FXY, FAX, FCO]. The Yen and Swiss Franc investments are there as systemic risk hedges. The Canadian bonds and the two Aberdeen funds are there for income generation. If energy stays up, Canada might never need to borrow in the future. I also have a short-term bond fund [GFY] trading at a hefty discount, and cash. Finally, I have a speculative deflation in long Treasuries. [TLT]

This is a very eclectic portfolio that has done very well over the last 24 months. This portfolio will underperform if any of the following happen:

Inflation falls
The dollar strengthens
The yield curve steepens amid the Fed loosening
Credit spreads tighten

The Broad Market Portfolio

There are four things that give me pause about RealMoney. First, there is a real bias toward sexy stocks, and commonly known stocks. That bias isn’t unusual; it plagues all amateur investors. Two, few players talk about bonds, and how to make money from them, as well as reducing risk. Three, almost everyone trades more than me. Finally, there is a “home turf” bias, where everyone sticks to their niche, whether it is in favor or not.

I try to be adaptive in my methods through careful attention to valuation and industry rotation. Underlying all of it, though, is a focus on cheap valuations. There are seven summary categories here at present, and then everything else. Here are the categories:

Energy — Integrated, Refining, E&P, Services, Synfuels. I am still a bull here.
Light Cyclicals — Cement, Trucking, Chemicals, Shipping, Auto Parts
Odd financials — European banks, an odd mortgage REIT [DFR], and Allstate [ALL].
Latin America — SBS, IBA, GMK. All are plays on the growing buying power in Latin America.
Turnarounds — SPW, SLE, JNY. Give them time; Rome wasn’t burnt in a day.
Technology — NTE, VSH. Stuff that is not easily obsoleted.
Auto Retail — LAD, GPI.

So far this overall strategy has been a winner for the past seven years. No guarantees on the future, though. In the near term, rebalancing trades could include purchases of JNY and sales of DIIB and SPW. Beyond that, I am waiting for a week or so to sell my Lyondell. It is possible that another bid might materialize. Allstate is also on the sell block, though, I might just trim a little. What makesme more willing to sell the whole position is the disclosure of an above average position in subprime loans.

Insurance

There is one easy play going into earnings season, and one moderate play. Beyond that, there is dabbling in the misunderstood.

Easy: buy asset sensitive life insurers, ones with large variable annuity, life and pension businesses. Who? LNC, NFS, SLF, MFC, PNX, PRU, MET, HIG, and PFG. Why? Average fees from domestic equities are up 5% over the first quarter, and the third quarter looks even better for now. Guidance could be raised. Away from that, the dollar fell by 2% on average over the quarter, so those with foreign operations (excluding Japan) should do well also, all other relevant things equal.
Moderate: no significant hurricanes so far. Given that there is some positive correlation between June-July, and the rest of the season, are you willing to hazard some money on a calm storm season? With global warming DESTROYING OUR PLANET!!!! (not, this is cyclical, not secular.) If you are willing to speculate, might I recommend FSL? They manage their business well, though they are new.

Beyond that, I would commend to you both Assurant (a truly great company that will survive the SEC), and Safety Insurance (investors don’t get the risks here, they are small, and management is smart).

Summary

Managing portfolios has its challenges. One has to balance risk and reward on varying investments. Sometimes the market goes against you, and you question your intelligence. But good fundamental managers persevere over time, and produce good returns for their investors. That’s what I aim to do.

Full Disclosure: all of my portfolios are listed here.

Late editorial note: where I wrote FSL above, I meant FSR.? Thanks to Albert for pointing the error out.

Ten Important, but not Urgent Articles to Ponder

Posted on 16 July 200717 July 2007 by David Merkel

I am an investor who does not consider background academic and semi-academic research to be worthless, even though I am skeptical of much of quantitative finance. Here are a few articles to consider that I think have some importance.

Implied volatility is up. Credit spreads are up, and the equity market has not corrected. Time to worry, right? Wrong. When implied volatilities (and credit spreads) are higher, fear is a bigger factor; valuations have already been suppressed. Markets that rally against rising implied volatility typically have further rises in store.
Many thanks to those that liked my piece on the adaptive markets hypothesis. Here is a piece about Andrew Lo, one of the biggest proponents of the AMH, which fleshes out the AMH more fully. I would only note that the concept of evolution is not necessary to the AMH, only the concepts inherent in ecological studies. Also, all of the fuss over neuropsychology is cute, but not necessary to the AMH. It is all a question of search costs versus rewards.
John Henry alert! Will human equity analysts be replaced by quantitative models? Does their work have no value? My answer to both of those questions is a qualified “no.” Good quant models will eat into the turf of qualitative analysts, and kick out some of the marginal analysts. As pointed out by the second article analysts would do well to avoid focusing on earnings estimates, and look at other information that would provide greater value to investors from the balance sheet and cash flow statement. (I am looking at Piotroski’s paper, and I think it is promising. He has made explicit many things that I do intuitively.
I work for a hedge fund, but I am dubious of the concept of double alpha. It sounds nice in theory: make money off of your shorts and longs without taking overall market risk. As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade. Typically, hedge fund investors are only good at generating alpha on the long side. The short side, particularly with the crowding that is going on there is much tougher to make money at. If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare).
Maybe this one should have run in my Saturday piece, but some suggest that we are running out of certain rare metals. I remember similar worries in the early 70s, and we found a lot more of those metals than we thought possible then. There is probably a Hubbert’s peak for metals as well, but conservation will increase the supply, and prices will rise, quenching demand.
For those that remember my piece, “Kiss the Equity Premium Goodbye,” you will be heartened to know that my intellectual companion in this argument, Morningstar, has not given up. Retail investors buy and sell at the wrong times because of fear an greed, so total returns are generally higher than the realized returns that the investors recieve.
When there are too many choices, investors tend to get it wrong. When there is too much information, investors tend to get it wrong. Let’s face it, we can make choices between two items pretty well, but with many items we are sunk; same for choosing between two interpretations of a situation versus many interpretations. My own investing methods force me to follow rules, which limits my discretion. It also forces me to narrow the field rapidly to a smaller number of choices, and make decisions from that smaller pool. When I make decisions for the hedge funds that I work for, I might take the dozen names that I am long or short, and compare each pair of names to decide which I like most and least. Once I have done that, numeric rankings are easy; but this can only work with small numbers, because the number of comparisons goes up with the square of the number of names.
Jeff Miller aptly reminds us to focus on marginal effects. When news hits, the simple linear response is usually wrong because economic actors adapt to minimize the troubles from bad news, and maximize the benefits from good news. People don’t act as if they are locked in, but adjust to changing conditions in an effort to better their positions. The same is true in investing. Good news is rarely as good as it seems, and bad news rarely as bad.
This article describes sector rotation in an idealized way versus the business cycle, and finds that one can make money using it. Cramer calls methods like this “The Playbook.” (Haven’t heard that in a while from Cramer. I wonder why? Maybe because the cycle has been extended.) I tend not to use analyses like this for two reasons. First, I think it pays more to look at what sectors are in or out of favor at a given moment, and ask why, because no two cycles are truly alike. They are commonalities, but it pays to ask why a given sector is out of line with history. Second, most of these analyses were generated at a time when the US domestic demand was the almost total driver of economic activity. We are now in a global economic demand context today, and those that ignore that fact are underperforming at present.
Finally, it is rare when The Economist gets one wrong. But their recent blurb on bond indexing misses a key truth. So bigger issuers get a greater weight in bond indexes. Index weightings are still proportional to the range of choices that a bond manager faces. Care to underweight a big issuer because they have too much debt outstanding? Go ahead; there are times when that trade is a winner, and times when it is a loser. Care to buy securities away from the index? Go ahead, but that also can win or lose. If bond indexes fairly represent the average dollar in the market, they have done a good job as a benchmark; that doesn’t mean they are the wisest investment, but indexes by their very nature are never the wisest investment, except for the uninformed.

Well, that’s it for this evening. Let’s see how the market continues to move against the shorts; there are way too many shorts, and too many people wondering why the market is so high. Modifying the concept of the pain trade, maybe the confusion trade is an analogue, the market moves in a way that will confuse the most people.

Portfolio Reshaping Mid-Year 2007, Part 3

Posted on 5 July 200720 June 2017 by David Merkel

Time for my most recent portfolio changes. The reshaping is complete, here is the data file and here are the qualitative details:

Buys

Arkansas Best [ABFS] — Inexpensive, and trucking is out of favor. Trucking should pick up with the economy in the second half of 2007, and as the dollar cheapens, trucking is needed to get the exports to the ports.
Deutsche Bank [DB] — Cheap major European bank. I’m light on financials (though if I lost my restrictions you would see a lot of insurance in my portfolio). 9-10x earnings for the next two years seems too cheap for me. Can they have that much exposure to the same problems faced by Bear Stearns? Maybe, but the valuation compensates for that.
Gruma SA [GMK] — Inexpensive, and a play on the growing middle class in Mexico. Also a play on the growing popularity of Mexican food in the world. I don’t have a lot in consumer staples, so this helps.
Mylan Labs [MYL] — returning to a name I last owned in 1988. Inexpensive generic drugmaker. I have nothing in healthcare, so this diversifies me a little. Generics are unlikely to fare badly as the branded pharmaceuticals should the Democrats win in 2008.

Sales

Sold Komag [KOMG] because of the merger, and the arb premium (amount of incremental gains from holding on until deal consummation) was less than what I could earn in cash.
Sold St. Joe [JOE], and I wish I had sold when one of my colleagues explained their likely troubles to me one month ago. St. Joe is going to have it tough for a while because they don’t have a lot of ways to generate cash, without selling property, and the land market is not as good as it was two years ago.
Sold Sappi [SPP]. The glossy paper market, like other fiber markets faces their share of challenges. Demand is sluggish, and likely to stay that way for a while.
Sold a little of Lafarge [LR]. Still have a position there. It’s had a nice run, so I rebalanced down to my normal target weight.

With these moves, I am back to 35 positions, up from 34. I am running with 16% cash, which is high for me. At the beginning of the year, I reinvested and brought cash down to 5% of the portfolio, but good investment results, combined with rebalancing has brought the cash back, and then some. If the cash hits 20%, I will raise my normal portfolio position size, and move cash to 10% or so. Maybe we get a pullback?

What I did not sell

SPX Corp — the turnaround continues. For now, honor the momentum.
Noble Corp — Hey, I just bought this last during the reshaping; I am not kicking it out so soon, no matter how well it has done.
Sara Lee — the turnaround continues. No momentum here; maybe management will succeed. A few of their ideas seem to be on target.

What I did not buy

Many more entries here. As I worked down my list, I kept saying, “Cheap for a reason… cheap for a reason…”

Too small: Charles and Colvard, PAM Transportation
Don’t care for the industry: Chipmos Technologies, Finish Line, Foot Locker, Encore Wire, First Consulting, Freightcar America, Korea Electric, and Metrogas
Already own something that I like better in its industry, and don’t want to increase exposure: Crystal River and MVC Capital (both interesting, though I like Deerfield better)
Irregular operating history: Optimal Group and Northgate Minerals
Tyco International is not as cheap as the data would indicate because of the recent spinoffs.

After I finish this, I will adjust the portfolio over at Stockpickr.com.
Full Disclosure: Long SPW NE SLE LR GMK DB ABFS MYL

Efficient Markets Versus Adaptive Markets

Posted on 2 July 200720 June 2017 by David Merkel

The Efficient Markets Hypothesis in its semi-strong form says that the current market price of an asset incorporates all available information about the security in question. Coming from a family where my Mom was a successful investor, I had an impossible time swallowing the EMH, except perhaps as a limiting concept — i.e., the markets tend to be that way, but never get there fully.

I’m a value investor, and generally, over the past fourteen years, my value investing has enabled me to earn superior returns than the indexes. A large part of that is being willing to run a portfolio that differs significantly from the indexes. Now, not everyone can do that; in aggregate, we all earn the market return, less fees. The market is definitely efficient for all of us as a group. But how can you explain persistently clever subgroups?

Behavioral finance has been the leading challenger to the efficient markets hypothesis, but the academics reply that behavioral anomalies are not an integrated theory that can explain everything, like the EMH, and its offspring like mean variance analysis, the capital asset pricing model, and their cousins.

Though it is kind of a hodgepodge, the adaptive markets hypothesis offers an opportunity for behavioral finance to become an integrated theory. First, behavioral finance is a series of observations about how most investors systemically misinterpret investment data, allowing for value investors and momentum investors to make money, among others. The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

Consider risk arbitrage strategies for a moment. Arbitrage strategies earned superior returns through 2001 or so, until a combination of deals falling through, and too much money chasing the space (powered by hedge fund of funds wanting smooth returns) made it less worthwhile to be a risk arb. It is like there were too many fishermen in that part of the investment ocean, and the fish were depleted. After years of poor returns money exited the space. Today with more deals to go around, and fewer players, risk arbitrage is attractive again. No good strategy is ever permanently out of favor; after a strategy is overplayed to where the prospects of the assets are overdiscounted, a period of underperformance ensues, and it gets exacerbated by money leaving the strategy. Eventually, enough money leaves the the strategy is attractive again, but market players are slow to react to that, becaue they have been burned recently.

Strategies go in and out of favor, competing for scarce above-market returns in much the same way that ordinary businesses try to achieve above market ROEs. Nothing works permanently in the short run, though as a friend of mine is prone to say, “There’s always a bull market somewhere.” Trouble is, it is often hard to find, so I stick with the one anomaly that usually works, the value anomaly, and augment it with sector rotation and the remainder of my eight rules.

Now, I’m not a funny guy, so my kids tell me, but I’ll try to end this piece with an illustration. Here goes:

Scene One — Efficient Markets Hypothesis

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Nonsense. If there were a twenty dollar bill on the street, someone would have picked it up already.” They walk past, and a little kid walking behind them pockets the bill.
Scene Two — Adaptive Markets Hypothesis, Part 1
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. A little kid walking behind them runs in front of them, grabs the bill and pockets it.

Scene Three — Adaptive Markets Hypothesis, Part 2
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says quietly, “Tsst. Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. He grabs the bill and pockets it. The little kid doesn’t notice.
Scene Four — Adaptive Markets Hypothesis, Part 3
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He grabs the bill and pockets it. No one is the wiser.
Scene Five — Adaptive Markets Hypothesis, Part 4
An economics professor and a grad student are walking along the sidewalk, and the grad student is looking for a twenty dollar bill lying around. There aren’t any, but in the process of looking, he misses the point that the professor was trying to teach him. The professor makes a mental note to not take him on as a TA for the next semester. The little kid looks for the twenty dollar bill as well, but as he listens to the professor drone on decides not to take economics when he gets older.

Portfolio Reshaping Mid-Year 2007, Part 2

Posted on 23 June 2007 by David Merkel

Here are my current industry ratings.? Using my Bloomberg Terminal, I? ran a screen looking for cheap companies in those industries.? The result yielded eight tickers:

ACO CONN GMRK HES NSIT PDE SMRT SSI

I also added in the top 12 tickers from the last time that didn’t make it into my portfolio, and aren’t on the current list.? Here are the tickers:

ABFS [DBK GR] FINL FL GGC HERO [NGX CN] PTSI RADN SNSA URI WIRE

If you have other stock ideas for me, let me know (post a comment!).? Remember that I am a value investor.? I like them cheap.

Aside from any names that readers might give me, my list of possible replacements is done.? All that is left is to run my valuations/technicals model, and think about what to but and sell.? Early next week, I will run those models, and make the decisions by Independence Day.

Portfolio Reshaping Mid-Year 2007, Part 1

Posted on 23 June 200723 June 2007 by David Merkel

Well, the second portfolio reshaping of the year has begun. To refresh your memory on what I do here, you can review this short post. Here are the tickers from my initial stack, candidates to replace my current portfolio:

ABY ACI ACTU AFN APA ARLP ASEI BBG BHP BLX BMI BOW BTU BVN C CBE [CMB PE] CMC CNX CQB [CRY CN] CRZ CTHR CTL CVX CWEI CY DELL DNR DVN DVR EMR EOG EPEX EPL ERF ESV FCGI FCX FRD FRO FRX FSS FST FTO GIFI GMK GMR GSF GVHR GW GYI HHGP HNR IDCC IMMR IMOS INTX IO IR ITW IVAC KAR KEP LRCX LRW [LUN CN] MEOH MGS MKSI MLR MRO MTL MVC NAT NBL NBR NFX NR NRP OMM OPMR PCZ PH PRKR PTEN PVX PWE R RDC RDS RGS RIG RIO ROK RRC RSH S SHOO SPH SPI STZ SU SWKS TAP TLM TPL TSO TX TXI TYC UNT UNTD UPL WCC WDC WFC WIN XTO

If you have ideas, post them in the comment section of this post.? I’ll be running my industry model and an additional screen to generate a few more tickers, and then the comparison to my current portfolio. I should have more later today. Till then.

Nine Business Days Ago

Posted on 15 June 2007 by David Merkel

The most recent closing high in the S&P 500 was on June 4th.? Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.? That’s why I wrote late on Thursday at the RM Columnist Conversation:

	David Merkel
	Bonds and Stocks Decoupling? They were only Together by Accident.
	6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.? In this case, it was the bond market.? Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.? But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.? One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.? Volatile markets scare inexperienced investors into making the wrong moves.? My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.? As I stated in the CC on Friday:

	David Merkel
	Rebalancing Trades
	6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
Forcing a review process at certain price levels
Taking the emotion out of selling and buying
Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.? My methods are designed to be able to cope with volatility and some back smiling.? Why can I go on business trips or vacation and not worry about the markets?? Why don’t I get scared by many of the negative macroeconomic situations out there?? First, I trust in Jesus; my life is not just the markets.? But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.? You’ll get to see how I make choices in my portfolio.? Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.? Have a great weekend.

Full Disclosure: long CX TNP LYO NE

One Dozen More Compelling Articles Around the Web

Posted on 11 May 2007 by David Merkel

1)? Picking up where I left off last night, I have a trio of items from Random Roger.? Is M&A Bullish or Bearish?? Great question.? Here’s my answer: at the beginning of an M&A wave, M&A is unambiguously bullish as investors seize on cheap valuations that have gone unnoticed.? Typically they pay cash, because the investors are very certain about the value obtained.

From the middle to the end of the M&A wave, the action is bullish in the short run, and bearish in the intermediate term.? The cash component of deals declines; investors want to do the deals, but increasingly don’t want to part with cash, because they don’t want to be so leveraged.

My advice: watch two things. One, the cash component of deals, and two, the reaction of the market as deals are announced.? Here’s a quick test: good deals increase the overall market cap of the acquirer and target as a whole.? Bad deals decrease that sum.? Generally, deal quality by that measure declines over the course of an M&A wave.

2) Ah, the virtues of moderation, given that market timing is so difficult. This is why I developed my eight rules, because they force risk control upon me, making me buy low and sell high, no matter how painful it seems.? It forces me to buy when things are down, and sell when things are running up.? Buy burned out industries.? Reshape to eliminate names tht are now overvalued.? These rules cut against the grain of investors, because we like to buy when comapnies are successful, and sell when the are failures.? There is more money to be made the other way, most of the time.

3) From Roger’s catch-all post, I would only want to note one lesser noticed aspect of exchange traded notes.? They carry the credit risk of the issuing institution.? As an example, my balanced mandates hold a note that pays off of the weighted average performance of four Asian currencies.? In the unlikely event that Citigroup goes under, my balanced mandates will stand in line with the other unsecured debtholders of Citigroup to receive payment.

4) Bespoke Investment Group notices a negative correlation between good economic reports and stock price performance.? This should not be a surprise.? Good economic news pushes up both earnings and bond yields, with the percentage effect usually greater on bond yields, making new commitments to bonds relatively more attractive, compared to stocks.

5) From a Dash of Insight, I want to offer my own take on Avoiding the Time Frame Mistake.? When I take on a position, I have to place the idea in one of three buckets: momentum (speculation), valuation, or secular theme.? What I am writing here is more general than my eight rules.? When I was a bond manager, I was more flexible with trading, but any position I brought on had to conform to one of the three buckets.? I would buy bonds of the brokers when I had excess cash, and I felt the speculative fervor was shifting bullish.? If it worked, I would ride them in the short run; if not, I would kick them out for a loss.

Then there were bonds that I owned because they were undervalued.? I would buy more if they went down, until I got to a maximum position.? If I still wanted more, I would do swaps to increase spread duration.? But when the valuations reached their targets, I would sell.

With bonds, secular themes don’t apply so well, unless you’re in the mid-80s, and you think that rates are going down over the next decade or two.? If so, you buy the longest noncallable bonds, add keep buying every dip, until rates reach your expected nadir.? Secular themes work better with equities, where the upside is not as limited.? My current favorite theme is buying the stock of companies that benefit from the development of the developing world.? That said, most of those names are too pricey for me now, so I wait for a pullback that may never come.

6) I’ve offered my own ideas of what Buffett might buy, but I think this article gets it wrong.? We should be thinking not of large public businesses, but large private businesses, like Cargill and Koch Industries.? Even if a public business were willing to sell itself cheap enough to Buffett, Buffett doesn’t want the bidding war that will erupt from others that want to buy it more dearly.? Private businesses can avoid that fracas.

7) And now, a trio on accounting.? First, complaints have arisen over the discussion draft that would allow companies to use IFRS in place of GAAP.? Good.? Let’s be men here; one standard or the other, but don’t allow choice.? We have enough work to do analyzing companies without having to work with two accounting standards.

8) SFAS 159?? You heard it at this blog first, but now others are noticing how much creative flexibility it offers managements in manipulating asset values to achieve their accounting goals.? My opinion, this financial accounting standard will be scrapped or severely modified before long.

9) Ah, SFAS 133. When I was an investment actuary, I marveled that hedges had to be virtually perfect to get hedge treatment.? Perfect?? Perfect hedges rarely exist, and if they do, they are more expensive than imperfect ones.? Well, no telling where this one will go, but FASB is reviewing the intensely complex SFAS 133 with an eye to simplifying it.? This could make SFAS 133 more useful to all involved… on the other hand, given their recent track record, they could allow more discretion a la SFAS 159, which would be worse for accounting statement users, unless disclosure was extensive. Even then, it might be a lot more work.

10) ECRI indicates better growth and lower inflation coming soon.? I’ll go for the first; I’m not so sure about the second, with inflation rising globally.

11) What nation has more per capita housing debt then the US?? Britain. (And its almost all floating rate…)? With economics, it is hard to amaze me, but this Wall Street Journal article managed to do so.? Though lending institutions bear some blame for sloppy underwriting, it amazes me that marginal borrowers that are less than responsible can think that they can own a home, or that people who have been less than provident in saving, think that they can rescue their retirement position by borrowing a lot of money to buy a number of properties in order to rent them out.? In desperate times, desperate people do desperate things, but most fail; few succeed.? We have more of that to see on this side of the Atlantic.

12) I am not a fan of what I view as naive comparisons to other markets and time periods.? There has to be some significant similarity in the underlying economics to make me buy the analogy.? Thus, I’m not crazy about this comparison of the current US market to the Nikkei in the late 80s.? Japan was a much more closed economy, and monetary policy was far more loose than ours is today.? I can even argue that the US is presently relatively conservative in its monetary policy versus the rest of the developed world.? So it goes.

The Great Garbage Post

Posted on 25 April 200727 April 2007 by David Merkel

Perhaps for blogging, I should not do this. My editors at RealMoney told me that they liked my “Notes and Comments” posts in the Columnist Conversation, but they wished that I could give it a greater title. Titles are meant to give a common theme. Often with my “Miscellaneous Notes” posts, there is no common theme. Unlike other writers at RealMoney, I cover a lot more ground. I like to think of myself as a generalist in investing. I know at least a little about most topics.

Now, I have to be careful not to overestimate what I know, but the advantage that I have in being a generalist is that I can sometimes see interlinkages among the markets that generalists miss. Anyway, onto my unrelated comments…

1) So many arguments over at RealMoney over what market capitalization is better, small or large? Personally, I like midcaps, but market capitalization is largely a fallout of my processes. If one group of capitalizations looks cheap, I’ll will predominantly be buying them, subject to my rule #4, “Purchase companies appropriately sized to serve their market niches.” Analyze the competitive position. Sometimes scale matters, and sometimes it doesn’t.

2) My oscillator says to me that the market is now overbought. We can rise further from here, but the market needs to digest its gains. We should not see a rapid rise from here over the next two weeks, and we might see a pullback.

3) My, but the dollar has been weak. Good thing I have enough international bonds to support my balanced mandates. I am long the Yen, Swissie, and Loony.

4) Sold a little Tsakos today, just to rebalance after the nice run. Cleared out of Fresh Del Monte. Cash flow looks weak. Suggestions for a replacement candidate are solicited.
5) Roger Nusbaum is an underrated columnist at RealMoney in my opinion. Today, he had a great article dealing with understanding strategy. He asked the following two questions:

If you had to pick one overriding philosophy for your investment management, what would it be?
If you had to pick four of your strategies or tactics to accomplish this philosophy, what would they be?

Good questions that will focus anyone’s investment efforts.

6) In the “Good News is Bad News” department, there is an article from the WSJ describing how the SEC may eliminate the FASB by allowing US companies to ditch GAAP, and optionally use international accounting standards [IFRS]. If it happens, this is just the first move. Eventually all companies will follow an international standard, that is, if Congress in its infinite wisdom can restrain itself from meddling in the management of accounting. The private sector does well enough, thank you. Please limit your scope to tax accounting (or not).

7) Also from the WSJ, an article on how employers are grabbing back control of 401(k) plans. Good idea, since most people don’t know how to save or invest. But why not go all the way, and set up a defined benefit plan or a trustee-directed defined contribution plan? The latter idea is cheap to do; we have one at my current employer. Expenses are close to nil, because I mange the money in-house. Even with an external manager, it would be cheap.Would there be people who complain, saying they want more freedom? Of course, but they are the exception, not the rule, and of those who complain, maybe one in five can do better than an index fund over the long haul. I am for paternalism here; most ordinary people can’t save and invest wisely. Someone must do it for them.

8) Finally, the “hooey alert.” The concept of using custom indexes to analyze outperformance smacks of the inanity of “returns-based style analysis.” I wrote extensively on this topic in the mid-90s. Anytime one uses constrained optimization to calculate a benchmark using a bunch of equity indexes, the result is often spurious, because the indexes are highly correlated. Most differentiation between them is typically the overinterpretation of a random difference between the indexes. Typically, these calculations predict well in the past, but predict the future badly.

That’s all for now.

Full Disclosure: long TNP FXY FXF FXC