Category: Portfolio Management

Dividends *Can* Lie

Posted on by David Merkel

Photo Credit: Simon Cunningham || Not paying a dividend does not create an enforceable claim, as happens when an interest payment is not made.

Don’t get me wrong, I love dividends. I even have a money management strategy based off of them. But I know that dividends are more fickle than most of their fans admit. The infatuation that some money managers have with dividends is misplaced. To say that “Dividends don’t lie,” is an overstatement. Yes, the check will clear, and you get money, but that does not mean that the next dividend will get paid.

I have always said that reliable dividends flow from businesses with predictable free cash flow. As such, I don’t look for dividends, but free cash flow. As a check on that, I watch debt levels in the companies that I own. If the debt levels are persistently increasing as a fraction of assets, it is likely a sign that the company is borrowing to pay the dividend.

Borrowing to pay the dividend — an old phrase, dating back to the 1970s and prior. Companies know that a consistent and growing dividend attracts investors. They are reluctant to not grow the dividend, much less cut it, lest massive selling take place. But businesses have their limits, and paying a dividend beyond those limits leads to an eventual dividend cut.

No management team will admit to being uncomfortable with its dividend payout. The Fed may as well admit that they don’t know what they are doing. It’s not gonna happen. But prior to a surprise dividend cut, the company will borrow more, probably hoping that business will rebound, and that the increased dividend will be sustainable.

In the 1970s, there were many dividend cuts. At the end of the 70s there was no cachet to dividends. With interest rates so high, income was to be found in bonds, even if inflation was going to the sky.

I remember the 1970s even if I was a teenager then. I was gifted two bits of stock in the 1960s, and the companies paid their dividends until they failed. I remember taking my dividend checks to the bank to add to my savings account. I still knew that the two stocks I had been gifted, Magnavox and Litton Industries, were disappointments that had given me less than the value of when the stocks were purchased.

In a significant recession, many companies will cut their dividends in order to avoid bankruptcy. Dividends are subject to the boom/bust cycle as much as any other aspect of corporate behavior.

This is why I say be careful regarding dividends. We are in a bull market now, with prices near the recent peak. Financing is plentiful and cheap. As Buffett has said:

Only when the tide goes out do you discover who’s been swimming naked.

brainyquote.com/quotes/warren_buffett_383933

Summary

My main point to you is this: don’t assume that dividends are automatic. Test the companies whose stock you want to buy to see that they have adequate capacity to pay the dividends, and that they are not borrowing to pay them.

I like my dividend portfolios. They are roughly half as volatile as the market, and have had decent returns. But I don’t blindly trust the dividends that companies pay as if they are an obligation. Be wary and analyze the safety of the dividends that you are paid.

On Stock Market Games for Children

Posted on by David Merkel

Photo credit: https://boardgamegeek.com || I probably played Jate 100+ times with my friends as a kid. Even at the time, I knew the market did not behave the way it did in Jate, or any other stock market game that I played.

All of the common board games that I have run into on the stock market are unrealistic. The stock market does not work the way the board games say that it works.

Nonetheless, I think that board games, and other games that involve money are useful for children. Why? Because they encourage kids to think in terms of budgets (money is limited), and in terms of using money to gain returns.

Business is a large part of life, and it is difficult to get children to appreciate what goes on there. Business games, though not realistic, promote curiosity regarding business and investing. Nothing is ever as easy in business or investing as in a game, but nonetheless the concepts of budgeting, compounding, and diversification (or lack thereof) appear.

I am not endorsing any particular game. My view is that game that involve money as a major aspect of the game are good for children, as it teaches them about goals, investing, and limits.

ETFs Increase Correlations, but not Overall Amplitude

Posted on by David Merkel

Photo Credit: Steve @ the alligator farm

Recently in a tweet, I said:

Index Fund Investment Strategy: Michael Burry Warns of Bubble @Bloomberg https://bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos? The most this would do is increase the correlation of the movements. Unit creation & liquidation serve the same role as futures arbitrage programs that have existed since the mid-80s

https://twitter.com/AlephBlog/status/1179927420884983809

I am not in the crowd that thinks that indexing or ETFs will create a crisis. As I have said before, long-term performance of assets relies on the underlying productivity of the businesses issuing the assets. Short-term performance is also affected by the behavior of secondary market traders, but those effects get eventually washed out by the underlying productivity of the businesses issuing the assets.

And there you have it in slightly different garb: Ben Graham’s weighing machine versus the voting machine. The voting machine is transitory. The weighing machine is permanent. After all, think of a private business — it only has the weighing machine, and it does well enough producing cash flow for the owners, creditors, etc., without the sideshow of the price of its stock and bonds being publicly estimated each day.

In this case, the voting machine has people buying and selling bundles of stocks. But what does that replace? People owning equivalent amounts of individual stocks. People have varying propensities toward panic and greed. Those who would have sold their stocks in a panic or bought stocks in a bullish frenzy will do the same with the ETFs that they hold. It will be the same amount of selling pressure in aggregate.

Now, it is possible that some stocks are misrepresented in the ETFs in which they reside. My favorite example is refiners in the Energy Select Sector SPDR Fund (XLE) . The economics of most stocks in XLE are positively geared off of crude oil and natural gas prices. Refiners, unless they are gambling on their hedges, usually don’t hedge fully, and the economics are negatively geared to energy prices. Ever since XLE became popular, the refiners often trade in tandem in the short run with the rest of the Energy stock complex.

So what happens? Refiners then correct after a bull run of energy prices when their earnings don’t reflect the stock price. Vice-versa for positive earnings surprises in a bear phase for energy prices.

Summary

ETFs do present some anomalies for the markets, but they are localized to the sectors or strategies that are being pursued. For the market as a whole, they are simply pass-through vehicles that have little to no macro effects, aside from increasing short-run price correlation between stocks in the largest ETFs.

The Balance: Short Selling Stocks- Not for the Faint Hearted

The Balance: Short Selling Stocks- Not for the Faint Hearted

Posted on by David Merkel

Photo Credit: Heather Wizell || Ah, Wallstrip with Lindsay Campbell (look at the microphone…)

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Here’s another article that I edited at The Balance:?Short Selling Stocks- Not for the Faint Hearted.? The original author started out conservative on the topic, and I took it up another notch.

For this article, I:

  • added the information about changes to the uptick rule (which did not reflect anything post-2006),
  • corrected a small math error,
  • made the example more realistic as to how margin works in this situation,
  • added almost all of the section on risks
  • totally rewrote the section on picking shorts (if you dare to do it), and,
  • added the famous comment by Daniel Drew.

I have shorted stock in my life at the hedge fund I worked at, hedging in arbitrage situations, and very rarely to speculate.? Shorting is a form of speculation shorts don’t create economic value.? They do us a service by pruning places that pretend to have value and don’t really have it.

In general, I don’t recommend shorting unless you have a fundamentally strong insight about a company that is not generally shared.? That happens with me occasionally in insurance where I have spoken negatively about:

  • Penn Treaty
  • Tower Group
  • The various companies of the Karfunkels
  • The mortgage and financial guaranty insurers
  • Oh, and the GSEs… though they weren’t regulated as insurers… not that it would have mattered.

But I rarely get those insights, and I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited.? It is really a hard area to get right.

Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long.? If you just hold stocks, bonds, and cash, no one can ever force you out of your trade.? The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment.? Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.

So be careful, and in general don’t short stock.? If you want more here, also read The Zero Short.? Fun!

The Balance: Are You a Speculator or an Investor?

The Balance: Are You a Speculator or an Investor?

Posted on by David Merkel

Photo Credit: Bernard Spragg. NZ?|| Ah, Hong Kong. Home to speculation and Investment.

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One thing to do at The Balance is fix old articles.? This article compares speculators and investors.? What I brought to this article was the following:

  • Change the phrasing from trading to speculating to be more pointed.
  • Add more and better criteria to what an investor does.
  • Added the entire section “What To Do”
  • Added a picture and more links.? Corrected grammar in a few spots and tightened up some language.

The main reason to edit this article as I did was to give readers more disciplined ideas with respect to buying and selling, and encourage them have rules, and keep a journal of decisions, together with why they bought, and at what point would they sell.? If not, then investors will not take losses when they ought to, and not sell when their thesis is proven false.? That is the way of more and deeper losses.

WIth that, enjoy the article.? It also features my selling rules in the links.

 

Why I Like Foreign Small Cap ETFs

Why I Like Foreign Small Cap ETFs

Posted on by David Merkel

Photo Credit: amanda tipton || It may not be foreign, and not an ETF, but it IS a small cap

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This should be a short post.? When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.? Why?

  • They diversify a US-centric portfolio better.? There are several reasons for that:
  • a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
  • b) the large companies are typically exporters, and the smaller companies are typically not exporters.?Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
  • They are often cheaper than the large caps.
  • Institutional interest in the small caps is smaller.
  • They have more room to grow.
  • Less government meddling risk.? Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.? There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.? If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.? Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.? The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.? (Our portfolios all have the same composition.)

Estimating Future Stock Returns, December 2017 Update

Estimating Future Stock Returns, December 2017 Update

Posted on by David Merkel

The future return keeps getting lower, as the market goes higher

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Jeff Bezos has a saying, “Your margin is my opportunity.”? He has found ways to eat the businesses of others by providing the same goods and services at a lower cost.? Now, that makes Amazon more productive and others less productive.? The same is true of other internet-related businesses like Google, Netflix, etc.

And, there is a slight net benefit to the economy from the creative destruction.? Old capital gets recycled.? Malls that are no longer so useful serve lower-margin businesses for locals, become homes to mega-churches, other area-intensive human gatherings, or get destroyed, and the valuable land so near many people gets put to alternative uses that are better than the mall, but not as profitable as the mall prior to the internet.

Laborers get released to other work as well.? They may get paid less than they did previously, but the system as a whole is more productive, profits rise, even as wages don’t rise so much.? A decent part of that goes to the pensions of oldsters — after all, who owns most of the stock?? Indirectly, pension plans and accounts own most of it.? As I have sometimes joked, when there are layoffs because institutional investors representing pension plans? are forcing companies to merge, or become more efficient in other ways, it is that the parents are laying off their children, because there are cheaper helpers that do just as well, and the added profits will aid their deservedly lush retirement, with little inheritance for their children.

It is a joke, though seriously intended.? Why I am mentioning it now, is that a hidden assumption of my S&P 500 estimation model is that the return on assets in the economy as a whole is assumed to be constant.? Some will say, “That can’t be true.? Look at all of the new productive businesses that have been created! The return on assets must be increasing.”? For every bit of improvement in the new businesses, some of the old businesses are destroyed.? There is some net gain, but the amount of gain is not that large in aggregate, and these changes have been happening for a long time.? Technological progress creates and destroys.

As such, I don’t think we are in a “New Era.”? Or maybe we are always in a “New Era.”? Either way, the assumption of a constant return on assets over time doesn’t strike me as wrong, though it might seem that way for a decade or two, low or high.

As it is today, the S&P 500 is priced to deliver returns of 3.24%/year not adjusted for inflation over the next ten years.? At 12/31/2017, that figure was 3.48%, as in the graph above.

We are at the 95th percentile of valuations.? Can we go higher?? Yes.? Is it likely?? Yes, but it is not likely to stick.? Someday the S&P 500 will go below 2000.? I don’t know when, but it will.? There are enough imbalances in the world — too many liabilities relative to productivity, that crises will come.? Debt creates its own crises, because people rely on those payments in the short-run, unlike stocks.

There are many saying that “there is no alternative” to owning stocks in this environment — the TINA argument.? I think that they are wrong.? What if I told you that the best you can hope for from stocks over the next 10 years is 4.07%/year, not adjusted for inflation?? Does 1.24%/year over the 10-year Treasury note really give you compensation for the additional risk?? I think not, therefore bonds, low as they may be, are an alternative.

The top line there is a 4.07%/year return, not adjusted for inflation

If you are happy holding onto stocks, knowing that the best scenario from past history would be slightly over 3400 on the S&P 500 in 2028, then why not buy a bond index fund like AGG or LQD that could virtually guarantee something near that outcome?

Is there risk of deflation?? Yes there is.? Indebted economies are very susceptible to deflation risk, because wealthy people with political influence will always prefer an economy that muddles, to higher taxes on them, inflation, or worst of all an internal default.

That is why I am saying don’t assume that the market will go a lot higher.? Indeed, we could hit levels over 4000 on the S&P if we go as nuts as we did in 1999-2000.? But the supposedly impotent Fed of that era raised short-term rates enough to crater the market.? They are in the process of doing that now.? If they follow their “dot plot” to mid-2019 the yield curve will invert.? Something will blow up, the market will retreat, and the next loosening cycle will start, complete with more QE.

Thus I am here to tell you, there is an alternative to stocks.? At present, a broad market index portfolio of bonds will likely outperform the stock market over the next ten years, and with lower risk.? Are you ready to make the switch, or at least, raise your percentage of safe assets?

The Rules, Part LXIV

The Rules, Part LXIV

Posted on by David Merkel

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

  • Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
  • Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
  • Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
  • Students and middle-to-lower classes borrowing too much (autos, credit cards)
  • Interest rates and goods and services price inflation stay low in the face of this.
  • Low volatility (until now)
  • Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
  • Low credit spreads

No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:

  • Preservation of capital
  • Dry powder
  • Not finding opportunities
  • Momentum gives way to negative arbitrages.
  • Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?

There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

On the Migration of Stock

On the Migration of Stock

Posted on by David Merkel

Photo Credit: ashokboghani

This should be a brief article.? I remember back in 1999 to early 2000 how P&C insurance stocks, and other boring slower-growth industries were falling in price despite growing net worth, and reasonable earnings.? I was working for The St. Paul at the time (a Property & Casualty Insurer), and for an investment actuary like me, who grew up in the life insurance business it was interesting to see the different philosophy of the industry.? Shorter-duration products make competition more obvious, making downturns uglier.

The market in 1999-2000 got narrow.? Few groups and few stocks were leading the rise.? Performance-conscious investors, amateur and professional, servants of the “Church of What’s Working Now,” sold their holdings in the slower growing companies to buy the shares of faster growing companies, with little attention to valuation differences.

I remember flipping the chart of the S&P 1500 Supercomposite for P&C Insurers, and laying it on top of an index of the dot-com stocks.? They looked like twins separated at birth, except one was upside down.

When shares are sold, they don’t just disappear.? Someone buys them.? In this case, P&C firms bought back their own stock, as did industry insiders, and value investors — what few remained.? When managed well, P&C insurance is a nice, predictable business that throws of reliable profits, and is just complex enough to scare away a decent number of potential investors.? The scare is partially due to the effect that it is not always well-managed, and not everyone can figure out who the good managers are.

So shares migrate.? Those that fall in the midst of a rally, despite decent economics, get bought by long-term investors.? The hot stocks get bought by shorter-term investors, who follow the momentum.? This continues until the gravitational effects of relative valuations gets too great — the cash flows of the hot stocks do not justify the valuations.

Then performance reverts, and what was bad becomes good, and good bad, but as with almost every investment strategy you have to survive until the turn, and if the assets run from the prior migration, it is cold comfort to be right eventually.

As an aside, this is part of what fuels dollar-weighted returns being lower than time-weighted returns.? The hot money migration buys high, and sells low.

Thus I say to value investors, “Persevere.? I can’t tell you when the turn will be, but it is getting closer.”

On a Letter from an Old Friend

On a Letter from an Old Friend

Posted on by David Merkel

Photo Credit: jessica wilson {jek in the box}

David:

It’s been a while since we last corresponded.??I hope you and your family are well.

Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?

This in a market that seemingly doesn’t?go down, where the risk of being cautious is missing out on big gains.

In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold.?Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.

Please let me know your thoughts.

Regards

JJJ

Dear JJJ,

Good to hear from you.? It has been a long time.

Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.? I suspect that you are like me, and play for a longer horizon.

I’m at my lowest equity allocation in 17 years.? I am at 65% in equities.? If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.? Another 20% will go if the market rises 10% from here.? At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.? That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.

The stocks that I do have are heading in three directions: safer, cyclical and foreign.? I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.? A few are cyclicals, and may benefit if commodities rise.

The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.? That said, a lot of broad market and growth investors are making “new era” arguments.? That gives me more comfort about this.? Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.? The overall productivity of risk assets is not rising.? People are looking through the rearview mirror, not the windshield, at asset returns.

I can endorse some gold, even though it does nothing.? Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.? Commodities are undervalued at present.? I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.? When economies are heavily indebted they tend not to inflate, except as a last resort.? (The wealthy want to protect their claims against the economy.? The Fed generally helps the wealthy.? Those on the FOMC are all wealthy.)

I also hold more cash than normal.? The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.

The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.

That said, I would be careful about bank debt.? Be careful about the covenants on the bank debt; it is not as safe as it once was.? I don’t own any now.

Aside from that, I think you are on the right track.? The most important question is how much you have invested in risk assets.? Prudent investors should be heading lower as the market rises.? It is either not a new era, or, it is always a new era.? Build up your supply of safe assets.? That is the main idea.? Preserve capital for another day when risk assets offer better opportunities.

Thanks for writing.? If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.

Sincerely,

David

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