Category: Portfolio Management

Aiming for Transparency

Aiming for Transparency

Posted on by David Merkel

Here’s another letter from a reader:

David,

I’m starting this fund, and I wanted to get your opinion.

?It is best explained on YouTube in 55 seconds: let me know what you think?https://www.youtube.com/watch?v=frwOrQd3f6w. It (hopefully) will provide incentive for transparency in funds.

?Thank you!

Okay, I can’t embed?the short video, so click on the link above and watch it — it is less than a minute, and well-done.

To the writer:

I admire your efforts at providing transparency here, but let me tell you where I think this may have unintended negative consequences.

Anytime you provide total transparency, you invite front-running, if the manager is any good. ?New ideas are often most potent at their beginning, and given the delay between notifying mutual fund shareholders, voting and implementation, critical time is sacrificed, and some of your shareholders may front-run you.

Imagine a person investing the minimum in your fund so that he could front-run your picks with a greater amount of money. ?But even if front-running does not happen, it is generally wise to move rapidly once the manager has come to a decision. ?The delay from?having shareholders vote on it is likely a money-loser. ?Also during times of crisis, the manager may have some of his best ideas, but when average people are scared, will they be willing to pull the trigger? ?I have my doubts.

In general, I favor investment methods where decision-making is done by individuals. ?If I were running a hedge fund, or a large mutual fund, I would delegate all decisions to the sector/industry analysts. ?Let sharp opinions prevail. ?I’ve worked in areas where groupthink muddies investment decisions — it does not lead to outperformance.

Transparency

You don’t need to have shareholders vote on investments to have transparency. ?You could do what I do, because all of my investors have full transparency.

I manage separate accounts using Interactive Brokers. ?We buy and sell as a group. ?We all get the same buy and sell prices. ?I don’t trade often, but any investor can monitor his/her account all day long. ?They can set up a daily download so that they can see what actions have been taken, if any. ?There is total transparency, to the degree that my investors want to make the effort. ?And remember, making investors go through a lot of effort is a negative.

If I Were in Your Shoes

If I wanted to give your investors transparency, I would give them access to a website showing the portfolio in real time, set up in such a way that only they could see it. ?I would not let them vote on investments. ?If you are hiring a manager, let him manage. ?Second-guessing and delay are a waste of time and money.

Now those are my thoughts, and maybe your views on running a democratic fund are important to you. ?Do what you think is best — just remember that democracy is not the same as transparency, and to achieve transparency, democracy is not needed. ?Information is power, and you want to be careful in how you share it.

All that said, I hope you succeed, and that it works out well for you and your shareholders!

One More Note on Failure

One More Note on Failure

Posted on by David Merkel

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement. ?Why did this happen? ?Two things went wrong at the same time:

  1. The toilet needed to be plunged, because there was a blockage preventing water discharge, and
  2. The flapper malfunctioned, and so water continued to flow.

If only one of these problems had happened, we would have had an ordinary problem. ?I can plunge a toilet, easy. ?I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

Most of the time, when we plan against failure, we look at solutions that address single failures. ?We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often?two things that went wrong at the same time. ?Usually it follows a pattern like this:

  1. Take a risk that in ordinary times often works out, but
  2. You don’t get that times are not ordinary, and so the odds are actually stacked against you.

I have several examples for this. ?Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system. ?But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.” ?Multiple failures leading to large bad results are worth thinking about. ?So what aren’t we thinking about now?

  • Failures in retirement security systems as the Baby Boomers age.
  • Failures in government debt as overleveraged governments can’t make debt payments.
  • Inflation rises rapidly as the economy revives amid increased lending from banks.
  • Deflation persists as the central?bank tries to force-feed credit to an already overleveraged economy.

(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis. ?High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

  • Are there hidden factors that could lead to a big failure? ?(Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
  • How well would the investment?fare if inflation went up significantly?
  • How well would the?investment?fare if real interest rates?went up significantly?
  • How well would the?investment?fare if?we hit another patch where financing is not available? ?Can the investment self-fund?
  • How much future prosperity does the current price of the investment embed in its valuation?

I know, glum words. ?But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.

The Reason for Failure Matters

The Reason for Failure Matters

Posted on by David Merkel

When I was a young actuary, say in the early 90s, my boss came to me, and gave me an unrequested lesson. ?He said something to the effect of:

Most pricing actuaries make assumptions. ?Well, I test assumptions. ?That involves checking how actual results are coming in?expected, but in the early phases of a new product, you are living under the law of small numbers — you don’t have enough data to be statistically credible. ?You should still do the statistical analysis, but I take it one step further.

I pull the first 10-20?claim files and look at the cause for the claim. ?If the qualitative causes are not chance events, but are indications that the business is being sold improperly to those who know they are close to death (or disability) and evade the limited underwriting of the group coverage, that means the group is low quality, and the program should be discontinued, or severely modified.

He then told me about some credit life insurance that the company was offering through two well known, prestigious banks, and how the deaths were coming in from non-random causes: AIDS, Cancer, Drowned in the Hudson River, Murder, etc.

He fought to get that insurance line shut down, and it took him five years, as the line manager argued there was not enough experience. ?The line manager tried to get my boss fired, and finally, the line manager was fired. ?But if the company had listened early they would have lost $10M. ?As it was, they lost several hundreds of millions of dollars.

Now, most of my readers don’t care much about insurance, but this tale is meant to illustrate that reason for losses matters as much, and sometimes more than the absolute amount lost. ?Now to illustrate this for a different and perhaps more timely reason:

Wups, wups,?wups,?wups, pop, Pop, POP, Yaaaaaauuughhhh!

Maybe I am growing up a little, but I am trying to have better titles for my articles. ?The subheading above would have been my title. ?But let me explain what it means:

The credit cycle tends to be like this: in the bull phase, a long period (4-7 years) with few defaults and low loss severity followed by a bear phase, a shorter period (1-3 years) with high defaults and high loss severity. ?This is a phenomenon where history may not repeat exactly, but it will rhyme very well.

In the bull phase of the credit cycle there are a few defaults, but when you analyze the defaults, they occur for reasons unrelated to the economy as a whole. ?What do the failures look like? ?Fraud (think Enron), bad business plans from a megalomanic (think Reliance Insurance, ACH, Southmark, etc.) , a sudden shift in relative prices (think Energy Future Holdings), etc. ?Bad banking — think Continental Illinois in 1984.

In the bull phase, companies that fail would fail in any environment. ?But now let’s talk about the transition between the bull and bear phase — that is the “pop, Pop, POP.”

As the credit cycle shifts, a few companies fail that are closely related to the crisis that will come. ?They are your early warning. ?Think of the subprime lenders under stress in 2007, or the failure of Bear Stearns in early 2008. ?Think of LTCM in 1998, or the life insurers that came under stress for writing too many GICs [Guaranteed Investment Contracts] in the late 80s and invested the money in commercial mortgages.

As the cycle moves on defaults become more closely related to the financial economy as a whole. ?Fed policy is tight, and a bunch of things blow up that borrowed too much money short term. ?This is when the correlated failures happen:

  • Banks, mortgage insurers, and overly leveraged homeowners default 2008-2011.
  • Dot-coms fail because they can’t pay their vendor finance.
  • Mexico and the mortgage markets blow up in 1994.
  • Commercial mortgages blow up in the early 90s.
  • LDC loans blow up in the early 80s.

To the Present

The present is always confusing. ?I get it right more often than most, but not by a large margin. ?We have companies threatening to fail in China?and?Portugal, but I don’t see much systemic lending risk in the US yet, aside from what is leftover from the last crisis.

It is worth noting that deleveraging has occurred more in word than in deed over the last five years. ?Yes, debt has traveled from public to private hands, but that only defers the problems, as governments will either have to inflate, tax more, or default to deal with the additional debts.

I am not trying to sound the alarm here. ?I am trying to tell you to be ready. ?During the intermediate phase between bull and bear, the weakest companies fail from unrecognized systemic risk. ?Personally, I think I have heard the first ‘pop.” ?It is coming from nations that did not delever, and that may suffer further if the bad debts overwhelm the banking systems.

Are you ready for the bear phase of the credit cycle? ?Screen your portfolios, and look for weak names that will not survive a general panic where only the best names can get credit.

What to do when Valuations are High?

What to do when Valuations are High?

Posted on by David Merkel

A letter from a reader:

Hi David,

What would you recommend for a long only equities portfolio?

I too think the market may be overheating, but as always, it’s impossible to tell when the party will end. I would have said the same thing last year this time as well.

This is what I am doing now:

  1. Cash is presently 16% of my portfolio.? I let that fluctuate between 0-20%.? I try to be fully invested during crises, and build up some cash when valuations are extended. ?16% means valuations are high, but they could get higher — we aren’t at nosebleed levels.
  2. I have more invested in foreign companies than I normally do.? Around 40% of the portfolio is in foreign companies, which are at present undervalued relative to similar US companies.
  3. Emphasize companies with strong balance sheets, in industries that will not go away.
  4. I own cheap stocks.? The median valuation of the stocks that I own is around 10x earnings, and 1x Net Worth (Book Value).

This isn’t sexy, and if the market roars ahead, my clients and I will underperform.? But if there is a reason that emerges that causes the market to fall, my clients and I will do better than most.

I take more risk when the market is in the tank, and less when everyone thinks things are great. ?This is particularly true when policymakers like the Fed are triumphant over high valuations, and low yield spreads.

This is a time to take less risk, in my opinion, but not a time to take no risk.

When Was the Last Time We Had Two Down Days in a Row?

When Was the Last Time We Had Two Down Days in a Row?

Posted on by David Merkel

I met with some board members from the local CFA Society for lunch today. ?I commented, “When was the last time you saw two down days in a row?” ?The answers ranged from at least a month, to sometime in May. ?I use the S&P 500 as a measure, as most professionals do, and the answer is June 24th. ?Admittedly, one of those declines was very small, but if you want to go back further, there were three down days in a row ending on June 12th.

This teaches a?lesson: in a bull market, most professionals get skittish, and are looking for the turn, and think the market is running mindlessly higher without respite.

For investors that have reduced risk, sensing overvaluation, the continued rise in prices numbs the senses, and makes things seem worse than they are for those that are trying to beat the market.

Why do I write this? ?We all need to take ?step back and focus on first principles. ?What are our goals for clients? ?What time horizon are we looking at? ?Why are we looking at day-to-day performance?

Far better to try to analyze what is being neglected, than agonize over past performance.

On Fixed Payment Annuities

On Fixed Payment Annuities

Posted on by David Merkel

Before I start, thanks to all those who e-mailed me over my “sorted weekly tweets.” ?I am likely to continue doing them. ?That will start next week, because I have had a flood of new clients, and other obligations.

On Fixed Payment Annuities

How often do you run into articles in quality publications talking about annuities that will pay a fixed sum over your life, or over your life if you live past a certain age? ?Not often, right? ?Right. ?Well, today I got two articles on the same day:

Longevity insurance is an important topic, and everyone should consider getting an income that they can’t outlive. ?That said, there are two problems with this:

  • Inflation, and
  • Credit risk (will the insurer survive to make the payments?)

It is possible to buy inflation-protected annuities, but at a cost of a lower initial payment. ?With credit risk, consider what the state guaranty funds will cover in insolvency, and realize that any payments over that amount could be lost due to insurer insolvency. ?If you have a large payment, only buy from strong insurers.

Then there are the deferred fixed payment annuities. ? You are 50 years old, and you want a payment stream that kicks in when you are 80, should you live so long. ?You can buy a lot of income that far out, which will help you if you survive, subject to the same two main risks: inflation and credit risk. ?I am not aware of any deferred inflation-adjusted payment annuities.

Now, you can think of your annuity as a replacement for long-dated fixed interest bonds. ?A portfolio of fixed payment annuities, cash, maybe some commodities/gold, and stocks could be very stable, balancing the risks of inflation and deflation, and of high and low real rates.

There is the added benefit of the regular income which is useful to average people, who are okay with budgeting, but really don’t understand investments. ?Just beware inflation and credit risk.

One more note: most insurance agents will never suggest immediate annuities to you because when you buy one, that’s the last commission the agent ever gets. ?They would rather you buy a deferred annuity, where they can gain another commission when the surrender charge period is up, and roll you to a new product.

Summary

Longevity insurance is good, but be sure you avoid credit risk, and have other assets to compensate for potential inflation risk.

What is Liquidity? (Part VII)

What is Liquidity? (Part VII)

Posted on by David Merkel

For those that want the quick hit and don’t care about the underlying ideas, here is the main idea:

A vehicle holding assets may appear more liquid than the assets themselves, but that is only true in bull markets. ?When bad times come, the liquidity proves elusive, particularly for large trades.

ETPs are wonderful things, but there is one thing that ETPs can’t do. ?They can’t change the underlying assets that they own. ?Merely because you have the ability to buy or sell at will does not change the performance of the assets held. ?Like most investment products, the amount of assets invested expands in a bull market and contracts in a bear market.

People follow trends. ?As they follow trends, they tend to lose money, because they buy and sell too late. ?As such, average investors in ETPs tend to lose money relative to buy and hold investors.

In this sense, liquidity is not your friend. ?Just because you can trade, does not mean that you should. ?Speculators tend to lose to the longer-term investors, who hold for longer periods of time. ?Trading itself is a zero-sum game, but bearing risk is a positive sum game, if done with a margin of safety.

Also, if you are trying to do an institutional-size trade in an ETP, you will find that the market impact costs are significant. ?Just because there is an exit door in the theater does not mean that everyone can get out instantly.

Repo Transactions

But here is my favorite bugbear in liquidity: repo transactions. ?Repurchase?transactions turn a long-term asset financed short into a short term asset. ?Now the Fed thinks that it can control the repo market.

Honestly, the easy solution is to disallow the accounting treatment of repos, and force those who do them to display them as a long asset and a short liability. ?Why?

Because in crises, the long assets are illiquid, and as such the value shrinks when liquidity is prized. ?The liquid liabilities still demand to be paid at par.

The accounting change would be better than what the Fed thinks that it might do. ?You can’t make long-dated assets liquid. ?The cash flows are distant. ?Yes, there may be some interest payments that are near, but ultimate repayment of principal is distant.

Let me suggest a better concept of liquidity: assets are liquid to the degree that you can turn the?underlying?into cash. ?When I say that, I do not mean trading big blocks of stock, but selling companies for cash. ?That is liquidity, and as such most risky assets do not have significant liquidity, though many trade every day during bull markets.

Liquidity is a scaredy cat, it disappears when it is most needed. ?That happens because people think they can sell at par when they can’t.

All for now, but remember this — liquidity is a bull market phenomenon. ?People are far more likely to trade when they have unrealized?gains rather than losses.

 

Book Review: Investing in India

Book Review: Investing in India

Posted on by David Merkel

51rdhXWu3BL I learned a lot from this book. India is an amalgam of nations inside one country. It is difficult to generalize about investing in India but there are a few themes to follow.

Most companies in India have a dominant shareholder, or family of shareholders. ?As such, though there are some companies like this in the US, the first prism you view any Indian company through is how they treat outside passive minority shareholders, particularly foreign ones. ?If they constantly give minority shareholders the short end of the stick, no matter how attractive the investment, avoid them.

Analysis of corporate governance is paramount, because it is very difficult to take a company over in a hostile manner. ?Assume that the present management will never be changed. ?Does the company still look cheap if the value -destroying management team will remain there?

Analyze capital allocation as well. ?If management?acts like value maximizing businessmen, it could be a good company to invest in. ?If not, avoid.

Structure of the Book

The book is a slow ramp up as far as business goes, talking about culture, politics, economy, and financial structure, before really digging into investing. ?These are good things to learn about, but the amount of time the book dedicates to making practical investment decisions in India is maybe 25% of the book.

The Main Problem

After you read this book, you will realize that without detailed local knowledge, you don’t stand a chance of investing in public Indian companies directly. ?As such, the book is of limited value to most people. ?So, though it is a good book, you probably would not benefit from reading it, aside from learning about Indian culture and government. ?You would have to build up a lot of knowledge about the Indian families who run public corporations in India — which ones are favorable to outside passive minority investors, and which are not.

Aside from that, they mention the website for the book, but it is just a collection of documents for the companies mentioned in the book.

Summary

India is an unusual country with many challenges. ?You will learn a lot about it and its economy reading this book. ?When you are done reading this book, you will likely conclude that investing in Indian companies is best left to local experts like the author. ?The book gives a good framework, but one embarking upon investing in India will need to develop knowledge of which Indian families treat minority shareholders fairly and who do not. ?If you want to, you can buy it here:?Investing in India, + Website: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World (Wiley Finance).

Full disclosure:?The PR flack asked me if I would like a copy, and I said yes.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

A Straw Blowing in the Wind

A Straw Blowing in the Wind

Posted on by David Merkel

I would like to point your eyes to this article:?Cash No Longer King as Stock, Asset Swaps Drive Takeovers. ?This is another sign that equity valuations are getting high. ?When equities are cheap, corporations part with cash to buy other corporations and assets. ?When equities are rich, corporations use them as a currency to buy assets. ?After all, it is a lower risk way to do things, because paying cash raises the leverage of the combined enterprise.

When acquirers are certain they pay cash. ?When they are not so sure, they pay with shares.

As such, this is another indicator that equities are expensive relative to cash. ?That’s all for now.

What to Do After a Bad Day?

What to Do After a Bad Day?

Posted on by David Merkel

As for my portfolio, June was looking pretty good, then yesterday happened. ?Worst relative performance day in 2 years. ?The US Government announced that it would allow the export of partially refined crude oil, and US refiners got hit. ?Two articles:

Sadly, this hits a concentrated area of my portfolio, which has a concentration in oil refiners. ?That concentration has benefited my clients in the past. ?So what to do now?

Nothing.

I do nothing. ?I find many refiners, particularly those that I own, to be attractive at present levels, and at slightly lower levels, I will start to buy more of the refiners.

I knew this issue was out there, and I think the reaction was overdone, as said Fadel Gheit:

Oppenheimer’s Mr. Gheit said the selloff in refiners’ shares is an overreaction, but added that the news has increased investors’ focus on the sector. “My phone hasn’t stopped ringing today,” he said.

“The market is extrapolating this one step to mean this is a prelude to lifting the oil-export ban,” he added. “It’s a knee-jerk reaction, on a very little bit of information.”

The correct reaction to most sudden market moves is nothing. ?Sit back, and analyze what the opportunity is relative to current prices, and if you conclude that?your opportunities are markedly worse at current prices, sell some. ?If opportunities are better at current prices, buy some.

I suspect I will buy more of the refiners over the next month, and I think I will do well with the position. ?Refiners are less cyclical than they used to be, and their low valuations are unwarranted. ?Also remember, many of these refiners have significant hedging operations; they are not just floating at spot.

So I do nothing at present, and I am not crying, nor compelled to action after a bad relative performance day.

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