Portfolio Management – Page 28

Post 2500: What is the Aleph Blog About?

Posted on 12 June 201420 June 2017 by David Merkel

Every hundred or so posts, I take a step back, and try to think about broader issues about blogging about finance. ?Tonight, I want to explain to new readers what the Aleph Blog is about.

There have been many new followers added to my blog recently, ?through e-mail, RSS, and natively. ?This is because of this great article at Marketwatch, which builds off of this great article at Michael Kitces’ blog.

I am humbled to be included among Barry Ritholtz, Josh Brown, and Cullen Roche, and am genuinely surprised to be at number 4 among RIAs in social media influence. ?Soli Deo Gloria.

What Does the Aleph Blog Care About?

I’m writing this primarily for new readers, because I’ve written a lot, and over a lot of areas. ?I write about a broader range of topics than almost all finance bloggers do because:

I’m both a quantitative analyst and a qualitative analyst.
I’m an economist that is skeptical about the current received wisdom.
I like reading books, so I write a lot of book reviews.
I’m also a skeptic regarding Modern Portfolio Theory, and would like to see it discarded from the CFA and SOA syllabuses.
I believe in value investing, in both the quantitative and qualitative varieties.
I believe that risk control is a core concept for making money — you make more money by not losing it.
I believe that good government policy focuses on ethics, not results. ?The bailouts were not fair to average Americans. ?What would have been fair would have been to let the bank/financial holding companies fail, while protecting the interests of depositors. ?The taxpayers would have been spared, and there would have been no systematic crisis had that been done.
I care about people not getting cheated. ?That includes penny stocks, structured notes, private REITs, and many other financial innovations. ?No one on Wall Street wants to do you a favor, so do your own research and buy what you want to own, not what someone wants to sell you.
Again, I don’t want to see people cheated, so I write about ?insurance. ?As a former actuary, and insurance buy-side analyst, I know a lot about insurance. ?I don’t know this for sure, but I think this is the blog that writes the most about insurance on the web for free. ?I write as one that invests in insurance stocks, and generally, I buy the stocks because I like the management teams. ?Ethical, hard working insurance management teams do the best.
Oddly, this is regarded to be a good accounting blog, because as a user of accounting statements, I write about accounting issues.
I am a skeptic on monetary and fiscal policy, and believe both of them tend to sacrifice the future to benefit the present. ?Our grandchildren will hate us. ? That brings up another issue: I write about the effects of demographics on the markets. ?In a world where populations are shrinking in developed nations, and will be shrinking globally by 2040, there are significant economic impacts. ?Economies don’t do well when workers are shrinking in proportion to those who are not working. ?(Note: include stay-at-home moms and dads in those who work. ?They are valuable.)
I care about the bond market. ?There aren’t that many good bond market blogs. ?I won’t write about it every day, but I will write about i when it is important.
I care about pensions. ?Most of the financial media knows things are screwed up there, but they do not grasp how bad the eventual outcome will likely be. ?This is scary stuff — choose the state you live in with care.

Now, if you want my most basic advice, visit my personal finance category.

If you want my view of what my best articles have been, visit my best articles category.

If you want to read about my “rules,” read the rules category.

Maybe you want to read some of my most popular series:

My blog is not for everyone. ?I write about what I feel most strongly about each evening. ?Since I have a wide array of interests, that makes for uneven reading, because not everyone cares about all the things that I do. ?If that makes my readership smaller, so be it. ?My blog expresses my point of view; it is not meant to be the largest website on finance. ?I want to be special, even if that means small, expressing my point ?of view to those who will listen.

I thank all of my readers for reading me. ?I appreciate all of you, and thank you for taking the time to read me.

As one final comment, I need to say this. ?I note people unfollowing my blog at certain times, and I say to myself, “Oh, I haven’t been writing about his pet issue for a while.” ?Lo, and behold, after these people leave, I start writing about it again. ?That is not intentional, but it is very similar to how the market works. ? People buy and sell investments at the wrong times.

To all my readers, thank you for reading me. ?I value all of you, and though I can’t answer all e-mails, I read all e-mails.

In summary: the Aleph Blog is about ethics and competence. ?I want to do what is right, and do what gives the best investment performance, in that order.

On Bond Risks in the Short-Run

Posted on 7 June 20148 June 2014 by David Merkel

From a letter from a reader:

Hi David,

I’ve been following your blog for the last few months and the articles are extremely insightful.

I’ve been working with fixed income credit trading the last few years but I feel that I have not been measuring risk well. I only look at cash bonds

Right now I’m only looking at DV01 and CR01, but my gut tells me that there’s a lot more to risk monitoring that can be done on a basic cash bond portfolio.

From your experience as a bond portfolio manager, what other risk metrics have you found useful?

I’d really appreciate if there were a few pointers you could give or just a trail that you could show me and I’ll follow it.

First, some definitions:

Basis Point [bp]: 0.01% — one one-hundredth of a percent. ?If you have $10,000 in a money-market fund, and they pay one basis point of interest per year, at the end of the year you will have $10,001. ?In this environment, that’s not uncommon.

DV01:?A?bond valuation?calculation?showing the?dollar?value?of a one?basis point?increase or?decrease?in?interest rates. It shows the?change?in a?bond’s?price?compared to a decrease in the bond’s?yield.

CR01: Credit Sensitivity ? Credit Default Swap [CDS] price change for 1bp shift in Credit par spread — same as DV01, but applied to CDS instead of a bond.

Now, onto the advice: when you manage bonds, the first thing you have to do is understand your time horizon. ?Is it days, weeks, months, or years? ?When I managed bonds for a life insurer 1998-2003, the answer was years. ?Many years, because the liabilities were long. ?That gave me a lot of room to maneuver. ?You sound like you are on a short leash. ?Maybe you have a month as your time horizon.

When the time horizon is short, the possibilities for easy profits are few, and here are a few ideas:

1) Momentum: yes, it works in the bond market also. ?Own bonds that are rising, and sell those that are falling. ?Be sensitive to turning points, and review the relative strength index.

2) Stick with sectors that are outperforming. ?Neglect those that underperform.

3) If you have significant research that has a differential insight on a bond, pursue it with a small amount of money if it may take a while. ?If the change might happen soon, increase the position.

4) Try to understand when CDS is rich or cheap vs cash bonds by issuer. ?Look at the price history, and commit capital when pricing is significantly in your favor.

5) Set spread?targets for your investing. ?Decide on levels where you would commit minimum, normal, and maximum funds. ?Be generous with the maximum level, because markets are more volatile than most imagine.

6) Look at the criteria for my one-minute drill:?http://alephblog.com/2010/07/17/the-education-of-a-corporate-bond-manager-part-ii/

(and look at the end of the piece, but the whole piece/series has value.)

7) Analyze common factors in your portfolio, and ask whether those are risks you want to take:

Industry risks
Duration risks
Counterparty risks

8 ) Look at the stock. ?If it is behaving well, the bonds will follow.

Maybe your best bet is to trade CDS versus cash bonds, if the spread is thick enough to do so. ?If not, I would encourage you to talk with more senior ?traders to ask them how they survive. ?Trading is a tough game, and I do not envy being a trader.

On Value Traps

Posted on 6 June 20146 June 2014 by David Merkel

One thing that floors me regarding my readers, is who reads me. ?I have many professional readers who read me regularly, and I thank you for doing so. ?Tonight’s piece stems from an e-mail from one of my professional readers:

Hi David,

Big compliments for your blog, it?s probably the best on the net and one of the very few I am reading these days. I really like your overall approach to investing and I am using some of your methods myself with success in my ZZZ?Fund (ZZZ on Bloomberg) like having an even-weighted portfolio of 30-40 stocks with regular rebalancing or focusing on the strongest players in weak industries (southern European banks anyone?).

Now my question for you that might interest all reader is how you handle potential value traps like Staples that spring on you in slow motion. I think you had that one in your portfolio some time ago, but the specific case doesn?t matter that much. For full disclosure, I am holding Staples in my fund at the moment.

The typical pattern is something like this: You find a stock that has some growth issues, but is attractively valued with a 10% FCF/EV yield, which implies no growth or a slow decline forever. Then there?s a profit warning, the profit or FCF estimate goes down by 10%, but the stock price drops even more by 15% or so. And again and again? or not. It?s especially tricky in cases like Staples where it is not so obvious that their business model is becoming obsolete compared to, for example, Nokia or Blackberry/RIM a few years ago.

In my experience, that?s one of the situations where I tend to lose the most money. How do you handle them? Sell at the first profit warning, reasoning that the investment case got fundamentally altered even though the stock dropped even more? Or keep it and wait for a confirmation of the negative trend? For how long?

Out of experience, I probably should sell Staples asap and have another look in year or so. But the value guy in me can?t sell much hated stocks with high FCF yields and some potential for a fundamental turnaround.

I used to own Staples, but I think their lunch is getting eaten by Amazon. ?I sold somewhere in the $16s. ?Retailers are tough, in my opinion. ?They are so cyclical and faddish.

There are many reasons that a stock can be a value trap. ?Let me try to list them:

The accounting is liberal, with revenue recognition policies that let more revenue accrue than will be realized. ?Or, the assets aren’t worth as much as the book value posits. ?This is particularly common with financials.
Many value traps are lower quality companies. ?They may seem cheap, but there is a lot of debt, and will they earn enough to refinance the debt?
Some companies waste their free cash flow buying back stock, or acquiring companies that do not add to value. ?When valuations are high, issue special dividends rather than buying back stock. ?Your?shareholders have better opportunities for the money.
They are up against stronger competition. ?Try to understand the industry as a whole, and see whether the?company’s?profits are likely to come under pressure.
The high dividend has attracted a lot of yield investors who push the price up, but the yield is not sustainable.
And there are likely more reasons…

I’ve lost significant money in a few stocks in my life, but only once in the last 10 years. ?It was a highly levered mortgage REIT that did it “the right way” as I saw it, and was opportunistic with debt assets. ?I lost 90%+ of my money on that one, one of my worst losses ever. ?Had I paid greater attention to the amount of leverage, particularly heading into the crisis in 2008, I would not have lost so much.

As a friend of mine once said, “There are lousy companies, but to really see the price fall, it has to have significant debt.” ?I tend to buy higher quality companies. ?That’s not a panacea, but it tends to prevent large losses. ?Avoid overly indebted companies relative to the??industry.

Analyze the accounting. ?How much of income is coming from accruals? ?How often do they deliver negative earnings surprises? ?How is cash flow from operations versus earnings? ?Is book value growing a lot more slowly than earnings less dividends would indicate?

Is this a stock held by those sucking on dividends? ?Is the dividend sustainable? ?Think of the ’70s where dividend-paying stocks got whacked when they reduced their dividends.

Analyze the competition. ?It is rarely a good idea to buy the stock of a weak company in a competitive industry, regardless of the valuation. ? Better to buy the more expensive competitor.

Finally, stock buybacks and acquisitions are not always good. ?Many stocks, like IBM, tread water because of the buyback. ?The stock price is too high, and remains too high because of the buyback. ?There is no good solution to this for IBM management, aside from new avenues of profitable organic growth, and those solutions are rare. ?Thus I avoid IBM.

My methods aren’t perfect, but they are pretty good. ?I stumbled into a lot more value traps when I was younger, but not so much anymore. ?Live and learn.

Investment Management: A Science to Teach or an Art to Learn?

Posted on 5 June 2014 by David Merkel

Imagine for a moment that you move to a new country that you have never been to before. ?When you get there, they give you a map of the country. ?But as you use the map, you find that it does not accurately represent the country at all. ?You never get to the place you want to go.

So, you complain to some of your new friends about the map, and they acknowledge the shortcomings of the map, but they say it is correct in theory, and is better than having no map at all.

This is economics and finance today, and there are changes that need to be made. ?They would rather have a wrong map than admit that their theories are bogus.

Today I read?Investment?Management: A Science?to Teach or an Art to?Learn?? I think its 99 pages are well worth reading, and if half or more of the observations get implemented by the CFA Institute, the Society of Actuaries, and Departments of Business, Finance, and Economics, the entire industry will be better off.

It is better to have an accurate uncertainty, than an inaccurate certainty. ?We are better of professing ignorance of what we don’t know, than being certain about things where we are wrong.

Investing is an art to learn. ?There is little science here. ?Stocks and other investments do not behave like modern portfolio theory would dictate. ?There is not one central risk factor that accounts for most of investing. ?There are many risk factors, and the credit cycle. ?The credit cycle is dominant, because as debts build, there is a boom in the favored asset classes. ?Then, as debts become unsustainable, there are crashes where the previously favored asset class returns to reasonable pricing or less.

We have to absorb the idea that most people are not rational, they merely imitate. ?”If my friends are doing it, it must be a ?good idea,” is the thought of many. As such, crises are easy to understand, because people imitate “the success” of others, not realizing that an asset?bought at a lower price might be good, but the same asset bought at a higher price might be bad.

We also have to grasp that physics is the wrong model for finance, and ecology offers us a better model — actors pursuing scarce resources in order to survive/thrive. ?In physics, it is simple. ?Human actions don’t matter; what humans care about does not affect physics. ?It does affect economics.

Beta vs Credit

Beta is not risk. ?Risk is more akin to the likelihood of bankruptcy, and the severity thereof. ?Crises happen when a lot of companies and individuals face the threat of bankruptcy. ?In some ways, we need to retrain all investors to think like bond managers — examining balance sheets, cash flow statements, and avoid companies that have higher probability of bankruptcy.

What do we Need to Change?

We need to end the idea?that markets natively are in?equilibrium. ?Indeed markets may weakly tend toward equilibrium, but the shocks to the system are far greater than the equilibrium tendency. ?Markets may tend toward equilibrium, but they are almost never in equilibrium.

We must teach students that the beauty of markets is that they function in disequilibrium. ?That is their glory. ?We should not expect perfection of markets in the short-run, but in the long-run many imperfections get eliminated where the government is not interfering.

We need to teach that crises are normal, and not accidents. ?They happen because a class of assets gets overbid, and often because of debt incurred to buy the assets.

We need to teach economic history to students, so that they grasp the wide array of what can happen in markets. ?What? ?That can’t happen today because the Fed watches over us? ?No way.? The same problems will recur in different forms.

The most important thing to teach new students about statistics is how they can be manipulated. ?Teaching them advanced statistics is overkill, because the markets are more random than that.

Quibbles

We don’t need to teach more macroeconomics to investors, because the theoretical foundations are shaky. ?I agree that we need to teach more qualitative reasoning to students. ?Maybe there should be some practical tests, where they work in a startup, and have to reason broadly, because there is no one to break it down to a simple level for the newcomer.

Beyond that,on page 98, if you don’t know how to value a derivative contract, you will not be able to trade it properly. ?As a former mortgage bond manager, it helped me a lot to understand the math. ?I could make better bids than most could.

Summary

The main idea here is to develop qualitative reasoning, and neglect quantitative reasoning when there is no reason to think it is impartial.

I write this as a mathematician who mostly understands where math fairly represents the world, and where it does not.

Buy Stocks When Credit Spreads are High, Sell When They are Low

Posted on 3 June 2014 by David Merkel

Credit spreads and implied volatility are cousins. ?When there is complacency, both are low. ?When there is panic, both are high. ?For those of us with strong balance sheets, when do we buy? ?We buy during panic. when we can get quality assets at bargain prices. ?When things are euphoric, we sell, or at least reduce exposure, increase quality, etc.

That’s why I don’t have much sympathy for articles talking about Great Moderation 2.0. ?Ask yourself, “How did the Great Moderation work out? ?Was taking a lot of risk then a good idea?

There were many that chased past returns 2005-7 that got hosed 2008-9. ?So when I see articles like?Trends Point to Growth & Stability, I shake my head and say, “Driving by looking through the rear-view mirror.”

I feel the same about this article,?Investors Rewarded for Trek Into Little Known Markets. ?Anytime a lot of new money spills into any new asset class, returns are high and implied volatility falls. ?That tells us little about the future.

When implied volatility and credit spreads are low, that tells us that people are very certain about the future, and they are relying on things remaining stable. ?It doesn’t tell us when the bear market will come, but it does tell us that gains are limited before the bear market.

I can’t tell you when things will break, or how badly they will break. ?I can tell you that stocks are producing earnings gains by levering up more, and not through organic growth. ?In the short run, it pays to issue debt to buy back stock, but the additional debt eventually exacts its price — when the cycle turns, and the price of liquidity rises, the debts will still be there, and interest costs to refinance them will be considerably higher. ?Or, equity might have to be issued at an unfavorable moment.

One practical tip — the area with the greatest percentage amount of credit growth is usually the one that performs the worst when the cycle turns — candidates for that include E&P firms engaged in fracking, student loans, US Government debt, and more. ?If anyone can think of additional areas, please mention them in the comments.

I’m not running away. ?I’m just trimming here and there, and investing in safer companies that seem to have good accounting. ?All for now.

A Bond Manager Thinks about the Equity Premium

Posted on 31 May 20141 June 2014 by David Merkel

One of the things that annoys me about the concept of the equity premium is that it is an academic creation that does not grasp the structures of the markets. ?Send the academics to be bond and equity portfolio managers for a time, and maybe we would get a better theory than Modern Portfolio Theory [MPT].

Here is the first thing that is wrong with MPT — it doesn’t understand the bond market. ?The best estimate of what bonds will return over time is the current yield less expected losses from defaults and optionality. ?Hold a bond to its maturity, and the standard deviation of returns is low, over the full time horizon.

Thinking about bonds in the current environment, virtually nothing is earned with high-quality short-dated debt. ?The yield curve is still relatively steep, as people expect the economy and lending to pick up.

Think for a moment. what is a longer asset, a corporate bond, or the stock of the same company? ?The stock is the longer asset, because the cash flows of the business in question potentially stretch far longer than the maturity of the corporate debt, at least in most cases.

Also think, in a bad scenario, where insolvency is possible, who has the better claim: the equity or the unsecured debt? ?The unsecured debt, of course.

Longer assets in general possess more risk and should carry higher yields to induce people to take those risks. ?Inverted yield curves are exceptions. ?Also in general, longer corporate bonds have higher spreads over Treasuries most of the time, than shorter corporate bonds.

The one significant advantage that equities have over corporate bonds is that of control. ?Increases in earnings go to the stockholders. ?Buyouts go to the stockholders. ?Bondholders get paid off at best.

That said, in the losing scenario, bondholders get back 40% of par on average, while stockholders get little if anything.

I believe that the equity of a company needs to be priced to return more than the longest unsecured debt or preferred stock of the company.

Thus when I think about MPT, I think they are positing an asset-liability mismatch, comparing T-bills versus a long asset, common stocks. ?The comparison should be broken down into several spreads:

T-bills vs T-notes/bonds of the longest maturity issued by companies like them.
Corporate bond yields minus Treasury yields at the same maturity.
The earnings yield of the stock minus the corporate bond yield.

This takes apart the seemingly simple MPT calculation, revealing the complexity within, helping to explain why beta doesn’t work. ?It embeds an asset-liability mismatch. ?Stocks are long term, T-bills are not. ?There is no reason why their returns should be considered together, without a model of yield curve spreads, corporate spreads, and equity financing spreads.

That’s a sketch of the correct model, now who wants to try to build it out?

Sorted Weekly Tweets

Posted on 31 May 20141 June 2014 by David Merkel

Debt Markets

Leverage Addicts Get Junk-Loan Fix With Derivatives ETF?http://t.co/CWMxLXlz3v?Not much different than a HY closed-end fund or a CLO $$?Jun 01, 2014
Bond Market Flips the Script on Risk and Reward?http://t.co/3geslTXRMo?Difficult for rates 2 rise when monetary velocity keeps falling. $$?Jun 01, 2014
Shakeout Threatens Shale Patch as Frackers Go for Broke?http://t.co/pGj2CUiTxG?Not healthy 4 so many 2b financing w/high amount of debt $$?Jun 01, 2014
Bond Market to Fed: Your 4% Rate Forecast Is Way Too High?http://t.co/Ji55pmAlYZ?Forward rates r much lower than wrong Fed forecasts $$?Jun 01,
New Fund Stars Ride Junk Bonds to the Top?http://t.co/1WtqogYOZX?Junk credit & HQ long duration risks have paid off, what an odd couple $$?Jun 01, 2014
The Hidden Risks in Your Local Housing Market?http://t.co/7OcDXnTvGC?As the amount of debt behind housing rises, systemic risks rise also $$?Jun 01, 2014
Pimco Rehires Former Senior Executive Paul McCulley?http://t.co/7U71N8jO12?Wish he had stayed retired; I enjoyed him not publishing $$?Jun 01, 2014
And so it begins: Square is to start lending to customers?http://t.co/F7xDzGTxAQ?Harder than it looks 2b a lender; 2 much optimism $$?May 31, 2014
S&P, Moody?s Lose Bid to Block Calpers $800M Suit?http://t.co/crQdAbw2v2?Ratings r advice not guarantees, sophisticated investors know it $$?May 31, 2014
How to Manage Bankers Voracious Risk Appetites?http://t.co/yrwkZkQaHW?Criminal liability, clawback of pay, & boards holding mgmt acctable $$?May 31, 2014
Goldman Shuns Bonds Pimco?s Gross Favors in ?New Neutral??http://t.co/bTPbJpi6Me?Go with Goldman over Pimco; buy tails, short belly $$ $GS?May 31, 2014
You?re All Whales in Bond Market Now With Trading Volume Slump?http://t.co/ewXmldKzC5?It means that more Tsy notes r held 2maturity $$ $IEF?May 30, 2014
Pimco Rehires Former Senior Executive Paul McCulley?http://t.co/7U71N8jO12?Wish he had stayed retired; I enjoyed him not publishing $$?Jun 01, 2014
How to Manage Bankers Voracious Risk Appetites?http://t.co/yrwkZkQaHW?Criminal liability, clawback of pay, & boards holding mgmt acctable $$?May 31, 2014
Goldman Shuns Bonds Pimco?s Gross Favors in ?New Neutral??http://t.co/bTPbJpi6Me?Go with Goldman over Pimco; buy tails, short belly $$ $GS?May 31, 2014
You?re All Whales in Bond Market Now With Trading Volume Slump?http://t.co/ewXmldKzC5?It means that more Tsy notes r held 2maturity $$ $IEF?May 30, 2014

US Politics & Policy

Geithner’s Dubious Accounting?http://t.co/8uwwJyeKHo?”justifying the bailouts b/c a simplistic measure shows the govt made $$ is a stretch.”?Jun 01, 2014
Seven States Running Out of Water?http://t.co/pXpEU9Hu7K?All in southern west & midwest — CA, NV, NM, KS, AZ, OK, & TX $$?Jun 01, 2014
State Pension Transparency Is Right Message At Right Time?http://t.co/vwGqJn7ZDq?Read about troubles of North Carolina Public Pensions $$?Jun 01, 2014
‘Pink Slime’ Makes Comeback as Beef Prices Spike?http://t.co/XmDfVz5zAB?”Finely textured beef” returns to cheap hamburger; ask yr butcher $$?May 31, 2014
Economy Shrank, U.S. Now Says?http://t.co/qm9rarCX9P?They’re blaming the weather which is always a weak reason 4 the structural slowdown $$?May 30, 2014

Rest of the World

Japan Begins Purposely Dumping 100s Of Tons Of Radioactive Water From Fukushima In2 The Pacific?http://t.co/TklIa4ECs2?Source fish w/care $$?Jun 01, 2014
Spain Sees Embers Glow in Wreckage of Property Crash?http://t.co/J1KWh56u0l?Prices finally gaining real money buyers $$?Jun 01, 2014
Escape From Tiananmen: How Secret Plan Freed Protesters?http://t.co/yAmoc6MfKT?Unlikely group of people risked their lives 2 aid escapees $$?Jun 01, 2014
Iran, Stable but Miserable?http://t.co/1HNuO03Ncv?@Steve_Hanke Once Govts start giving subsidies, is very difficult 2 end them $$ #bigbang?May 31, 2014
Aging Swiss Face Pension Funding Dilemma on Immigration?http://t.co/9k2X7Oeszf?Demographic eclipse faces Switzerland, needs immigrants $$?May 30, 2014
No, China Isn’t Really Rebalancing?http://t.co/HbR7rVIiOZ?@WilliamPesek notes quick return of stimulus measures in China as growth flags $$?May 30, 2014

Market Impact

Bad Credit No Problem as Balance-Sheet Bombs Rally 94%?http://t.co/6xLjaGnBCp?A backward-looking insight, one common 2 late bull markets $$?Jun 01, 2014
Reynolds Aims to Oust Fidelity in Push to Gain 401(k)s?http://t.co/CO9RF3YZsk?401k financial servicing is a scale game 4 Great-West Fin’l $$?Jun 01, 2014
Bets on Higher Food Costs Reach 11-Week Low: Commodities?http://t.co/Bqi5PPkTsS?Time for food costs to move up $$?Jun 01, 2014
Neff?s do?s and dont?s?http://t.co/Sx2oExlAHb?The thinking of John Neff is underrated in my opinion; this article summarizes some of it $$?Jun 01, 2014
Top 10 Valuation Ratios and How to Use Them?http://t.co/bbdT2lMHeI?Worth a read $$?Jun 01, 2014
Dragon King beats Black Swan: Ted Talk with Didier Sornette?http://t.co/QMJNGE3N8w?Listen to Sornette; black swans can be predicted $$?Jun 01, 2014
New Rules 2 Alter How Companies Book Revenue?http://t.co/3siTlXkluz?Mostly liberalizes revenues, lowers earnings conservatism, watch $$ flow?Jun 01, 2014
Nasdaq Nears 13-Year High as Technology Becomes Loved?http://t.co/0Q7VrPsnUy?Note unprofitable IPOs coming 2 market eating sideline cash $$?Jun 01, 2014
Dennis Gartman: We Were Wrong Calling for a Correction?http://t.co/IhmICbVO2M?Few more capitulations & then the topping process will end $$?Jun 01, 2014
Managing a Portfolio I – Stop Wasting Time, Start Adding Value, Part V?http://t.co/2z2bLQV7zK?A very good series, very worthy of a read $$?May 31, 2014

Other

Little Children and Already Acting Mean?http://t.co/4RRva4OVu1?Should only surprise if u think ppl r natually good; good must b trained $$?Jun 01, 2014
The Myth of the Climate Change ‘97%’?http://t.co/BCsHXfzudX?I know science Ph.D.s who don’t agree, but how 2do a fair count? $$?Jun 01, 2014
How Many Kidneys Is an NFL Career Worth??http://t.co/EdaeHVt8zW?Gives reasons to eliminate team doctors; players, get yr own doc 4 safety $$?May 31, 2014
Mementos of triumphs make a return to bankers? desks?http://t.co/1fetPsXSrc?Deal toys made of Lucite return to Wall Street $$ $GS $MS $XLF?May 30, 2014
My Resume?http://t.co/lkMocQczJB?James Altucher spills all of the beans on his business career & life. A train wreck in slow motion $$ $SPY?May 30, 2014
Railcar Shortage in US Pushes Up Lease Rates?http://t.co/bcaqp0DvwV?If pipelines aren’t built, more crude will flow by rail $$ $GATX $TRN?May 30, 2014

Wrong

Wrong: SEC Set to Spur Exchange Trading?http://t.co/jU2JJvc3vi?This may help mutual fund managers, but it won’t help small investors $$?Jun 01, 2014
Wishful thinking: Is Hillary Clinton Too Old for the White House??http://t.co/Fy0qYw11a6?People, particularly women live longer than b4 $$?Jun 01, 2014
Wrong:Annotated History Of The World’s Next Reserve Currency?http://t.co/XtCSg2WQPt?Only free countries w/open markets r reserve curncies $$?Jun 01, 2014
Fink Says Leveraged ETFs May ?Blow Up? Industry?http://t.co/cVTubsqeiY?More likely they blow themselves up, & not the all mutual funds $$?Jun 01, 2014
Wrong: Paper money is unfit for a world of high crime and low inflation?http://t.co/XC4pAWjHf2?We need 2get currency out of govt hands $$?May 31, 2014
Wrong: Borrowers Show in Rush to Grab US Rate Break?http://t.co/H8yJX9TCQQ?Funny how everyone keeps saying rates will rise $$ FD: + $TLT?May 30, 2014
Wrong: Make more money by dumping your investment adviser?http://t.co/8hSPQqgDlr?Investment advisers can prevent panic & greed $$ $TROW

Retweets, Replies & Comments

RT @ReformedBroker: Nice that we printed a new record S&P 500 high today. Too bad so few stocks are involved. Via @allstarcharts?http://t.c??May 26, 2014

Classic: The Ins and Outs of Stable Value Funds

Posted on 30 May 2014 by David Merkel

The following article was published at Realmoney.com in 2004. ?Rates were lower then but the issues remain the same.

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My 401(k) plan has a stable value fund that currently pays a preannounced annual rate of 5.30 percent. ?The fund enters into guaranteed investment contracts (GICs) with insurance companies which invest in government and corporate bonds and mortgages.
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I’ve heard that stable value funds can now be purchased outside of retirement plans.? Does anyone know of any fund families or brokers that offer these funds to individual investors?

— Reader Question from M. J.

In my career, I have run a GIC (Guaranteed Investment Contract) desk at an insurer, designed one stable value fund, and helped administer and invest for several others.? I know stable value funds, respect them, invest in them when it makes sense, but I am still a skeptic at some points.

Legal Risks Lead to Elimination of Non-401(k)-type Stable Value Funds

Last year, there was a big scandal over mutual fund pricing, and non-401(k)-type stable value funds came under the microscope because of the obvious difference between the value of the assets and the stated NAV of the funds.? The SEC made an inquiry about the accounting for the funds in December 2003.? Since then non-401(k)-type mutual funds have died a slow death. ?There is one left, and they are probably going to turn the fund into a short term bond fund, as the others did.? Their reason for existence has gone away, and now they are expensive short-to-intermediate term bond funds.

Your opportunity to invest in stable value funds outside of 401(k)/defined contribution world has gone away, but given that there is over $200 billion invested in stable value funds, and not much has been written on them from a third party point of view, I?ll describe them in more detail.

Defining the Investment

So what?s a stable value fund?? It?s a short-to-intermediate term fixed income pool that has some agreements on the side to allow the assets to be accounted for at book value, so that the investment accrues at a positive rate.? It looks like a savings account to the investor, not a short-to-intermediate term bond fund.? Because it invests at longer maturities than money market funds, they deliver higher yields than money market funds, except in years worse than 1994, where yields rise rapidly and the yield curve inverts.? (Stable value funds did not exist in the 1979-1981 era; perhaps money market yields would have been higher than stable value yields would have been then.? The precursor to Stable value funds, initial participation guarantee funds, ran into trouble then.? That trouble led to the development of GICs.)

A stable value fund invests in insurance contracts, money markets, and highly rated (usually AAA) short-to-intermediate term bonds.? Insurance contracts are always valued at book value, unless in default, which we saw a little of in the early 90s.? Among major GIC writers, default has not been a problem since 1994.? (General American gave us a scare in 1999; Metlife bought them, and all payments were made.)

The bonds held in stable value funds can?t be valued at book value because accounting rules require that they be held at market.? The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value.? The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book value loss.? Typically, wrap agreements are only done on the highest rated bonds (AAA), so credit risk is not covered by most wrap agreements.? With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped.? The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool?s credited rate.

Since wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10%/year of assets wrapped.? The only risk a wrapper faces is that the interest rate-related losses on a bond in a rising interest rate scenario is so severe that the losses can?t be repaid out of the yield of the wrapped bond.? In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change.? There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value.? When the stable value fund has a higher market value than book value, typically it pays an above market yield.

There is a risk that in an environment where interest rates have risen sharply, that a stable value fund would have a lower market value than book value, with a below market yield.? In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields.? If that happens to a high degree, it will worsen the gap between the market value and book value of assets, which will be covered by the wrappers in the short run, but will reduce the fund?s yield as they pay the wrappers back.

It is unlikely, but possible to get a death spiral here, if more and more shareholders leave the pool and the yield sags to zero.? It hasn?t happened yet, so this is theoretical for now.? In theory, the wrappers would keep paying once the funds credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation.? There would likely be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability.? In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral are further reduced, but not eliminated.

Asset Default Risks

As an aside, for the most part, stable value funds take little credit risk, but (little known) this is not universally true.? Some of them buy corporate bonds, or other riskier structured product bonds.? Some of them take credit risk in hidden ways.? Here?s an example: there are some exotic, asset- or commercial-mortgage backed interest-only bonds that are rated AAA by the rating agencies.? The agencies rate them AAA because they can?t lose principal; they have no principal to lose.? But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened.? The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA.

If an asset in a stable value fund defaults, the fund will likely temporarily suspend withdrawals while it pursues one or two courses of action.? If the loss is small, they might buy a wrap contract for the loss, which will haircut the yield on the stable value fund for the life of the wrap contract.? If the loss is big, they will reduce the NAV, and attempt to keep the NAV stable from there.? Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn?t rely on that.

Summary

There are two main risks: asset default, and severely rising interest rates.? In exchange for those risks, what do you receive?? In most circumstances, you get a higher yield than a money market fund, with nonguaranteed stability of principal.

If you need a good yield, and stability of principal with modest risk, a stable value fund can be a good place to get it. That said, if you can live with fluctuations in the NAV over the intermediate term, it would be better to use a short-to-intermediate-term bond fund, and thus avoid the wrapper and high asset manager fees.? Stable value manager fees are typically higher than those for bond funds.? Over a five-year period (or so), your total return should be better.

Questions from Readers

Posted on 29 May 2014 by David Merkel

Miscellaneous questions post — here goes:

Thank you very much for your blog! I am hooked since I found it and have been getting smarter by the day!

I like Safety Insurance Group, found it through your blog, noticed you were no longer long. They don’t do life insurance, just cars and houses – I know you say not to mix because they are sold and underwritten differently. They had a rough Q1 but a good 2013, seems like the winter Mass weather might have done it. They are over Book of 1 so there are other insurers that are cheaper, but they look like a good compliment to NWLI (also found through you and like very much) in the auto space, in a small (and thus dominate-able) market.?

Am I missing something about SAFT??

Many sincere thanks David!

I like the management team at Safety Insurance. ?When I met with them years ago, they impressed me as bright businessmen competing well in one of the most dysfunctional insurance markets in the US — Massachusetts. ?Most major insurers did not write auto and home insurance there as a result. ?But then the state of Massachusetts began to loosen up their tight regulations, and some of the bigger insurers that stayed away have entered — GEICO, MetLife, Liberty Mutual, etc.

When the market was more closed, SAFT had strategies that allowed them to profitably take market share Commerce Group [now Mapfre]. ?With more competition in Massachusetts, Safety’s earnings have suffered. ?I can’t get excited about a short tail P&C insurer trading above book at 13-14x forecast earnings.

Maybe people are buying it for the 4%+ dividend. ?I don’t use dividend yield as an investment criteria, for the most part. ?I would avoid Safety Insurance. ?It’s well-run, but the price of the stock is too high. ?If it drops below $35, it would be a compelling buy.

Hi David,

I was interested in your comment on Normalized Operating Accruals as an indicator of accounting quality.

Why is this?

I tend to view changes in accruals as an indication of the underlying strength of a business, but would appreciate your insight on this.

Thanks

The idea behind net?operating accruals is that accrual entries represent future cash flows, which are less certain than cash flows that have already happened. ?Companies that report high levels of accounts receivable, inventories, etc., as a fraction of assets or earnings, tend to offer negative earnings surprises, because many of those accruals will not convert to cash as expected.

Here is how I measure Net Operating Accruals:

(Total assets – Cash ?- (Total liabilities – Short-term debt – Preferred stock – Long-term debt))/Total assets (or earnings)

An apology here, because the term commonly used is “net operating accruals” and I messed up by calling it “normalized.”

Companies with conservative accounting (fewer accruals) tend to have stronger earnings than those that are more liberal in revenue recognition.

Dave, you and I are too old school. We need to move into this century. The way that most people seem to get into the investment industry has nothing to do with what you talk about. It is far easier to become a “financial advisor” that pushes annuities on the 60+ crowd. You don’t really have to learn anything about investing. All you need to know is about salesmanship. Offer a free lunch/dinner and reel them in!

I honestly think that more folks are going this route instead of the “hard way” you have outlined. . .

Maybe you can do a sarcastic post: “How to NOT be valuable, but make a lot of money in the Investment Business.”

Personally I find the annuity and non-traded REIT pushers very repulsive. At the same time, I know several of them that have done very well . . .

There are two factors at work here — yield and illiquidity. ?The need for yield is driven by monetary policy. ?Particularly with a?sizable?increase in retirees, many of whom can’t make enough “income” when interest rates are so low, they take undue risks to get “income,” not realizing the risks of capital loss that they are taking.

When I was an analyst/manager of Commercial Mortgage Backed Securities, there was a key fact one needed to understand: safe mortgages?do not depend on whether the businesses leasing the properties operate well or not. ?Safe mortgages have no operational risk, and thus avoid theaters, marinas, etc. ?Stick to the four food groups: Multifamily, Retail, Office, and Industrial.

There will be negative events with insecure investments offering a high yield. ?You may not get the return of your money, as you try to get a high return on your money.

Then there is the illiquidity — that is what allows the sponsors the ability to pay high commissions to those who sell the annuities and non-traded REITs. ?Because the investors can’t leave the game, the income stream of the sponsor is very certain. ?They take a portion of the anticipated income stream, and pay it in a lump sum to their agents as a commission. ?And that is why the agents are so highly motivated.

Eventually, the demand for yield will be disappointed. ?Uncertain yields will fail in a crisis, and reset much lower. ?Income that stems from dividends, preferred dividends, MLPs, junk bonds, structured notes, etc., is not secure in the short-to-intermediate run. ?It is far better to invest to grow value than to invest for income. ?They can pay you a yield, sure, but if the underlying value is not growing, you will eventually get capital losses, and after that, much less yield.

Look for safety in yield investments. ?If you are going to take risks in investing, take risk, but ignore the income component. ?Don’t stretch for yield.

A Survey on Trading/Investing

Posted on 28 May 201430 May 2014 by David Merkel

I received a survey in the mail on Trading/Investing. ?I felt that if I was going to answer it, I may as well do it for my readers. ?Here goes:

1) How long have you been trading?

I’ve been investing for my own account for 25 years. ?During that time, I’ve done a lot of different things:

Played around with closed-end funds, and shorted overvalued companies 1989-1993
Value investing for myself 1993-98, with a lot of microcap value thrown in. ?(Weird stuff, and very illiquid.)
Created multiple manager funds for group pension business 1995-1998 — got to interview many of the best managers at that time.
Set investment policies for a some major life insurers 1993-2003
For major life insurers — Mortgage bond manager 1998-2001, Corporate bond manager 2001-2003, Investment risk manager 1993-2003.
Small deal arbitrage for myself 1998-2000
Settled on my current value investing strategy, as expressed by my eight rules 2000-2014
Buy side analyst for a financials only hedge fund 2003-2007. ?Managed the firm’s profit sharing and endowment monies using my value investing strategy.
Started my RIA in 2011, to offer clients my value strategy — they get a clone of what I own in my value strategy. ?I am my largest client, and I eat my own cooking.

2) What style of trading / investing do you practice (technically driven, fundamental, systematic, a combination etc)?

Mostly fundamental. ?Most of my trading is governed by these rules:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

I tend to resist momentum in the intermediate term. ?From my era of hiring managers, those that used this technique said it added 1-3% to performance. ?I think that’s about right.

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

I limit changes to the portfolio, because it takes time for investment ideas to play out. ?I turn over the portfolio at a ~30% rate. ?I try to be as businesslike as possible when I sell a?company and buy another. ?Investors can be very good at evaluating whether a company or group of companies, is better than another company or group of companies. ?What is harder is asking, “Would I rather hold cash than this company?”

3) How do you feel when a trade goes against you?

Good. ?I get to buy a little more at a lower price, after I check my investment thesis, which if it does not check out, I sell the whole thing. ?For the few trades that do badly for a long time — 20 of them over the last 25 years, of course it hurts, but the gains far outweigh the losses, so I ignore those, except to memorialize why the failure happened, and feed that back into my investing processes. ?Every time I have lost badly, it was because I violated at least one of my rules.

4) How do you feel when a trade goes for you?

I like it, but I let my rules govern my trading. ?Everything is done by rules; there is almost no discretion in my trading.

5) How have these feelings changed over your trading career? ?(Can you recall how you originally used to feel and elaborate on how this has changed over time?)

When I was 20-25 years younger, every move in the markets would make me excited. ?By the mid-90s, I got my emotions under control. ?I learned to focus on eliminating risk on the front end, so that I would have fewer problems on the back end.

6) Do you have any practices that you do away from the trading screen to help you mentally and emotionally handle trading??(e.g. meditation, yoga, running, Tai Chi, kicking the dog, hitting the bottle etc)

I pray to Jesus Christ every day, but that is not a means to handle trading. ?I ask Him to guide?my decisions, and that I would do my investing to glorify Him.

Because I use my rules, there is little, if any, stress over trading. ?My processes are designed to take my emotion out of my infrequent buying and selling.

7) Have you always done this??

I’ve done this for the last 14 years. ?Prior to that, I was experimenting and developing my methods.

My time managing bond assets for life insurers taught me a lot about trading 1998-2003. ?I traded over $10 Billion in bonds over that short window of time. ?I was far more active as a bond manager, because it was simpler to ascertain when value-enhancing trades could be done. ?That fed into my value investing processes, which are designed to mimic the way a bond trader would look at stocks.

8) If not, how have you learnt to deal with the feelings that come up when trading?

Look, first, it’s only money. ?If you don’t take some significant losses during your life, you probably aren’t taking enough risk.

Second, investing takes time. ?I hold my positions three years on average, and the longest positions have been there for 5-10 years. ?A tree in my backyard won’t grow any faster if I worry about it. ?The same is true of my stocks. ?I review them quarterly. ?Between those times, I try to muffle the nose, aside from rebalancing trades which resist the market.

9) Can you describe a time in your trading life which really rammed home the point that so much of trading comes down to psychological factors?

As a value investor, I don’t worry much about trading. ?In 2000 & 2008, I did detailed studies of my trading. ?In 2000, I found that many of my best trades stemmed from getting the industry right. ?In 2008, I found that my top 11 gains paid for all of my losses, 2000-2008. ?That was with a 70/30 win/loss ratio, and 180-190 stocks held over the period.

10) If you could give aspiring traders one piece of advice about emotionally handling the market what would it be?

If we are talking traders, it would be this: start out each morning looking at the disasters of the day, and then wait for volume to climax, and price to nadir. ?Wait about 5-10?minutes, and then buy. ?Close out the trade within a week, maybe at the end of that day.

That said, I would encourage traders become investors. ?There is too much competition at the short time horizons of the market, and not so much over 3+ year periods. ?Study the greats: Graham, Buffett, Munger, Klarman, Price, Heine, Neff, Soros, Dalio, and many others. ?Learn to recognize long-term value, and wait for it to be realized. ?There are no barriers of entry to trading. ?Long-term value investing has natural barriers to entry, because it is work, and as such, few do it.

I don’t worry about my stock portfolio. ?Because my time horizon is long, day-to-day fluctuations don’t mean much. ?That makes me free to research ideas that can benefit me and my investors in the future. ?That’s a great place to be.

Closing

“Richard Chignell of Embrace The Trend asked me to take part in his Pro’s Process series.? Here are the first couple of answers and for the whole thing please read it here: www.embracethetrend.com“.