Category: Portfolio Management

Avoid Buying Individual Stocks in Distress

Avoid Buying Individual Stocks in Distress

Posted on by David Merkel

There is a temptation, particularly among novice value investors, to throw money at a stock that has fallen hard. ?Bargains are hard to pass up.

It can be worse if you owned the stock prior to the fall, and kept investing as it went down. ?There is the temptation to follow blindly the axiom, “Well, if you liked it before, you must love it now! ?Load the boat!” ?Far better to sit down and talk with a friend who has more skill than you, who does not own the stock, and if he/she has time, ask for his opinion. ?While you are waiting, go out to the web, and listen to the opinions (perhaps triumphal opinions) of those that did not like the stock. ?Particularly take note of:

  • Allegations that the accounting is aggressive, or worse, crooked
  • Claims that the management team has goals different than that of shareholders.
  • Check to see that the balance sheet isn’t weak. ?Compare it to the balance sheets of competitors.
  • Is there too much debt? ?Is there too much debt potentially coming due soon, and too little resources to pay the debt?
  • Is revenue falling dramatically? ?What competitor is benefiting from the firm’s troubles?

But even if you didn’t own the stock, you might be wary of a stock that has fallen hard for a number of reasons, if the fall indicates the company may be in danger of default.

  • It’s likely that the management team that is responsible for the problem is still in charge.
  • Most ordinary management teams are not used to managing a company that is in distress.
  • Suppliers become less likely to extend favorable credit terms to the firm.
  • Rival companies spread rumors that you are going under and try to attract your best customers away.
  • Talented employees look for greener pastures as opportunities dry up. ?It’s no fun to turn from growing a profitable business, to putting out fires.
  • Management will be distracted with staying alive, maybe vulture investors, analysts seeking more data, regulatory requests, lenders seeking assurances, etc.
  • Credit will be harder to get from bonds, loans, etc., and if the firm gets?it, it will be expensive. (Especially if the firm uses?the Financing Methods of Last Resort.)
  • And, management may make things even tougher by having a round of layoffs. ?Less people to do the same work.
  • Not only that, but even if you are right about the stock, there will be a lot of sellers selling as the stock price rises, because they got back to even.

When a company is in distress, everything fights against it. ?All of the normal courtesies are gone, replaced by a haze of suspicion. ?At the time it most needs friends, they vanish. ?Tempting as it may be to buy the stock quickly, it might be worth it to wait and see whether things get worse, and analyze who would like to buy the company to use?some subset of the assets for their?own company.

Now recently I read a classic Journal of Finance article called, “In Search of Distress Risk, by?Campbell, Hilscher, and Szilagyi.” [Download is for wonks only, I will summarize.] ?Distress tends to happen to firms that have negative price momentum, are small, and are classified as value stocks because of the high ratio of net worth to market capitalization. ?As a result, some suggested that the risk premiums that exist for owning small and value stocks must be related to distress. ?But firms under distress tend to do badly, while small and value stocks tend to do well. ?Negative momentum fits, but distress is a small part of that anomaly.

So maybe if you are a value investor or a small cap investor, you might be able to improve your performance by screening out distress situations. ?The simplified variables used in the paper are (and their effect on the probability of distress [page 2910]):

  • Net Income / Total Assets (lower means higher probability of distress)
  • Total Liabilities?/ Total Assets (higher means higher probability of distress)
  • Three month total returns?(lower means higher probability of distress)
  • Realized stock price volatility over the last three months?(higher means higher probability of distress)
  • Market capitalization?(higher means higher probability of distress)
  • Stock price under $15??(yes means higher probability of distress)
  • Cash and near cash as a fraction of total assets (lower means higher probability of distress)
  • Market to Book?(higher means higher probability of distress)

Most of these make intuitive sense. ?The one for market capitalization doesn’t except the the effect of a stock being under $15/share is more closely related to distress.

One thing that might make you change you mind is if a new management team is brought in. ?Every quarter I pull together a list of companies that have fired or replaced their CEO, and I throw them in as competitors against the existing companies in my portfolio. ?[there were about 80 over the last three months] A fresh set of eyes, a fresh mind can change things, but analyse to see whether the new man or team has the right ideas.

SEASTo close with an example: don’t buy Seaworld [SEAS] after the negative surprise of yesterday, at least not yet. ?Analyze for solvency. ?Try to figure out whether the actions management is proposing will actually make things better, or whether the company’s prospects have been permanently reduced.

Don’t try to catch a falling knife. ?Rather, analyze, and if it makes sense when the panic has died down, buy some as a part of a diversified portfolio.

PS — In distress, the real pros look down the capital structure to see whether the preferred stock, junior debt, senior debt, bank loans, or trade claims look attractive. ?That’s beyond the average investor, but in times of distress, those securities trading at a discount may be where the real action is. ?The securities that get hurt but not destroyed will typically control the firm post-bankruptcy.

Full Disclosure: No holdings in any securities mentioned

A Few Investment Notes

A Few Investment Notes

Posted on by David Merkel

Just a few notes for this evening:

1) I’ve been a bull on the long end of the Treasury curve for a while. ?It’s been a winning bet, and the drumbeat of “interest rates have nowhere to go but up” continues. ?Here’s an argument from Jeffrey Gundlach on why long rates should remain low, and maybe go lower:

Gundlach, however, was one of the very few people?who believed rates would stay low, especially with the Federal Reserve committed to keeping rates low with its loose monetary policy.

It’s important to note that U.S. Treasuries don’t have the lowest yields in the world. French and?German government bonds have yields?that are about 100 basis points lower than those of Treasuries. In other words, those European bonds actually make U.S. bonds look cheap, meaning that yields have room to go lower.

This will trend toward lower rates will eventually have to end, but neither GDP growth, inflation, or business lending justifies it at present.

2) From Josh Brown, he notes that correlations went up considerably with all risk assets in the last bitty panic. ?Worth a read. ?My two cents on the matter comes from my recent article, On the Recent Anxiety in High Yield Bonds, where I noted how much yieldy stocks got hit — much more than expected. ?I suspect that some asset allocators with short-dated or small stop-loss trading rules began selling into the bitty panic, but that is just a guess.

3) That would help to explain the loss of liquidity in the bond market during the bitty panic. ?This article from Tracy Alloway at the FT explores that topic. ?One commenter asked:

Isn’t it a bit odd to say lots of people sold quickly *and* that there isn’t enough liquidity??

Liquidity means a number of things. ?In this situation, spreads widened enough that parties that wanted to sell had to give up price to do so, allowing the brokers more room to sell them to skittish buyers willing to commit funds. ?Sellers were able to get trades done at unfavorable levels, but they were determined to get the trades done, and so they were done, and a lot of them. ?Buyers probably had some spread target that they could easily achieve during the bitty panic, and so were willing to take on the bonds. ?Having a balance sheet with slack is a great thing when others need liquidity now.

One other thing to note from the article is that it mentioned that retail investors now own 37%?of credit, versus?29% in 2007, according to RBS. Also that?investment funds has been able to buy?all?of the new corporate debt sold since 2008.

There’s more good stuff in the article including how “matrix pricing” may have influenced the selloff. ?When spreads were so tight, it may not have taken a very large initial sale to make the estimated prices of other bonds trade down, particularly if the sales were of lower-rated, less-traded bonds. ?Again, worth a read.

4) Regarding credit scores, three articles:

From the WSJ article:

Fair Isaac?Corp.?said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.

I think there is less here than meets the eye. ?This only affects those borrowing from lenders using the particular FICO scores that were modified. ?Not all lenders use that particular score, and many use FICO data disaggregated to create their own score, or ask FICO to give them a custom score that they use. ?Again, from the WSJ article:

Fair Isaac releases new scoring models every few years, and it is up to lenders to choose which ones to use. The new score will likely be adopted by credit-card and auto lenders first, says John Ulzheimer, president of consumer education at CreditSesame.com and a former Fair Isaac manager.

Mortgages are likely to lag, since the FICO scores used by most mortgage lenders are two versions old.

The?impact of the changes on borrowers is likely to be significant. Accounts that are sent to collections, including credit-card debts and utility bills, can stay on borrowers’ credit reports for as long as seven years, even when their balance drops to zero, and can lower their scores by up to 100 points, said Mr. Ulzheimer.

The lower weight given to unpaid medical debt could increase some affected borrowers’ FICO scores by 25 points, said Mr. Sprauve.

But lowering the FICO score by itself doesn’t do anything. ?Some lenders don’t adjust their hurdles to reflect the scores, if they think the score is a better measure of credit for their time-horizon, and they want more loan volume. ?Others adjust their hurdles up, because they want only a certain volume of loans to be made, and they want better quality loans at existing pricing.

Megan McArdle at Bloomberg View asks a different question as to whether it is good to extend more credit to marginal borrowers? ?Didn’t things go wrong doing that before? ?Her conclusion:

That in itself [DM: pushing for more loans to marginal borrowers as a matter of policy] is an interesting development. Ten years ago, politicians were pressing hard for banks to extend the precious boon of homeownership to every man, woman and shell corporation in America. Five years ago, when people were pushing for something like the CFPB, the focus of the public debate had dramatically shifted toward protecting people from credit. Oh, there were complaints about the cost of subprime loans, but ultimately, on most of those loans, the problem?wasn?t the interest rate but the principal: Too many people had taken out loans that they could not realistically afford to pay, especially if anything at all went wrong in their lives, from a job loss to a divorce to an unexpected illness. And so you heard a lot of complaints about predatory lenders who gave people more credit than they could handle.

Credit has tightened considerably since then, and now, it appears, we?re unhappy with that. We want cheaper, easier credit for everyone, and particularly for the kind of financially struggling people who have seen their credit scores pummeled over the last decade. And so we see the CFPB pressing FICO to go easier on people with satisfied collections.

That?s not to say that the CFPB is wrong; I don?t know what the ideal amount of credit is in a society, or whether we are undershooting the mark. What I do think is that the U.S. political system — and, for that matter, the U.S. financial system — seems to have a pretty heavy bias toward credit expansion. Which explains a lot about the last 10 years.

Personally, I look at this, and I think we don’t learn. ?Credit pulls demand into the present, which is fine if it doesn’t push losses and heartache into the future. ?We are better off with a slower, less indebted economy for a time, and in the end, the economy as a whole will be better off, with people saving to buy in the future, rather than running the risk of defaults, and a very punk economy while we work through the financial losses.

Industry Ranks August 2014

Industry Ranks August 2014

Posted on by David Merkel

Industry Ranks 6_1521_image002My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted?? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

You might notice that I have no industries from the red zone. That is because the market is so high. I only want to play in cold industries. They won?t get so badly hit in a decline, and they might have some positive surprises.

If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion. I generally play in the green zone because I hold stocks for 3 years on average.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh? Why change if things are working well? I?m not saying to change if things are working well. I?m saying don?t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology stocks here, some industrials, some healthcare and consumer stocks, particularly those that are strongly capitalized.

I?m looking for undervalued industries. I?m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive. I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting. The red zone is pretty cyclical at present. I will be very happy hanging out in dull stocks for a while.

That said, some dull companies are fetching some pricey valuations these days, particularly those with above average dividends. This is an overbought area of the market, and it is just a matter of time before the flight to relative safety reverses.

The Red Zone has a Lot of utilities and other dividend-paying industries; as I said, be wary. ?What I find fascinating about the red momentum zone now, is that it is loaded with cyclical companies.

In the green zone, I picked almost all of the industries. If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

Will cyclical companies continue to do well? Will the economy continue to limp along, or might it be better or worse?

But what would the stock screening model suggest that I have displayed the last few times I have done this post?

Wish I could tell you. ?In an “upgrade” Value Line’s stock screener can’t do the Value Line subscription that it used to, because its 3-5 Year Projected Annual Total Return field is blank for the screening software.

Maybe next time, but until then, play it conservative in your industry and stock selections — look for companies that can easily survive if industry conditions worsen. ?Once weaker players are marginalized, they will do well.

On the Recent Anxiety in High Yield Bonds

On the Recent Anxiety in High Yield Bonds

Posted on by David Merkel

Quoting the beginning of a recent article at Bloomberg.com:

As?junk bonds?plunge in value, many investors are wondering why.

There?s no obvious explanation for the 1.5 percent decline in U.S. high-yield securities in the past month, or the $9.9 billion of cash pulled from mutual funds that buy the debt. The most likely reason is that investors are increasingly uncomfortable hanging onto bonds that are expensive by historical measures.

Chalk this one up to a collective bout of angst that looks quite different from the 3.2 percent drop in speculative-grade bonds in May and June of last year. That rout was triggered by the prospect of less Federal Reserve stimulus and, while a withdrawal of easy-money policies still weighs on investors? minds, that?s not the full story now.

On June 24th, the junk bond markets were fairly tightly bid, and volume in the main high yield ETFs [JNK & HYG] were moderate. ?By August 1st, that bid had seemingly disappeared, but volume in the main high-yield ETFs were high. ?Many running for the exits. ?Things have calmed down?since then, at least it seems that way. ?Have a look at this set of credit yield curves:

Credit Yield Curves_22463_image001

Source: FRED

Credit quality goes down as you go from left to right on my chart. ?The lower rated the?bonds, the more they fell, which was the opposite of slower moving but long-lasting bull phase. ?Let’s look at what the losses/gains were like in percentage terms:

Date 5-yr Tsy AAA AA A BBB BB B CCC JNK ($/sh) HYG ($/sh) SPY ($/sh) DVY ($/sh)
6/24/14 1.70 2.57 2.44 2.67 3.44 4.20 5.09 7.91 41.80 95.24 194.70 76.51
8/1/14 1.67 2.54 2.45 2.70 3.50 4.89 6.05 9.16 40.21 92.04 192.50 73.67
8/6/14 1.66 2.52 2.44 2.68 3.50 4.83 5.97 9.11 40.54 92.64 192.07 72.79
Divs 0.86 0.39
Return to 8/1 0.30% 0.39% 0.21% 0.16% 0.12% -2.32% -3.31% -4.18% -1.75% -2.95% -1.13% -3.71%
Return to 8/6 0.36% 0.50% 0.29% 0.27% 0.17% -2.03% -2.92% -3.87% -0.96% -2.32% -1.35% -4.86%

The return calculations are approximations. ?These are indicative, not exact. ?The losses on high yield debt haven’t been horribly large over this period — around 3% give or take, and the ETFs surprisingly did a little better. ?No panic in investment grade bonds, and the losses of the stock market have been minor over that time, leaving aside the fact that the market rallied for a few more weeks after high yield began to slide.

But here’s an odd bit — take a look at the last column in my table. ?That last column is the iShares Select Dividend?ETF [DVY], a very popular place for getting alternative yield. ?It yields about 3.1% now — a little less than you can get on BBB bonds, but ?maybe the dividend will grow. ?(It usually does.)

When you have many different parties going into the markets seeking income, not caring where they get it from, and a shock hits one part of the market, the effect flows to other areas ?If all of a sudden yields on junk bonds look cheaper, the yield trade-offs of buying junk and selling dividend paying common stocks looks attractive.

Now there are few permanent rules for yield relationships — even in corporate debt on its own. ?We can calculate average spread differences, sure, but there is a LOT of variation around those means (which may even bear no resemblance to future means). ?If it is that difficult asking what the right spread tradeoffs are?with?bonds different qualities, then how would we ever come up with the right tradoffs for common stocks, preferred stocks, REITs, MLPs, bonds of varying qualities, etc?

The best we can do is something like GMO does, and go to each asset class?and try to estimate the free cash flow yield of each asset class over the next full market cycle (5-10 years) given the current prices being paid. ?The higher the price paid, the lower future returns will be, and vice-versa. ?Assume that valuations will normalize over the forecast horizon, and don’t just look at valuations using earnings. ?Try book, free cash flow and sales as well. ?Results will vary.

So remember,?The Investments Matter More than their Form. ?Also remember,?Ignore Yield. ?Focus on what is building value for you in every investment. ?I like to own stocks where earnings quality is high,?valuations are low, and free cash flow gets put to good use. ?Do I always get that? ?No. ?But if I get it right enough of the time, then returns will be good enough.

Back to the beginning, though. ?Is this move in the junk bond market a hiccup, or the start of something big? ?I’m open to other opinions, but for it to be something big, you have to have a lot of things that look misfinanced. ?Where are there economic entities with short-term debt financing long term assets that look overvalued? ?Where have debts grown the most? ?I can’t identify a class like that unless we try student loans, or government debts. ?Corporate debt has grown, but doesn’t seem unreasonable now.

So, with high yield, I lean toward the hiccup. ?But even at current yields, it is not cheap. ?Speculators may play; I will stay away.

Ignore Yield

Ignore Yield

Posted on by David Merkel

Yield is not an inherent feature of an asset. ?Why?

  • Dividends can be cut.
  • Bonds can default.
  • Taxable income can fall for REITs, BDCs, and MLPs, thus lowering their distributions.
  • Bonds sometimes have funny features where they can be called away from you, and you get to reinvest in a lower yield environment.
  • With structured notes, your income or principal can be considerably reduced when bad events happen that you thought were unlikely, but really aren’t so unlikely.

Rather, focus on the things that drive the increase in value of an asset. ?You can create your own “dividends” by selling off pieces of investments that you own. ?Commissions are small if you have the right broker.

Why do I write this, this evening? ?I keep running into writers and investment advisors that say, “You need a certain yield? ?I can get you that yield!”

Yes, and I can get you that yield too, but I would hate doing it because it would expose you to risks that I would not like to take with my own money. ?People forget all of the dividend cuts in the ’70s. ?They forget how many times REITs have failed as a group over the past 50 years. ?They forget how much money was lost on Limited Partnerships in the ’80s while trying to cheat the taxman.

Even Jonathan Clements, a writer who I would recommend to everyone, is somewhat duped by the need for yield. ?Getting yield from stocks is an uncertain proposition. ?Focusing on the highest quality stocks, and it is less uncertain, but still uncertain.

One thing is a constant with stocks and dividends — it is better to focus on stocks with low dividends that are growing rapidly, than on stocks with high dividends that grow slowly. ?The reason for this is that good management teams pay out a conservative amount of free cash flow as dividends, and reinvest most of the free cash flow to grow the company.

It is also not certain that bond yields will rise. ?The US economy is not strong, and there is no great demand for business loans at banks.

At a time like this, charlatans arrive telling you how high yields can be achieved in a low yield environment. ?Investment banks offer structured notes with high yields. ?Don’t believe them. ?Instead focus on the investments that might preserve or increase value best.

Now for the controversial bit: time to increase allocations to cash and gold (or commodities). ?You might think, “Wait, are you you saying in a low yield environment, I ought to drop my yield further?” Yes. ?I am also saying that when yields are too low, the opportunity costs of holding gold or cash are also low, and maybe that will help to preserve value if things go wrong.

I manage stocks and bonds for total return. ?I don’t look at yield as an important guide to future?total return in an environment like this. ?I try to ?view all investments through a “What could go wrong?” lens, rather than a “How much cash will this investment send to me next year?” lens.

Here’s a way to think about it. ?Pretend that all investments don’t make distributions. ?What investments would you want to own? ?Which grow value the best? ?That is your first pass in how you should think about investments. ?The second refines it by adjusting for tax rules, because some types of income are tax-favored. ?That said, put value generation first, and tax consequences second.

 

On Management Fees

On Management Fees

Posted on by David Merkel

Yet another letter from a reader:

Hi David –

Thank you for your commitment to sharing your wisdom, ideas, and experience.? I aspire to one day enjoy the success and happiness that you have in your life and career as an investor.

My question may be a bit more tactical than others that you have profiled: In our current world of 2% & 20% fee structures and where in past eras Buffett promoted a 25% performance fee above a 6% threshold (with the objective of aligning partners’ wealth creation incentives), why do investment managers choose to promote % of AUM only fee structures?? I believe you also promote a similar fee only structure??

I’m curious about your insights on the rationale for fee only versus performance only structures.? Does your philosophy have anything to with your faith or past experience working at a hedge fund??

Many thanks and much continued success to you!!

Personally, I like the flat 1% of assets?fee (0.3% for bonds), because it does not make me swing for the fences. ?I don’t take extra risks or chances with client assets because of a performance fee. ?The main goal of investing is to avoid losing money. ?That is what I aim to do over a full market cycle, and I have been successful at it over the last 20+ years.

I respect those who do performance only, like Buffett’s formula, but?my value proposition is that those who invest alongside me get what I get, less the small fee. ?If I underperform in the future, I will be dejected, and it will hurt me far more, than any money I receive in fees. ?I aim to do as well as Buffett, but charge less. ?I am not driven by profits, but by service to clients.

Another way to say it is to hire guys who will do this business even if they weren’t paid. ?That is the way I feel about investing.

I am out to do well, and?not to give my clients a bad deal.

Can the “Permanent Portfolio” Work Today?

Can the “Permanent Portfolio” Work Today?

Posted on by David Merkel

Another letter from a reader:

Dear Mr. Merkel:

I just discovered your blog through Valuewalk, which I read most days. I haven’t read much yet on your blog, but from what I’ve seen, I really like your insights and comments.

I’ve been thinking for a long time about the idea of a permanent portfolio concept, based on writing from years ago of an investment analyst, Harry Browne, now deceased. I’ve been thinking about this for my own investment requirements and also because I intend to write a book on the subject.

The big problem with a permanent portfolio today, versus 30 years ago, in my judgement, is identifying a long term fixed income vehicle would survive a major financial collapse. Browne always used 30 year US Treasury bonds, in an era when it seemed clear those bonds could survive a monetary deflation.

Of course, the Fed isn’t about to institute a policy of sustained monetary deflation any time soon, on a voluntary basis. Any such deflation would occur, either because the Fed were unable or unwilling to monetize assets fast enough to head off cascading cross defaults and massive bonk failures; or because the Fed decided to let the house of cards collapse, in some future recession-panic, because it became obvious to a plurality of Fed governors that to prop up the house of cards would guarantee hyper inflation in short order. Of course, a hyper inflation would not only destroy the financial system, including the central bank; it would overturn the established political order, and cause a famine as the division of labor fell apart.?

I think a monetary deflation will happen sooner or later, because of a financial “accident” (that reasonable people can foresee). Even if the central banks were to cause a hyper inflation, when that inflation ends after two or three years, the currency must be renounced. Then we would get deflation for a while via some new currency.

Since I think the deflation risk is realistic, I’m trying to figure out what-if any-bond instruments could survive deflationary destruction. Obviously, in a monetary deflation, all investment prices plummet, except default-free bonds. Default free bonds would rise in price, as interest rates plummeted. However, I’m not clear as to what bonds might work as vehicles in a permanent portfolio, because T bonds are no longer a reliable safe haven from eventual political default.

There might well be sovereign bonds in other countries that are more friendly to free enterprise and private property than contemporary US, and hence less prone to sovereign bond default,? but this introduces the risk of currency fluctuations. So it’s not a perfect solution. Perhaps some foreign sovereign debt combined with US Treasury debt would partly work. It has also occurred to me that some US utility or pipeline firm etc. might offer debt or preferred stock or other forms of fixed income debt/equity ownership that would survive default. In a terrible depression, I’d assume some utility companies would continue to function although, of course, not flourish. Obviously, any such debt or equity would be a very special situation, since most firms are now loaded to the gills with debt, making them poor risks to survive a crushing deflation.

My impression is all this is right up your ally. (Except for my musing-theorizing about the risk of monetary deflation, which no doubt makes me seem like a religious fanatic or political crazy.) Anyway, I’d be interested if you think this problem can be solved. In other words, do you think some private debt issues that are long term or even medium term exist to be discovered that could avoid default in a huge deflationary depression? How would you go about conducting a search for such safe U.S. corporate bonds or other fixed income instruments?

What I really need to do is immerse myself in reading about fixed income analysis. Which I hope to get to in a few months.

None of my fixation with bonds has to do with forecasting a decline in interest rates; until the next crisis, rates on the long end could easily climb. I’m looking for a secure volatile instrument that would gain in price as other investments were falling during a financial panic and subsequent depression.

Thanks for reading through all this. I look forward to spending a lot of hours in the future on your blog.

Yours truly,

Dear Friend,

I have written about the Permanent Portfolio concept here. ?I think it is valid. ?At some point in the near term, I will update my analysis of the Permanent Portfolio, and publish it for all to see, which I have not done before.

In a significant inflation scenario, gold would soar, long T-bonds would tank, T-bills would actually earn nominal but not real money, and stocks would likely trail inflation, aside from investors that invest in low P/E stocks. ?The permanent portfolio would likely do okay.

Same ?for a deflation scenario. ?Stocks will muddle. T-bonds will do well. ?T-bills will do nothing. ?Gold will do badly. ?That said, the permanent portfolio concept is meant to be an all-weather vehicle, and has done well over the last 44 years, with only 3 losing years, and returns that match the S&P 500, but with half the volatility.

I’m usually not a friend of ideas like this, but the Permanent Portfolio chose four assets where the price responses to changes in real rates and inflation fought each other. ?The rebalancing method is important here, as it is a strategy that benefits from volatility.

With respect to where to invest in fixed income?to benefit from a depression is a touchy thing — it’s kind of like default swaps on the US government, which are typically denominated in Euros. ?How do you know that the counterparty will be solvent? ?How do you know that the Euro will be worth anything?

Personally, I would just stick with long US Treasuries. ?The US has the least problems of all the great powers in the world. ?You could try to intensify you returns by overweighting long Treasuries, but that is making a bet. ?The Permanent Portfolio makes no bets. ?It just takes advantage of economic volatility, and rides the waves of?of the economy. ?As a group, stocks, T-bonds, T-bills, and gold, react very differently to volatility, and as such do well, when many other strategies do not.

Warren Buffett is “scary smart,” so says Charlie Munger, who is “scary smart” himself. ?I think Harry Browne was “scary smart” with respect to the Permanent Portfolio idea. ?But am I, the recommend-er “scary smart?” ?I do okay, but probably not “scary smart,” so take my words with a grain of salt.

Sincerely,

David

PS — As an aside, I would note that if everyone adopted the “Permanent Portfolio” idea — gold would go through the roof, because that is the scarcest of the four investments.

How to Start an Investment Advisory Business from a Nontraditional Background

How to Start an Investment Advisory Business from a Nontraditional Background

Posted on by David Merkel

Another letter from a reader:

Hi,

I recently discovered your blog. I read that you have had quite a long history in the financial industry and you mentioned to be running your own asset management shop as well. I currently work as a software developer but I have had for a long time a strong passion for investing and lately I have combined both of the latter. During the last 2 years I have developed my own software for simulating all sorts of quantitative investment strategies mainly for myself but at times for clients too. However, currently I am in a situation where I would like to take my hobby and passion to the next step and start working in the financial industry as a programmer doing similar tasks as I have done now as a hobby. Would you happen to have any good advice how to move forward and where to start looking for this kind of a position?

Thanks in advance,

You have to make your expertise known. ?That can be through a blog, a newsletter (whether e-mail or paper), and must give people a taste of your expertise. ?Be aware that to gain reader interest, clever examples will suffice. ?To gain clients you will need a track record that shows the results of all decisions made ?over the non-discretionary accounts you advised.

Simulated results aren’t enough. ?You have to be able to show that you made actual money in real time. ?Once you can do that, make your expertise known, and then follow up with those who contact you.

Many clever investors have come from nontraditional backgrounds. ?I know more than a few. ?I will add only this: don’t quit your “day job” before you have a sense that your investment management firm will have traction.

Sincerely,

David

On Setting Up New Accounts

On Setting Up New Accounts

Posted on by David Merkel

Another great letter from a reader:

Hi David,

I enjoy your writing. I find myself of a similar mindset. I am an investment advisor running my clients individual accounts in a value fashion. I am currently have my clients invested in about 20 positions. My question is in regards to a new account….I have held off on buying the same positions in that new account unless any of the 20 positions still fall within my estimated “buy” range. Therefore, a new account opened today may sit in cash for some time until new ideas are found, or the 20 positions from the other accounts fall back to a buy range. How do you handle this? Do you use a model portfolio and all accounts consistently look alike?

Thank you and keep up the good work,

Dear Friend,

My value proposition is that clients get a clone of my accounts. ?I am my own biggest client; what I get, they get, less fees. ?I set them up to mirror my account within a week of receiving the assets.

The main reason I do it this way is that there is little rhyme and reason to target prices. ?I don’t have any target prices. ?Rather, I compare stocks against each other using a scoring system quarterly, and I sell companies that are relatively ?expensive and buy companies that are relatively cheap. ?Read my article Portfolio Rule Eight to understand this better. ?I realize few managers manage money this way, but I think it is a way that reflects how the markets really work. ?We should not compare individual stocks against cash, but compare stocks against each other. ?We should compare the stock market as a whole against cash, to analyze whether it is absolutely rich or cheap.

Sincerely,

David

The Investments Matter More than their Form

The Investments Matter More than their Form

Posted on by David Merkel
  • Open-end Mutual Funds, including index funds
  • Closed-end Mutual Funds
  • Exchange Traded Funds, including index funds
  • Separately Managed Accounts
  • Unit Investment Trusts
  • Hedge Funds
  • Private Equity
  • Other Limited Partnerships [LPs], including MLPs
  • Variable Annuities (and Life Insurance)
  • Equity-Indexed Annuities (and Life Insurance)

What do all of the above have in common? ?The first one is the easiest — they are all investments. ?The second one is harder — they are all ways of investing in the ownership interests of corporations.

Think of the underlying investments within these investment forms when analyzing the forms as investments. ?Now the forms aren’t entirely neutral:

  • Index funds don’t take a lot of fees.
  • Hedge Funds, Private Equity, and Insurance Products do take a lot of fees.
  • Insurance Products are tax favored. ?LPs,?MLPs and Private Equity have some tax advantages. ?Separately managed accounts can have tax advantages, if managed right. ?If you make the right investment, buying and holding has tax advantages, especially if you take it to the grave.

Thus, you should look at the manager, to try to analyze if he has skill. ?You should look at the fees to see what you are giving up. ?You should look at the tax advantages.

You should also think about the sensitivity of the investments to the overall risk cycle. ?I don’t like the concept of beta, because it is not a stable concept, but in broad hedge funds have low beta, and private equity has high beta, relative to an S&P 500 index fund. ?But neither in aggregate have much outperformance, after adjusting for the beta.

There are many clever investors scouring the world of investments looking for underpriced assets. ?At a time like now, there aren’t a lot of underpriced assets. ?I might find 2-4 per quarter, but they are only relatively underpriced, not absolutely underpriced (I.e. at this price, you should buy it regardless the the economic environment).

Every now and then, the market falls apart. ?At such a time, two things happen.

1) Because some sector of the economy had too much debt, prices for the stocks and corporate bonds (or trade claims) fall, and the market as a whole falls along with them, though to a lesser extent.

2) During the crisis, many assets get oversold, and those with better knowledge can profit from the overselling. ?The best example I can think of all of the hedge funds that bought non-agency mortgage-backed securities, when they were thrown out the window indiscriminately in 2008, and many of those securities have returned to par.

The ability to achieve alpha (outperformance) increases after a crisis. ?Some who prepare for that, like Seth Klarman and Warren Buffett, create their own outperformance by taking more risk when other investors are running away in panic.

As my boss asked me in 2007, “Why have you not done so well for us the last few years, when you did so well 2003-5? ?I answered, “When I came to you, the market was like an apple cart ?that had fallen over and I picked up the undamaged apples. ?Today, the market is rational, and there are not a lot of easy pickings to be had. ?That is the difference between the bust and the boom. ?It is much easier for a fundamental investor to act during the bust.

Thus I would encourage the following:

  • Pay attention to fees
  • Pay attention to tax advantages.
  • The time at which you invest matters ?a great deal: try to invest when opportunities are the greatest (and others are scared stiff)
  • Ignore the form of investing, but invest with skilled managers (if you can find them, otherwise index funds).

Think of Seth Klarman who hands back money to his clients when markets are not promising. ?Few professionals have the intelligence?to do that. ? Fewer have the ethics and courage to do so.

For my equity clients, I have reduced exposure, and I am close to my maximum cash level of 20%. ?I am watching the market, and am willing to add to my positions, 10%, 20%, and 30% lower. ?I own good companies. ?As has been true in the past, I get close to zero cash as the market bottoms. ?The market is somewhat high now — I think of it as the 80th percentile. ?But it is not at nosebleed levels.

Analyze your investments, and sense the skill of managers, and lack thereof, and the degree of sensitivity to the market as a whole, which is likely higher than you expect.

Then adjust as you see fit. ?Every situation is different, except for the parts that are the same.

All for now.

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