Learning from the Past – The Aleph Blog

Learning from the Past, Part 6 [Hopefully Final, But It Won’t Be…]

Posted on 8 October 20158 October 2015 by David Merkel

Photo Credit: Tony Webster || Bridges can collapse -- so can leverage... — Photo Credit: Tony Webster || Bridges can collapse — so can leverage…

This is the last article in this series… for now. ?The advantages of the modern era… I went back through my taxes over the last eleven years through a series of PDF files and pulled out all of the remaining companies where I lost more than half of the value of what I invested, 2004-2014. ?Here’s the list:

Avon Products [AVP]
Avnet [AVT]
Charlotte Russe [Formerly CHIC — Bought out by Advent International]
Cimarex Energy [XEC]
Devon Energy [DVN]
Deerfield Triarc?[formerly DFR, now merged with?Commercial Industrial Finance Corp]
Jones Apparel Group [formerly JNY — Bought out by Sycamore Partners]
Valero Enery [VLO]
Vishay Intertechnology [VSH]
YRC Worldwide [YRCW]

The Collapse of Leverage

Take a look of the last nine of those companies. ?My?losses?all happened during the financial crisis. ?Here I was, writing for RealMoney.com, starting this blog, focused on risk control, and talking often?about rising financial leverage and overvalued housing. ?Well, goes to show you that I needed to take more of my own medicine. ?Doctor David, heal yourself?

Sigh. ?My portfolios typically hold 30-40 stocks. ?You think you’ve screened out every weak balance sheet or too much operating leverage, but a few slip through… I mean, over the last 15 years running this strategy, I’ve owned over 200 stocks.

The really bad collapses happen when there is too much debt and operations fall apart — Deerfield Triarc?was the worst of the bunch. ?Too much debt and assets with poor quality and/or repayment terms that could be adjusted in a negative way. ?YRC Worldwide — collapsing freight rates into a slowing economy with too much debt. ?(An investment is not safe if it has already fallen 80%.)

Energy prices fell at the same time as the economy slowed, and as debt came under pressure — thus the problems with Cimarex, Devon, and to a lesser extent Valero. ?Apparel concepts are fickle for women. ?Charlotte Russe and Jones Apparel executed badly in a bad stock market environment. ?That leaves Avnet and Vishay — too much debt, and falling business prospect along with the rest of the tech sector. ?Double trouble.

Really messed up badly on each one of them, not realizing that a weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. ?As such, if you are worried about a crushing market environment in the future, you will need to stress-test to a much higher degree than looking at financial leverage only. ?Look for companies where the pricing of the product or service can reprice down — commodity prices, things that people really don’t need in the short run, intermediate goods where purchases?can be delayed for a while, and anyplace where high fixed investment needs strong volumes to keep costs per unit low.

One final note — Avon calling! ?Ding-dong. ?This was a 2015 issue. ?Really felt that management would see the writing on the wall, and change its overall strategy. ?What seemed to have stopped falling had only caught its breath for the next dive. ?Again,?an investment is not safe if it has already fallen 80%.

There is something to remembering rule number 1 — Don’t Lose Money. ?And rule 2 reminds us — Don’t forget rule number 1. ?That said, I have some things to say on the positive side of all of this.

The Bright Side

A) I did have a diversified portfolio — I still do, and I had companies that did not do badly as well as the minority of big losers. ?I also had a decent amount of cash, no debt, and other investments that were not doing so badly.

B) I used the tax losses to allow a greater degree of flexibility in investing. ?I don’t pay too much attention to tax consequences, but all concerns over?taking gains went away until 2011.

C) I reinvested in better companies, and made the losses back in reasonably short order, once again getting to pay some taxes in the process by 2011. ?Important to note: losses did not make me give up. ?I came back with vigor.

D) I learned valuable lessons in the process, which you now get to absorb for free. ?We call it market tuition, but it is a lot cheaper to learn from the mistakes of others.

Thus in closing — don’t give up. ?There will be losses. ?You will make mistakes, and you might kick yourself. ?Kick yourself a little, but only a little — it drives the lessons home, and then get up and try again, doing better.

Full disclosure: long VLO — made those losses back and then some.

Learning from the Past, Part 5c [Institutional Stock Version]

Posted on 2 May 2015 by David Merkel

This will be the last of my institutional error pieces. It is not that I have not made any other errors, but these were the big ones.

National Atlantic Holdings [NAHC]

I was wrong yesterday. ?I actually do have a lot available that I have written on this failure, since I wrote about it here at Aleph Blog. ?More than you can shake a stick at.

Let me start at the beginning. ?NAHC was an insurer with a niche presence in New Jersey. ?They competed only in personal lines, which usually is easy to analyze. ?New Jersey was a tough but not impossible state to operate in, and NAHC was a medium-sized fish for the size of the pond that they were in.

Chubb was not in NewJersey at that point in time, and so they wanted to insure autos, homes, and personal property, particularly that of wealthy people.

I thought it was an interesting company, trading slightly below tangible book, with a single-digit multiple on earnings, good protective boundaries, and a motivated management team. ?The CEO owned over 10% of the firm, which seemed to be enough to motivate, but not enough to ignore shareholders.

In 2005, we bought a 5%+ stake in the company, which in 2006 became 10%+, and eventually topped out at 17%. ?We might have bought more with the approval of the NewJersey Department of Insurance, which was easy at lower levels, and harder at higher levels, which was an interesting anti-takeover defense.

The company showed promise in many ways, but always seemed to have performance issues — little to medium surprises every few quarters. ?The stock price didn’t do that much bad or good. ?When I left Hovde at the end of July 2007, the position was at a modest gain. ?Hovde had a hard time finding long names in that era, so the performance up to that point wasn’t that bad.

If you want to see my original logic for buying the stock after I left Hovde, you can read it here.

Here was the stock price graph from May 2007 to May 2008:

My old employer Hovde owned 17%. ?I eventually owned 0.15%, at the prices you see there, at an average cost of $6.67 for me. ?I eventually sold out at an average price of around $6.10. ?(In the above graph, “Exit” was not a sale, but where I cut off the calculation.) ?This wasn’t my worst loss by any means, but it cost my former employer badly, and it was my fault, not theirs.

What Went Wrong?

Their competitive position deteriorated as companies that previously avoided New Jersey entered the state.
They announced that they had reserving errors, and reported moderate?losses as a result.
They announced a sale to Palisades Insurance, a private New Jersey insurer for $6.25/sh, valuing the company at less than 60% of tangible book value. ?The fairness opinion was a bad joke. ?The company would have been worth more in run-off.
Really, the management team was weak.

The first problem would be a tough one to solve. ?On the second problem, I never got a good answer to how the loss reserves got so cockeyed, and somehow no one was to blame for it. ?This is personal lines insurance — the reserves validate themselves every year.

But the third problem made me think the management was somewhat?dishonest. ?A larger company could have paid a higher price for NAHC, but that probably would have meant that management would lose their jobs. ?They gave shareholders the short end of the stick for the good of management, and perhaps employees.

My biggest error was giving too much credit, and too much patience to the management team. ?I met far better management teams in my time as a buy-side analyst, and they were on the low end of the competence scale. ?I let cheapness and a strong balance sheet blind me to the eroding competitiveness, and weak ability to deal with the problem.

Ultimately, Hovde found itself in a weak position because it could not file for appraisal rights, a fraud case would have been weak, and the NJ Department of Insurance would not let them acquire enough to block the deal. ?Besides, once arbs got a hold of over 40% of the shares, the deal was almost impossible to block.

As I often say, risk control is best done on the front end. ?On the back end, solutions are expensive, if they are available at all.

The front end for you can be learning from my errors. ?Wise men learn from the mistakes of others. ?Average men learn from their own mistakes. ?Dumb men never learn.

In closing, be conservative in investing, and be wise. ?I thought I was being both, so seek the counsel of others to check your logic.

Learning from the Past, Part 5b [Institutional Stock Version]

Posted on 1 May 2015 by David Merkel

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

This is one of the many times that I wish RealMoney.com had not changed its file structure, losing virtually all content prior to 2008. ?(It is also a reason that I am glad I started blogging. ?It’s more difficult to lose this content.) ?When I was a stock analyst at Hovde Capital Advisors, I made 2 humongous blunders. ?I wrote about them fairly extensively at RealMoney as the?situation unfolded, so if I had those posts, it would make the following article better. ?As it is, I am going to have to go from memory, because both companies are no longer in business. ?Here we go:

Scottish Re

Sustainable competitive advantage is difficult to find in insurance. ?Proprietary methods are as good as the employees creating and using them, and they can leave when they would like to. ?This applies to underwriting,?investing, and expense management. ?What else is there in an insurance company? ?There are back end processes of valuation?and?cash flow management, but those financial reporting processes serve to inform the front end of how an insurer operates.

One area that had and continues to have sustainable competitive advantage is life reinsurance. ?An global oligopoly of companies grew organically and through acquisitions to become dominant in life reinsurance. ?Their knowledge and mortality databases make them far more knowledgeable the life insurers that seek to pass some of the risk of the death of their policyholders to them. ?They can be very profitable and stable. ?I already owned shares of RGA for Hovde, and in 2005 wanted to expand the position by buying some of the cheaper and more junior company Scottish Re.

Scottish Re had only been in business since 1998, versus?RGA since 1973. ?These were the only pure play life reinsurers in the world. ?Scottish Re had grown organically and through acquisition to become the #5 member of the oligopoly. ?The top 5 life reinsurers controlled 80% of the global market. ?I made the case to the team at Hovde, and we took a medium-sized position.

The first thing I should have noticed was the high level of complexity of the holding company structure. ?Unlike RGA, they operated to a high degree?in a wide number of offshore tax and insurance haven domiciles — notably Bermuda, Ireland, Cayman Islands, and others. ?Second, their ownership diagrams rivaled AIG for complexity, and their market capitalization was less than 2% of AIG’s at the time. ?[Note: balance sheet complexity did not bode well for AIG either — down 98% since then, but it beats Scottish Re going out at zero.]

The second thing I should have noticed was the high degree of underwriting leverage. ?Relative to RGA, it reinsured much more life risk relative to the size of its balance sheet.

The third thing I should have noticed was the cleverness of some of the financing methods of Scottish Re — securitization was uncommon in life reinsurance, and they were doing it successfully.

The final thing that I should have noticed was that earnings quality was poor. ?They usually made their earnings, but often because their tax rate was so low… and the deferred tax assets were a large part of book value. ?(Note: deferred tax assets only have value if you are going to have pretax income in the future. ?That was soon not to be.)

In 2005, Scottish Re won the auction for buying up another member of the oligopoly, ING Life Re. ?I asked the CFO of RGA why they didn’t buy it, and his comment was that he didn’t think anyone would pay more than they bid. ?That should have led me to sell, but I didn’t. ?The price of Scottish Re drifted down, until August 3, 2006, when they announced second quarter earnings, reporting a huge loss, writing off a large portion of their deferred tax assets, and the stock price dropped 75% in one day. ?I eventually wrote about that at RealMoney, noting it was the single worst day in the hedge funds history, and it was due to my errors. ?You can also read my questions/comments from the conference call here?(pages 50-53).

If you look at the RealMoney article, you might note that we tripled our position at around $6.90?after the disaster. ?That took a lot of guts, and we didn’t know it then, but it was the wrong thing to do. ?The stock rallied all the way up to $10 or so. ?If it hit $11, we were going to sell out. ? That was not to be.

I spent hours and hours going through obscure insurance filings. ?I analyzed every document that I could get my hands on including?the rating agency analyses, because they had access to inside data in aggregate that no one else had outside of the company. ?The one consistent thing that I learned was that insolvency was unlikely — which would later prove wrong.

The stock price fell and fell all the way down to $3, with rumors of insolvency swirling, when Mass Mutual and Cerberus rode to the rescue on November 27, 2006, buying 69% of the company for a paltry $600 million in convertible preferred stock. ?At that point, I finally got it right. ?All of my prior research had some value, because when I read through the documents that day and saw the liquidity raised relative to the amount of ownership handed over. ?Given the data that they now handed out, I concluded that Scottish Re was worth $1/share, and possibly zero.

But there was a relief rally that day, and we sold into it. ?We ended up selling about 4% of the total market cap of Scottish Re that day at a price of $6.25.

The bright side of the whole matter was that we could have lost a lot more. ?Scottish Re was eventually worth zero, and?Mass Mutual and Cerberus took significant losses, as did the remaining shareholders.

As it was, the fault was all mine — my colleagues at Hovde deserved none of the blame.

The Lesson Learned

One year later, I wrote a note to the late Greg Newton who wrote the notable blog, Naked Shorts, when he was critical of Cerberus (they had a lot of failures in that era). ?This was the summary that I gave him on Scottish Re:

Cerberus got into SCT @ $3; it’s now around $2.? For me, on the bright side, when their deal with SCT was announced, I quickly went through the data, and recommended selling.? We got out @ $6.25.? That limited our losses, but it was still my biggest failure when I was at Hovde.? The mixture of leverage, alien domiciled subsidiaries, reinsurance underwriting leverage, plus complex and novel securitization structures was pure poison.? I was?mesmerized?by the?seemingly cheap valuation and actuarial studies that indicated that mortality experience was a little better than expected. ?I?violated my leverage and simplicity rules on that one.

He gave me a very kind response, better than I deserved. ?As it was Scottish Re went dark, delisting in May 2008, and trading for about a nickel per share at the last 10K?in July of 2008. ?It eventually went to zero.

The biggest lesson is to do the research better on illiquid and opaque financial companies, or, avoid them entirely. ?Complexity and leverage there are typically not rewarded. ?I’d like to say that I fully learned my lesson there, but I got whacked again by the same lesson on a personal investment later in 2008. ?That’s a subject for a later article.

I have one more bad equity investment from my hedge fund days, and I will write about that sometime soon, to end this part of the series.

Full disclosure: still long RGA for my clients and me

Learning from the Past, Part 5a [Institutional Bond Version]

Posted on 30 April 2015 by David Merkel

This will be the post where I cover the biggest mistakes that I made as an institutional bond and stock investor. In general, in my career, my results were very good for those who employed me as a manager or analyst of investments, but I had three significant blunders over a fifteen-year period that cost my employers and their clients a lot of money. ?Put on your peril-sensitive sunglasses, and let’s take a learning expedition through my failures.

Manufactured Housing Asset Back Securities — Mezzanine and Subordinated Certificates

In 2001, I lost my boss. ?In the midst of a merger, he?figured his opportunities in the merged firm were poor, and so he jumped to another firm. ?In the process, I temporarily became the Chief Investment Officer, and felt that we could take some chances that the boss would not take that in my opinion were safe propositions. ?All of them worked out well, except for one: The?– Mezzanine and Subordinated Certificates of?Manufactured Housing Asset Back Securities [MHABS]. ?What were those beasts?

Many people in the lower middle class live in prefabricated housing in predominantly in trailer parks around the US. ?You get a type of inexpensive independent living that is lower density than an apartment building, and?the rent you have to pay is lower than renting an apartment. ?What costs some money is paying for the loan to buy the prefabricated housing.

Those loans would get gathered into bunches, put into a securitization trust, and certificates would get sold allocating cash flows with different probabilities of default. ?Essentially there were four levels (in order of increasing riskiness) — Senior, Mezzanine, Subordinated, and Residual. ?I focused on the middle two classes because they seemed to offer a very favorable risk/reward trade-off if you selected carefully.

In 2001, it was obvious that there was too much competition for lending to borrowers in Manufactured Housing [MH] — too many manufacturers were trying to sell their product to a saturated market, and underwriting suffered. ?But, if you looked at older deals, lending standards were a lot higher, but the yields on those bonds were similar to those on the badly underwritten newer deals. ?That was the key insight.

One day, I was able to confirm that insight by talking with my rep at Lehman Brothers. ?I talked to him about the idea, and he said, “Did you know we have a database on the loss stats of all of the Green Tree (the earliest lender on MH) deals since inception?” ?After the conversation was over, I had that database, and after one day of analysis — the analysis was clear: underwriting standards had slipped dramatically in 1998, and much further in 1999 and following.

That said, the losses by deal and duration since issuance followed a very predictable pattern: a slow ramp-up of losses over 30 months, and then losses tailing off gradually after about 60 months. ?The loss statistics of all other MH lenders aside from Vanderbilt (now owned by Berkshire Hathaway) was worse than Green Tree losses. ?The investment idea was as follows:

Buy AA-rated mezzanine and BBB-rated subordinated MHABS originated by Green Tree in 1997 and before that. ?The yield spreads over Treasuries are compelling for the rating, and the loss rates would have to jump and stick by a factor of three to impair the subordinated bonds, and by a factor of six to impair the mezzanine bonds. ?These bonds have at least four years of seasoning, so the loss rates are very predictable, and are very unlikely to spike by that much.

That was the thesis, and I began quietly acquiring $200 million of these bonds in the last half of 2001. ?I did it for several reasons:

The yields were compelling.
The company that I was investing for was growing way too rapidly, and we needed places to put money.
The cash flow profile of?these securities matched very well the annuities that the company was selling.
The amount of capital needed to carry the position was small.

By the end of 2001, two things happened. ?The opportunity dried up, because I had acquired enough of the bonds on the secondary market to make a difference, and prices rose. ?Second, I was made the corporate bond manager, and another member of our team took over the trade. ?He didn’t much like the trade, and I told my boss that it was his portfolio now, he can do what he wanted.

He kept the positions on, but did not add to them. ?I was told he looked at the bonds, noticed that they were all trading at gains, and stuck with the positions.

Can You Make It Through the Valley of the Shadow of Death?

I left the firm about 14 months later, and around?that time, the prices for MHABS fell apart. ?Increasing defaults on MH loans, and failures of companies that made MH, made many people exceptionally bearish and led rating agencies to downgrade almost all MHABS bonds.

The effects of the losses were similar to that of the Housing Bubble in 2007-9. ?As people defaulted, the value of existing prefabricated houses fell, because of the glut of unsold houses, both new and used. ?This had an effect, even on older deals, and temporarily, loss rates spiked above the levels that would impair the bonds that I bought if the levels stayed that high.

With the ratings lowered, more capital had to be put up against the positions, which the insurance company did not want to do, because they always levered themselves up more highly than most companies — they never had capital to spare, so any loss on bonds was a disaster to them.

They feared the worst, and sold the bonds at a considerable loss, and blamed me.

[sigh]

Easy to demonize the one that is gone, and forget the good that he did, and that others had charge of it during the critical period. ?So what happened to the MHABS bonds that I bought?

Every single one of those bonds paid off in full. ?Held to maturity, not one of them lost a dime.

What was my error?

Part of being a good investor is knowing your client. ?In my case, the client was an impossible one, demanding high yields, low capital employed, and no losses. ?I should have realized that at some later date, under a horrific scenario, that the client would not be capable of holding onto the securities. ?For that reason, I should have never bought them in the first place. ?Then again, I should have never bought anything with any risk for them under those conditions, because in a large enough portfolio, you will have some areas where the risk will surprise you. ?This was less than 2% of the consolidated assets of the firm, and they can’t hold onto securities that would likely be money good amid a panic?!

Sadly, no. ?As their corporate bond manager, before I left, I sold down positions like that that my replacement might not understand, but I did not control the MHABS portfolio then, and so I could?not do that.

Maybe $50 million went down the drain here. ?On the bright side, it helped teach me what would happen in the housing bubble, and my next employer benefited from those insights.

Thus the lesson is: only choose investments that your client will be capable of holding even during horrible times, because the worst losses come from panic selling.

Next time, my two worst stock losses from my hedge fund days.

Learning from the Past, Part 4

Posted on 28 April 2015 by David Merkel

Welcome back to this irregular series where I go through the large blunders that I have committed in my investments. ?Let’s start with an unusual one: a telecommunications partnership.

In the late ’80s the US government allocated some telecom spectrum via a lottery process. ?I had some friends that participated in the first lottery, and received a decent amount of valuable spectrum. ?The only thing they had to do was have the engineering documents drawn up, which a third party consultant did. ?I said to myself that if it ever came around again, I would try to participate.

In the early ’90s, lo and behold, a second lottery with the same rules. ?I invested enough to gain a 30% interest in a partnership that would be going after the center of the US, ignoring the east and west coasts. ?I had seven partners with 10% interests, and they elected me to be the lead partner. ?So far, so good, right?

Well, seemingly. ?The thing is, why should the government allocate spectrum by lottery? ?Shouldn’t they sell it off to the highest bidder? ?After all, that’s what most people did with the spectrum they received in the first lottery. ?(I was planning on trying to create an operating company.) ?Shouldn’t the US government cut out the middlemen, and receive more for a valuable and somewhat limited asset?

Prompted by the telecommunication firms, who preferred having fewer and larger?auctions rather than buying from a bunch of disparate individuals, the US government acted in its own interests, and cancelled, even after all of the lottery participants plans had been approved.

In the end, we got back our fees from the government, but lost the money that we spent on engineering documents. ?After writing off the losses, it was a loss of 50%. ?That said, I also lost any profits from investing the money in stocks over the eight?years that the money was tied up. ?(The promoter that did the engineering documents went into hiding, having lost their shirts in the process, with a lot of annoyed people that bought their services.)

Small Cap Value Forever!

So what was I doing in equity investing in that era? ?Small cap value — little companies trading at bargain prices. ?Of all the managers that I interviewed when creating the multiple manager funds for my employer, I found the small cap value guys to be the most business-minded and interesting. ?A few of us at my firm would research out lesser known companies and?share the ideas. ?We had some fun with it. ?We would occasionally say to each other, “Small Cap Value Forever!”

Now, when the dot-com bubble came around, I was not tempted to play in that area of the market, but I fell into a lesser version of the same trap here. ?I started doing this just as small cap value’s period of outperformance was ending, and growth was taking over.

So how did I do? ?Not that bad… Small cap value lagged the S&P 500 by about 5%/year over the time I was focused on it, and I was able to beat the S&P 500 by a little bit. ?Not the greatest, but not the worst, either. ?In the process, I ran into a number of bizarre situations that taught me a lot, particularly with the smallest companies that I invested in.

In one case, I made the mistake of entering a market order to initiate a position. ?(Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was. ?The price promptly fell back to where it was prior to my purchase. ?Adding insult to injury, management ruined the place, and the price fell by over 80%. ?I looked at the situation, thought the assets were worth far more, and submitted a bid to an institutional investor to buy out his entire stake (and I would become a 5%+ holder of the company — I had to ask my compliance area if I could do that, and they were bemused at the odd request, and assented.) ?The investor did not take my bid, but held on, and the?management announced a buyout for the company at a level that would have given me a significant gain had I been able to buy the block of stock, but instead left me with a 80%+ loss on a small position, which wasn’t large enough to consider filing for appraisal rights.

Then there was one that went very well, but taught me the wrong lesson. ?A few weeks after I bought a stake in a small electronic parts company, Corcom, another company bought it for cash. ?At first I was happy with the quick and sizable win, but then I realized that I might have done better over time if the company hadn’t sold out.

That said, I noticed how wide the arbitrage spread was on the deal, and the annualized rate was 40%/year. ?I bought more and more of it, and eventually even used leverage to goose returns (this doesn’t sound like the older me, right? ?Right.) ?I made a lot of money in the process when the deal completed.

Here’s the wrong conclusion I drew: small deal arbitrage was lucrative and easy. ?I started doing that exclusively for two years during 1998-2000. ?During that time I learned:

It’s not easy. ?Small deal arbitrage investing is like investing in high yield bonds where the management teams have disproportionate opportunity to act against the interests of owners.
It’s not as lucrative as it looks, either. ?One deal gone wrong will eat the profits of ten that go right.
It takes a lot of time to find, analyze and compare new deals. ?I spent much more time on that than when I was doing value investing. ?I felt my time with my family was suffering.

More deals went bad than should have. ?My credit analysis on the deals was subpar. ?I particularly remember one where the buyer used an obscure clause to get out of the deal, and the company, Advanced Technical Products, took the acquirer to court and lost.

After the loss in court, I sold for a 70%+ loss, and then insult added to injury happened again… after 9/11, the products that they made for structural purposes came into high demand, and the stock shot up more than fifteen times. ?Had I held on, I would have quadrupled my original investment. ?(I smile and laugh a little as I write this.)

What did I learn?

This was the worst two years of all my investing, so I learned quite a bit:

Often your worst errors come trying to repeat a single abnormally large?success.
Stick to what you know best, which for me was value investing.
Don’t chase fads.
Analyze management teams of small companies very carefully. ?They can potentially get away with a lot more if there are no significant controlling investors.
Analyze your own investing to figure out what you are best at. ?I did such an analysis afterward, and saw value investing and industry analysis as key strengths.
Focus on risk control. ?Focus on risk control. ?Focus on risk control……
Do more analysis of unusual ways of investing before committing money.

On the bright side, this period set me for my best period of investing, which would be 2000-2010. ?The lessons and discipline learned would prove invaluable to me, and the companies that I served.

Learning from the Past, Part 3

Posted on 31 January 20151 February 2015 by David Merkel

Photo Credit: Thibaut Ch?ron Photographies

I wish I could tell you that it was easy for me to stop making macroeconomic forecasts, once I set out to become a value investor. ?It’s difficult to get rid of convictions, especially if they are simple ones, such as which way will interest rates go?

In the early-to-mid ’90s, many were convinced that interest rates had no way to go but up. ?A few mortgage REITs designed themselves around that idea. ?Fortunately, I arrived at the party late, after their investments that implicitly required interest rates to rise soon, fell dramatically in price. ?I bought a basket of them for less than book value, excluding the value of taxes that could be sheltered in a reverse merger.

For some time, the stocks continued to fall, though not rapidly. ?I became familiar with what it was like to go through coercive rights offerings from cash-hungry companies in trouble. ?Bankruptcy was not impossible… and I burned a lot of mental bandwidth on these. ?The rights offerings weren’t really good things in themselves, but they led me to buy in at a good time. ?Fortunately I had slack capital to deploy. ?That may have taught me the wrong lesson on averaging down, as we will see later. ?As it was, I ended up making money on these, though less than the market, and with a lot of Sturm und Drang.

That leads me to my main topic of the era: Caldor. ?Caldor was a discount retailer that was active in the Northeast, but nationally was a poor third to Walmart and KMart. ?It came up with the bright idea of?expanding the number of stores it had in the mid-90s without raising capital. ?It even turned down an opportunity to float junk bonds. ?I remember noting that the leverage seemed high.

What I didn’t recognize that the cost of avoiding issuing equity or longer-term debt was greater reliance on short-term debt from factors — short-term lenders that had a priority claim on inventory. ?It would eventually prove to be a fatal error, and one that an asset-liability manager should have known well — never finance a long term asset with short-term debt. ?It seems like a cost savings, but it raises the likelihood of insolvency significantly.

Still, it seemed very cheap, and one of my favorite value investors, Michael Price, owned a little less than 10% of the common stock. ?So I bought some, and averaged down three times before the bankruptcy, and one time afterwards, until I learned Michael Price was selling his stake, and when he did so, he did it without any thought of what it would do to the stock price.

Now for two counterfactuals: Caldor could have perhaps merged with Bradlee’s, closed their worst stores, refinanced their debt, issued equity, and tried to be a northeast regional retail player. ?It didn’t do that.

The investor relations guy could have given a more understanding answer when he was asked whether Caldor was having any difficulties with credit lines from their factors. ?Instead, he was rude and dismissive to the questioning analyst. ?What was the result? ?The factors blinked and pulled their lines, and Caldor went into bankruptcy.

What were my lessons from this episode?

Don’t average down more than once, and only do so limitedly, without a significant analysis. ?This is where my portfolio rule?seven came from.
Don’t engage in hero worship, and have initial distrust for single large investors until they prove to be fair to all outside passive minority investors.
Avoid overly indebted companies. ?Avoid asset liability mismatches. ?Portfolio rule three would have helped me here.
Analyze whether management has a decent strategy, particularly when they are up against stronger competition. ?The broader understanding of portfolio rule six would have steered me clear.
Impose a diversification limit. ?Even though I concentrate positions and industries in my investing, I still have limits. ?That’s another part of rule seven, which limits me from getting too certain.

The result was my largest loss, and I would not lose more on any single investment again until 2008 — I’ll get to that one later. ?It was my largest loss as a fraction of my net worth ever — after taxes, it was about 4%. ?As a fraction of my liquid net worth at the time, more like 10%. ?Ouch.

So, what did I do to memorialize this? ?Big losses should always be memorialized. ?I taught my (then small) kids to say “Caldor” to me when I talked too much about investing. ?They thought it was kind of fun, and I would thank them for it, while grimacing.

But that helped. ?Remember, value investing is first about safety, and second about cheapness. ?Cheapness rarely makes something safe enough on its own, so analyze balance sheets, strategy, use of cash flow, etc. ?This is not to say that I did not make any more errors, but this one reduced the size and frequency.

That said, there will be more “fun” chapters to share in this series, because we always learn more from errors than successes.

Learning from the Past, Part 2

Posted on 2 January 201516 February 2015 by David Merkel

Happy New Year to all of my readers. May 2015 be an enriching year for you in all ways, not just money.

This is a series on learning about investing, using my past mistakes as grist for the mill. ?I have had my share of mistakes, as you will see. ?The real question is whether you learn from your mistakes, and I can say that I mostly learn from them, but never perfectly.

In the early 90s, I fell in with some newsletter writers that were fairly pessimistic. ?As such, I did not do the one thing that from my past experience that I found I was good at: picking stocks. ?Long before I had money to invest, I thought it was a lot of fun to curl up with Value Line and look for promising companies. ?Usually, I did it well.

But I didn’t do that in that era. ?Instead, I populated my portfolio with international stock and bond funds, commodity trading funds, etc., and almost nothing that was based in?the USA. ?I played around with closed-end funds trying to see if I could eke alpha out of the discounts to NAV. ?(Answer: No.) ?I also tried shorting badly run companies to make a profit. ?(I succeeded minimally, but that was the era, not skill.)

I’ve been using my tax returns from that era to prompt?my memory of what I did, and the kindest thing I can say is that I?didn’t have a consistent strategy, and so my results were poor-to-moderate. ?I made money, just not much money. ?I even manged to buy the Japanese equity market on the day that it peaked, and after many months got out with a less-than-deserved 3% loss in dollar terms because of offsetting currency movements.

One thing I did benefit from was learning about a wide number of investing techniques and instruments, which benefited me professionally, because it taught me about the broader context of investing. ?That said, it cost time, and some of what I learned was marginal.

But not having a good overall strategy largely means you are wasting your time in investing. ?You may succeed for a while with what some call luck, but luck by its nature is not consistent.

Thus, I would encourage all of my readers to adopt an approach that fits their:

Knowledge
Personality
Available time

You have to do something that you truly understand, even if it is hiring an advisor, wealth manager, etc. ?You must be able to understand the outer edges of what they do, or how will you evaluate whether they are serving you well or not? ?Honesty, integrity, and reputation can go a long way here, but it really helps to know the basics.

Picking fund managers is challenging enough. ?How much of their good performance was due to:

their style being in favor
new cash flows in pushing up the prices of the assets that they like to buy
a few good ideas that won’t be repeated
a clever aide that is about to leave to set up his/her own shop
temporary alignment with the macroeconomic environment
or skill?

Personality is another matter — some people don’t learn patience, which cuts off a number of strategies that require time to work out. ?Few things also work right off the bat, so even a good strategy might get discarded by someone expecting immediate results.

Time is another factor which I will take up at a later point in this series. ?The best investment methods out there are no good for you unless you can make them fit into the rest of your life which often contains the far more important things of family, recreation, faith, learning, etc. ?It’s no good to be a wealthy old miser who never learned to appreciate life or the goodness of God’s providence in life.

And so to that end, I say choose wisely. ?My eventual choice was value investing, which isn’t that hard to learn, but requires patience, but can scale to the time that you have. ?For those that work in a business, it has the side-benefit that it is the most businesslike of all investment methods, and can make you more valuable to the firm that you work for, because you can learn to marry business sense with your technical expertise, potentially leading to greater profit.

For me, I can say that it broadened my abilities to think qualitatively, complementing my skills as a mathematician. ?The firms I worked for definitely benefited. ?Maybe it can do the same for you.

Till next time, where I tell you how value investing is *not* supposed to be done. 😉

PS — one more note: it is *very* difficult to make money off of macro insights in equities. ?Maybe there are some guys that can do that well, but I am not one of them. ?Limiting the effect of my insights there has been an aid to doing better in investing, because it forces me to be modest in an area where I know my likely success is less probable.

Learning from the Past, Part 1

Posted on 23 December 2014 by David Merkel

This is another Aleph Blog series of indeterminate length. ?I won’t bleed as much as my friend James Altucher, but I will reveal the?worst investments of my life. ?There have been a lot of them. ?Good investments have more than paid for the losses, but the losses were significant in two ways:

The losses were large enough to hurt.
Each loss taught me something; usually I did not make the same mistake twice.

After I finish this series, I hope that it can serve as a guide on what to avoid in investing for younger folks, so they don’t repeat my errors. ?Okay, older folks can benefit as well… and maybe along the way, I’ll throw in a few colorful stories of investments that weren’t losses, but still taught me something.

Here we go!

=-=-=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-

In the late 1980s, I fell prey to a boiler room scam. ?I was relatively new to investing for myself, though I had paper-traded stocks for years, and was seemingly able to pick good stocks. ?So why did I give in to the slick sales pitch? ?Inexperience, for one, and slack capital for two — in my late 20s?I really did not have a plan for what I wanted to do with my slack capital. ?I had done some investing in the stock market, but made money too quickly, and I feared that the market was once again too high (isn’t it always?).

Regardless, it was pretty dopey, and ended up being a 98% loss. ?A class action suit was created, which after 8 years ended up with nothing for any of the plaintiffs, and as far as I can tell, the lawyers lost money as well, since they were seeking a share of the recovery. ?Somewhat bitter at the end, the law firm closed its last letter saying something to the effect of, “At least we have the satisfaction that all of those that we have sued have lost all of the money that we can find.” ?Cold satisfaction, that.

I can tell you that the experience made me unwilling to transact any personal business over the phone that I did not initiate. ?For long-time readers, this helped lead to my saying,

Don’t buy what someone wants to sell you. ?Instead, research what you need, and buy that.

That’s a good lesson to begin with. ?Till next time.

Risk Tolerance — The Ability to Deal with Loss

Posted on 25 October 201426 October 2014 by David Merkel

No one knows their financial “risk tolerance” outside of the context of losing money. ?Part of the trouble is that risk and return are often described in the same breath as if they are inseparable, when they are more weakly related than most think, and certainly not linear.

Surveys, no matter how well-intentioned or -designed do not typically grasp the asymmetry of gain and loss. ?People feel losses much more acutely than gains, and are far more likely to change their behavior after losses. ?Can’t tell you how many times I have had people say to me, “I’m never buying stock again,” after 2000-2 and 2008-9.

Nothing can prepare you for the event of loss except prior losses. ?Those who have made it through losing money have coping strategies ranging from diversification to rebalancing to benign neglect, etc. ?The best look at it as a cost of doing business, and try to view it together with all other investment decisions made — there will always be losses, but were there gains as well, and more of them over the long haul?

Risk is best faced in prospect, and not retrospect: ask?yourself if?the current assets that you hold offer fair compensation for the risks that they have. ?Are they building value even if the market is not reflecting it yet?

I’m going to be starting a new irregular series at Aleph Blog, where I go through my past tax returns and pull out all of the blunders over the past 25 years. ?I hope it will be instructive to my readers in many ways, but perhaps the most important of those ways is that you have to get up and fight again if you have been knocked down. ?Don’t give up! ?If you leave the game, it is typically at the time prior to gains. ?Rather, ask whether what you are doing now is the right thing to do on a looking forward basis. ?The past is gone, and the only time to affect the future is now.

So look for the new series, and appreciate my packrat tendencies that I still have the records for these matters. ?Hopefully it will be fun, and particularly instructive for younger readers because I was young once too, and I started in this game as an amateur. ?I made a lot of mistakes, but I did not compound my mistakes by leaving the game.