Category: Portfolio Management

The Rules, Part LIII

The Rules, Part LIII

Posted on by David Merkel

The tech market washes out about every eight years or so.? The broad market, which is a more robust beast, washes out far less frequently.? My question: are these variants of the same phenomenon?

I wrote this back in early 2003.? I can now answer my own question: No.

I’ve looked at this question many times, and debated the answer, but there are a few things that have made me decide “No.”

  • Sectors often move independently of the market as a whole, particularly growthy sectors that lose their growth.
  • The big moves of the market as a whole have usually been correlated with credit crises, which are part of the financial sector, not the tech sector.
  • The tech sector grows more slowly as a whole now, and hasn’t washed out for a while.
  • The financial sector fails because of financial leverage, the firms are too levered, and take too much credit risk.? The tech sector fails because market players bid up the prices of stock assuming permanently high rates of growth.? These are fundamentally different reasons for over-valuation, because most tech stocks have little debt.

Credit crises lead to big overall declines in market values, particularly with financial stocks, but affecting all other stocks, because when credit conditions are tight, things slow for all firms.

When tech stocks are overbid, it is more of a local mania where market players overestimate the degree of growth the sector can achieve.? There is little collateral damage to the market.? A seeming exception to this is 2000-2002, where the market went down with tech, but financials were less affected. In that drawdown, tight Fed policy drew everything down, and tech more than everything else.? Remember the NASDAQ over 5000?? Still hasn’t returned there, while the Dow, S&P 500, and Russell 2000 have hit new highs.

Here’s the summary: financial stress tends to be pervasive, affecting everything.? Stress from growth expectations that disappoint tend to be sector-specific, and don’t drag down the market as a whole.

And so the answer to my question that I asked 10+ years ago is “no.”

The Rules, Part LII

The Rules, Part LII

Posted on by David Merkel

ge + E/P > ilongest bond

Let me explain.? The first term is the growth rate of earnings for a company.? The second term is the earnings yield of a company.? The last term is the yield on the longest, most subordinated bond or preferred stock a company has issued.

The idea here, is that the more risk you take with a company, the more return you should invest for.? Bank debt should yield less than senior unsecured debt, which should yield less than preferred stock, which should yield less than the expected total return from the common stock.

This is a simple idea, but it can occasionally yield good buy or sell ideas when the equation seemingly does not work.? If it does not work, consider buying the bonds and/or selling the stock.? On the other hand, when the equation works, and the gap is wide, consider buying the stock and/or selling the bonds.

The idea is to look for the best risk-adjusted returns, and not be wedded to one particular type of asset.

Another way to think about it is when a company would buy back its shares.? Would it buy them back when it costs more to borrow on safe terms than the company is earning, including likely increases? in earnings?? No, that’s not likely, they might even issue more shares in such a situation.? Buying the shares back requires that the debt or excess cash is less valuable than the stock being bought.

The main point of this rule is to think through the capital structure of a corporation, and look at the relative valuations.? Deviations of expected returns from likely risk deserve attention.

Here’s an example: my boss called me one day and told me he sold short two stocks that afterward doubled on him.? What should he do?? I looked at the bonds of the stocks and saw that they were trading above par.? He thought they were going bankrupt, but the bond market did not agree.? I told him to cover.? He objected, but I said, do you want to cover at a higher level?? Eventually he covered.

Pay attention to all of the securities in the capital structure of companies that you own (or short).? They may give you valuable data that the stock market does not know.

 

Should You Buy Shares of Stock or Not?

Should You Buy Shares of Stock or Not?

Posted on by David Merkel

Well, I was honored to be tweeted to by Mark Cuban.? Here it is:

@howardlindzon @AlephBlog the real question is why would an individual buy a share of stock? It no longer reps ownership in company

Now let me try to answer the question.? Yes, average people buying stocks with the small amount of money that they have, have no control over their investments.? What is worse is that those who invest through mutual funds have less control, because the mutual funds don’t care much about governance except when something critical comes to them: an acquisition, a spinoff, a merger, etc.

Small investors need to realize that they are riding on the bus of the company (ies) that they own.? They have little ability to affect the board of the company, much less management.

So why buy, if you don’t get control?

Well, let’s talk about institutional investing in alternatives.? Many institutions ride on the buses of general partners with expertise, while they are limited partners.? They have little to no control, and they invest because they think their LP interests will be worth more by the time the partnership matures.? The partnership must raise liquidity by the end of the term, and players get paid, even if they are rolling into the next deal.

The key here is a liquidity event, or the threat of one.? Something that forces the investment to interact with the cash world.? It can be a spinoff, selling a subsidiary, an outright sale of the company, etc.

But liquidity events are rare with publicly traded equities.?? Maybe not *so* rare, when you consider dividends and buybacks.? But full acquisitions happen rarely, and individuals play a small role in M&A.

So here is the answer, which only makes sense if you are a value investor: we buy stocks that we think will compound value.? We may not have control, but we look for situations where management honors the investments of outside passive minority shareholders.

We may be aided by larger investors that seek control, or not.? When you own an undervalued company, catalysts appear. It may take time, but the effort to make value emerge will work more than half of the time.

My view is to focus on companies that are growing value and own them.? That will result in increases in the underlying value of the companies held, which will result in high market values.

Yes, we may not have control.? But if we focus on undervalued equities, we may own companies that those large enough to buy whole companies will buy out, rewarding our patience in holding neglected companies.

And so, Mr. Cuban, though I am nowhere as successful as you, I regularly do better than the S&P 500 by picking stocks with my value discipline, buying stuff that few want to own, and profiting when the stocks exceed expectations.

That is why I own individual stocks, for myself and my clients.? I note that you on rare occasion buy common stocks, including this purchase of Apollo Group.? Guess what?? I own that as well.

I buy the stocks of companies that are out of favor, but have a margin of safety — if I am wrong, I won’t get killed.

That’s why I buy shares of common stock even though I know my ability to control is limited.? (That said, at least in the insurance industry, if I call they will listen to me, at least among the midcap and smallcap firms.)

But I agree with you.? Small investors ride on the backs of larger control investors.? Thus small investors should ask, “What will the large control investors like?? And that is why clever small investors should buy shares of stock, despite the lack of control.

Full Disclosure: Long APOL

On Alternative Investments

On Alternative Investments

Posted on by David Merkel

What makes an investment alternative?? Typically, it is because not many institutional investors own it.? But why don?t they own alternatives?? What attributes can characterize them?

  • Lower Liquidity ? this can take the form of long lockups for private equity, liquidity limitations on hedge funds, Real Estate LPs, etc.
  • Limited market for trying to sell out of limited partnership interests early
  • Can go both long and short financial instruments, use derivatives
  • Can hold commodities and collectibles (Art, wine, who knows?)

Typically, the form of the investment is a limited partnership.? The limited partnership can own all manner of assets, and short some of them also.

As with most valid investment ideas, those that get there first do the best.? You don’t want to be the last one to the party — you buy into a saturated market at an overvalued price.? Far better to avoid the market than to be the last one in.

You have to understand, there is nothing truly different about alternative investments.? They may invest in private businesses, and lever them up, but the returns aren’t greater than if we levered up public companies to the same degree.

They may go long and short, but there are so many trying to do it that the limits of arbitrage are tested, which is a major reason for why hedge funds are doing so badly.? When you have a lot of parties trying to make differential bets, the reward to the exercise declines.

Briefly, while working for Finacorp before it liquidated, I had the opportunity to give advice to some large pension plans that were charging into alternative investments in 2009.? I counseled them to stick to more liquid investments, because alternative investments had become common.? Alternatives are not magic — you have to evaluate them like any business, and ask whether the entry price discounts a high return or a low return.? Are the commodities/collectibles in over- or under-supply?? What possibility might you face of needing to raise liquidity at an inopportune time?

There are two matters affecting any investment:

  • Underlying behavior of the asset in term of its relative value, and
  • Behavior of those who hold the investment, their perception of relative value, and their need for liquidity.

To give an absurd example, think of Bernie Madoff.? The actual value of the assets never did anything.? But parties owning interests in Madoff’s “fund” needed to raise liquidity when the public equity markets plunged in 2008, which led to the insolvency.

Investor behavior affects asset prices.? Big surprise, not.? This is Ben Graham’s voting machine.? The weighing machine eventually catches up when there are liquidity events where investment vehicles get dissolved for cash or other securities.

This is not to say that there is no superior management talent with respect to alternative investments, but that it is subject to the same limits as public investments.? As more capital is allocated to a manager, he moves down his list and says, “Okay, what’s the next best thing to which I can allocate capital?”? Too much money kills even the best of managers.

Perhaps the best way to go is to focus on the Seth Klarmans and Howard Marks of our world, and be opportunistic.? Hold cash when it makes sense, or send it back to the limited partners, but invite them back and invest heavily when conditions warrant.

My view is this: given the wide level of investing in alternative investments, there is no reason why they should outperform, and no reason why they should be uncorrelated with other risk assets, because the same owners own both.

The Rules, Part LI

The Rules, Part LI

Posted on by David Merkel

65% of the time, the rules work.? 30% of the time, the rules don’t work. 5% of the time, the opposite of the rules works.

When I wrote that to Cramer in 2003, his comment was that he loved it.? To me, this meta-rule about market rules in general expresses how markets work.? Re-expressing the three periods:

1) There are rules, and they work most of the time.? Value and Momentum strategies work on average.? So do many other strategies that work off accounting quality, distress, neglect, company quality, low volatility, etc.

2) But they don’t work all of the time.? Sometimes it seems that there is no discernible reward to a strategy, and performance is market-like.

3) But even valid strategies occasionally attract too many followers.? Too many foxes versus rabbits, means that foxes will die.? During those times, you think that the world is coming to an end, but these times are usually mercifully short.

In early 2000, a lot of great value investors got fired.? They had just suffered the worst period of relative performance in a decade, and investors were fed up.? Those firings were a sign that things were about to improve for value investing.? Near market troughs, qualitative signals occur to show that people are giving up because the rules have been reversed.

What does this mean for us regarding portfolio management?? The first and easiest solution is to stick to your discipline no matter what, and ride out the hard times.? After all, the rules work most of the time; you will get rewarded following them.

It is like what Max Heine said to Michael Price during Price’s younger days (extreme paraphrase from memory): If you follow this method, you will earn 15% per year on average.? One year out of ten, you will look like a genius.? One year out of ten, you will look like a loser.? Be mentally prepared for that.

And perhaps, that is the main message here.? Be prepared, like a good Boy Scout.? Be prepared for the days when your strategies, so strong in the past, go dead, or even become corrosive.? That is not a reason to abandon strategies that have a strong argument behind them, like momentum, value, etc.? It is a time to show courage, and buy the best stocks you can find.? Crises test investors, and the best stick to their guns and concentrate on the best opportunities.

The irregularity of the markets exists to shake out market players that cannot handle losses.? Those that cannot handle losses had unrealistic expectations.? Markets are perverse, and they suck in amateurs near peaks, and the amateurs leave near troughs.? They help provide the excess performance of the best.

The second message is to realize there are no strategies that work year-after-year, and that you have to accept years where your normally valid strategies? don’t work, or worse, become toxic. Don’t lose heart.

The third message is after a strategy has had a long run of success, don’t be afraid to lighten up.?? Eventually the evil days come, when the results of investing at high prices relative to value are punished.

Follow the rules, then, and be ready to absorb losses during the fleeting bad times.

The Rules, Part L

The Rules, Part L

Posted on by David Merkel

Countries are firms that produce claims on assets and goods

If I were rewriting this today, it might read, “Countries are firms that produce claims on assets, goods, and income, and anything else they can dream of, in order to retain their privileged position.”

Countries exist for defense and internal justice.? That’s the bare minimum; think of it this way: can there be rivals for defense and internal justice without a civil war?? With many other issues, countries may be willing to share the load — charities that deal with the poor, in addition to welfare programs.

Countries have unique taxation rights, and though big businesses and other interest groups may bend countries to their will, the countries still have their rights.? In a crisis, that could be significant.

FDR confiscated gold during a crisis.? Cyprus swiped bank deposits in a crisis.? Argentina meddles with pension monies.? What could governments do as entitlement (welfare) payments rise more rapidly than taxes?? I don’t know for sure, but you can bet there will be some desperate moves made, tapping many sources of income, transactions, and assets, as well as limit benefits via benefits taxation and other methods.

You could even see widespread purging of the SS Disability Insurance [SSDI] rolls in a real crisis.? I think of an former neighbor, on SSDI because of a bad back who was regularly on his roof putting up and taking down Christmas lights.? He always seemed hale & hearty to me, but there he was on the government dole.

To the extent that they can, countries establish the rules of the economic game. reserving the right to change the rules.?? It has to be this way, because aside from God, there is no greater power that can make countries change their ways by fiat.? Yes, there are wars and civil wars, but those have no determinate outcome.? No one orders a country around directly.? Indirectly, things are different, as diplomacy may bring pressure that makes another country compromise.

The model where countries rule over others to get “a piece of the action” is a fair approximation economically of how countries act.? Consider it as you invest, especially with foreign investing.

Sorted Weekly Tweets

Sorted Weekly Tweets

Posted on by David Merkel

Companies & Industries

 

  • Falling gas prices this Fall http://t.co/EQkgsyKoSm Pollution requirements fall, people drive less, overcomes geopolitical effects $$ Aug 30, 2013
  • Wal-Mart vs Costco, Why My Critics R Wrong http://t.co/2eBuKkJ8G2 $WMT offers more variety vs $COST | thus more people lower wage rates $$ Aug 30, 2013
  • Brazilian Billionaire Who Controls Your Beer, Condiments, & Whopper http://t.co/CbfdxNQLAP Long piece on Jorge Lemann $$ #Heinz $BRK.B Aug 30, 2013
  • New York to Seattle Buyers Tap Brakes After Rates Rise http://t.co/uU0NS9CiCU Rising prices & mortgage rates mean loan payments 2 high $$ Aug 30, 2013
  • US Bank Legal Bills Exceed $100B Bloomberg http://t.co/BklYyebbFV Just think how profitable they will be when the dust settles 😉 $$ Aug 29, 2013
  • Cheap Corn Deters Buyers in US Sugar-for-Ethanol Plan http://t.co/sAYPAt1G9g Corn scarcity becomes corn glut, reinforcing sugar glut $$ Aug 29, 2013
  • Why Wal-Mart Will Never Pay Like Costco http://t.co/EPVjeV0OvF $WMT has much wider diversity of products, so more workers @ lower pay $$ Aug 29, 2013
  • Why Is Chicken More Expensive? Ask McDonald’s http://t.co/iU7OzuIF8f When $MCD adds a new ingredient to their menu, drives prices higher $$ Aug 29, 2013
  • Xerox Can Fix Number-Switching Scanners, but Not Altered Docs http://t.co/6HfzO8IqtV Could b a lot of work 2 re-scan originals if u havem $$ Aug 27, 2013
  • JPMorgan Worth 30% More If Broken Up, KBW Says http://t.co/b5eJc14Lio Pure play financial institutions always get better valuations $JPM $$ Aug 24, 2013
  • Apple, Samsung, IBM, World’s Universities in Graphene Gold Rush http://t.co/riFRiMHAzN Crystalline Carbon 1 atom thick sheets are amazing $$ Aug 24, 2013
  • College is like gasoline, demand for it is inelastic. Thus any subsidy gets captured by the college, & taxes get eaten by gas consumers $$ Aug 24, 2013
  • The Real Reason College Costs So Much http://t.co/NJNV3Ksovg Richard Vedder explains how federal subsidies push up the price on college $$ Aug 24, 2013
  • djco_corresp-031513.htm http://t.co/VwvVLv7mZi Munger’s law firm explains y $DJCO shouldn’t b viewed as an investment company. Well done! $$ Aug 24, 2013

US Politics & Policy

 

  • Obama Is About 2Undermine His Mideast Doctrine http://t.co/VveJslt6LM Obama has mostly tried 2disengage US from Mideast, this reverses it $$ Aug 30, 2013
  • The Rising Cost of Social Security Disability Insurance http://t.co/4sEVmFKDfc SSDI’s trust fund runs out is 2016; 2EZ 2get on disability $$ Aug 29, 2013
  • And Next Year There Will Be an Eighth Budget ?Showdown? http://t.co/2nflqEZLPM Rate of budget growth slowed, but scope of govt expands $$ Aug 29, 2013
  • Regulators Ease Mortgage Rules http://t.co/LuEU9uY1Hz Swiss cheese regs destroy direct incentives 4 originators 2 produce quality loans $$ Aug 29, 2013
  • Regulators Back Away From Tougher Mortgage Rules http://t.co/4WQwGVNnF9 More capital needs to be held against exotic mortgage loans, good $$ Aug 29, 2013
  • Obama Meets Panel Reviewing US Surveillance Programs http://t.co/kjDsoD3K7D Repeal the Patriot Act; modifications r not enough $$ Aug 28, 2013
  • College Leaders Wary of Obama Plan Linking College Aid to Rank http://t.co/jw7K3X29TV Plan could hurt the very parties Obama wants 2 help $$ Aug 25, 2013
  • Samantha Power on the Duty to Intervene http://t.co/B4ttOrPB3T This argues that the US should be the cop of the globe 4 the worst things $$ Aug 25, 2013

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Rest of the World

 

  • Sinopec-Apache Deal Shows China’s Resource Appetite http://t.co/90Yr1G9aUN China learns how 2negotiate minority stakes in oil properties $$ Aug 30, 2013
  • Hollande Draws Heat From Biz 4 Tax-Driven Pension Revamp http://t.co/62E5lKMHqr France?s tax burden is ~46% of GDP, 3rd highest in Europe $$ Aug 30, 2013
  • Scandinavia?s Weakest Nation Finds Welfare Habits Too Costly http://t.co/UCNH3umT7p Denmark looks forward, realizes it must cut welfare $$ Aug 30, 2013
  • The Abenomics Mirage: In Reality, Too Many Challenges? http://t.co/542B5V4JHw Japan imports on net so a lower yen doesn’t help much $$ Aug 30, 2013
  • Schaeuble Snubs Greek Plea for Direct Bank Recapitalization http://t.co/lCStBdF3Qc Perhaps Greece needs 2 establish effective taxation $$ Aug 29, 2013
  • Spaniards Fleeing Jobless Scourge Seek Jobs in Morocco http://t.co/pZZexcIzCY Can’t earn as much but can earn something as Spain shrinks $$ Aug 29, 2013
  • Start-Ups Fill Void Left by Spain?s 26% Unemployment Rate http://t.co/9a2RqRUG6i If u can’t work 4 someone else u can work 4 yourself $$ Aug 28, 2013
  • Czech Zero Percent Lending Rate Feeds Home-Buying Frenzy http://t.co/cWZ24eKjxb Bad things happen when there is seemingly free $$ available Aug 28, 2013
  • Vietnam Rises as Middle Power at Defense Summit http://t.co/tHVz8Yn4SP Wants to stay neutral btw the US & China, while protecting itself $$ Aug 28, 2013
  • Teachers Roil Mexico Capital http://t.co/qrQif3mpsY Maybe it’s time 2 move the capital out of Mexico City, to someplace more hospitable $$ Aug 28, 2013
  • Emerging-Market Rout Intensifies on Syria Jitters http://t.co/U4upWVYVAE Jitters affect oil mkt & it spills over in to weak emerging mkts $$ Aug 28, 2013
  • Fed Officials Rebuff Coordination Calls as QE Taper Looms http://t.co/kTaFgn7CwT Emerging markets whipsawed as US monetary policy shifts $$ Aug 28, 2013
  • Veteran Saudi Power Player Prince Bandar Works To Build Support to Topple Assad http://t.co/cXFO7hLG9W Islamic proxy war continues $$ Aug 27, 2013
  • Emerging Europe Is a Haven in Selloff http://t.co/OErr8eqJjt Hard to damage nations w/more orthodox fiscal policies, but still part of EZ $$ Aug 27, 2013
  • Emerging market slump highlights Fed’s global reach http://t.co/mxmfLY6ya2 The US sneezes & the world catches cold, again $$ Aug 27, 2013
  • Charlene Chu Interview with Goldman on China?s Credit Bubble http://t.co/ytHhrZYm7H Excellent Interview showing future China weakness $$ Aug 27, 2013

 

Other

 

  • Scientists Shed New Light on Black Holes http://t.co/oNyfGEJKHM The speed w/which gas is pulled toward a black hole repels some entering $$ Aug 30, 2013
  • Is It Evil to Send Your Kids to Private School??http://t.co/SljCeNm7qq Parents will always find ways 2keep children out of subpar schools $$ Aug 30, 2013
  • Age-Related Forgetfulness Tied to Diminished Brain Protein http://t.co/fFe2U2eqQw This may have some promise in reducing dementia $$ Aug 30, 2013
  • Definitive merger agreement between 2 business journalists http://t.co/Pup53ksizg Do some R&D, & create subsidiaries that will b spun off $$ Aug 30, 2013
  • How Haute Vegetables R Conquering $500 Tasting Menus http://t.co/QTAxKlwm1S Borage is a well-known medicinal herb; interesting 1st course $$ Aug 29, 2013
  • Six Reasons the US Will Dominate http://t.co/ZreqluzZJS Immigrants, more workers, entrepreneurship, labor flexibility, <Financing, strong $$ Aug 28, 2013
  • P2P lending pulls in big investors – should you bite? http://t.co/jyg3kdaSrr Soon 2 come, a peer2peer lending closed-end fund $$ #ohno #FTL Aug 28, 2013
  • Shoeshines Keep Wall Street in the Black (or Maybe Brown) http://t.co/LQNtODrhcP A unique institution stays alive on Wall Street $$ Aug 27, 2013
  • Sometimes I think Federal education policy is designed to weigh down the system, making it easier 4 private & home schools 2 outperform $$ Aug 27, 2013
  • Biggest Changes in a Decade Greet Students http://t.co/BIgJHbqiLN Some Teachers, Parents Push Back on New Standards “Common Core” $$ Aug 27, 2013
  • Home Births on the Rise for New York Families http://t.co/MYxaaeEWua Fascinating trend, though I think the best is a midwife @ a hospital $$ Aug 27, 2013
  • Midwives provides far better care than doctors w/normal deliveries, & they r cheaper. Being @ a hospital provides insurance if trouble $$ Aug 27, 2013
  • Are You Ready for the Post-College SAT? http://t.co/WyscN8A7W6 College is not valuable to some employers -> a new test 2 show your smarts $$ Aug 27, 2013
  • Regarding that last tweet, could testing replace college? Credentialing is important, but do we need to waste four years to credential? $$ Aug 27, 2013
  • Jail Becomes Home for Husband Stuck With Lifetime Alimony http://t.co/Mb4Q8Q0PjH Debtors prison returns in a new form $$ long article Aug 27, 2013
  • Muriel Siebert, First Woman to Buy Seat on NYSE, Dies at 84 http://t.co/qzeE9csU2K Used to have an account w/her firm; good company $$ Aug 27, 2013
  • Ben Franklin Gets a Makeover http://t.co/Rxm3ipFY0g Ben Franklin owned slaves?! Whouda thunk it! New presentation about a complex guy $$ Aug 25, 2013
  • Dishwashers Beat Clothes as US Moms Use Hand-Me-Downs http://t.co/cbcn0ENrp1 People buy things w/longer-term value, reduce luxuries $$ Aug 25, 2013

 

PPACA / Obamacare

 

  • A New Kind of Insurance Head-Scratcher: Estimating Future Income http://t.co/YeW19BKNhf Incentive will b2 under-report until checked $$ Aug 30, 2013
  • The Young and the Healthy http://t.co/PuODKsJBSZ One more calculator 4 Obamacare subsidies 4 young & not well-paid $$ Old win, young lose Aug 30, 2013
  • Senior Discounts http://t.co/Do37iNPq7I Interesting illustrative calculator on premium subsidies under Obamacare. Incentives to earn less $$ Aug 30, 2013
  • Thus PPACA will have an incentive 2 destroy working, & the exchanges will fail, as they will only attract the sick, young ppl stay away $$ Aug 30, 2013
  • Also, look at this graphic http://t.co/WTV8HAcVVZ As incomes go from 25K to 55K, subsidy is lost & an implied 17% tax from the loss $$ Aug 30, 2013
  • Subsidies for Older Buyers Give Health Insurers a Headache http://t.co/0eOfVj33XU Subsidies will will older poor in2 exchanges, not young $$ Aug 30, 2013

 

Harbinger Group Life Insurance IPO
?? Falcone Insurer Said to Seek $1 Billion Valuation in IPO – Bloomberg http://t.co/RoHy0ODzQu & my tart comments: http://t.co/JSu9QvtXhf $$ Aug 30, 2013

  • Harbinger’s insurance unit files for $100M IPO http://t.co/72DBoMSG6C $HRG pays itself a dividend; dig the 28pp of risk factors @ the SEC $$ Aug 29, 2013

 

Market Impact

 

  • Pimco Sees Taper in Worst MBS Slump Since 1999 http://t.co/UdXVCkajVo Bond market summary, particularly noting taper effect on MBS market $$ Aug 30, 2013
  • Some IPOs Aim for Small Investors http://t.co/3hh47lfQ6K Keep your hand on your wallet, alternative stock distribution methods untested $$ Aug 30, 2013
  • Currency Spikes at 4 PM in London Provide Rigging Clues http://t.co/fyG78r3RhI All human systems r gamed; need 2 acct 4 that w/benchmarks $$ Aug 28, 2013
  • How ?black squirrels? infested Wall Street http://t.co/6CIVfJcpAF Efforts to level playing field made it more opaque & hazardous $$ #complex Aug 27, 2013
  • Cyclical Stocks Looking Historically Cheap http://t.co/FomqlE3ZDq Yes, cheap. What will happen 2 cyclical earnings if the economy slows? $$ Aug 25, 2013

 

Central Banking

 

  • Fed’s IG says central bank violated document rules http://t.co/YCtbIbhfAJ Issued minutes of policy meeting a day b4 the scheduled release $$ Aug 30, 2013
  • Did Fed?s Forward Guidance Backfire? Paper Says Probably http://t.co/C4Ew7T2AXR The idea that clear Fed communication works is unproven $$ Aug 25, 2013
  • Summers as Obama Voice of Authority Rides Car Rescue in Fed Race http://t.co/EKKOnRhvq1 Good piece on y Obama may pick Summers 4Fed Chair $$ Aug 25, 2013

 

Wrong, Etc.

  • Wrong: CLO Rule Aimed to Pass Retention to Banks Won?t Work, RBS Says http://t.co/KkQQ8l2lqw Will shrink the # of issuers, that’s not bad $$ Aug 29, 2013
  • Bad title: Why Is Vladimir Putin Acting So Crazy? http://t.co/ILtxIFNOSO He’s acting rationally in response to changing conditions $$ Aug 29, 2013
  • Wrong:Will Obama Make the Fed Even Worse? http://t.co/YZblnIKzOe Not well argued. More about his view $$ policy is 2 tight, less about Obama Aug 27, 2013
  • Sort of: The Strong Case for Optimism About US Growth http://t.co/5LJgQuli4v Except it is optimism after 5 more years of deleveraging $$ Aug 27, 2013

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Retweets, Replies & Comments

  • RT @EddyElfenbein: Happy 83rd Birthday to Warren Edward Buffett @WarrenBuffett. The Dow was at 240.42 eighty-three years ago. Aug 30, 2013
  • #FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Aug 30, 2013
  • Thanks @OGMarcusC @Metalbanker for being top new followers in my community this week 🙂 | insight by http://t.co/sern3wLA13 Aug 30, 2013
  • @ledbetreuters If you had your own website, & had a Google Page Rank over 5, u would get around two of those per week. Very pesky. Aug 30, 2013
  • RT @azizonomics: Nobel War Prize Aug 30, 2013
  • RT @ianbremmer: Knock knock. Who’s there? The international community. The international community who? Precisely. Aug 30, 2013
  • RT @treehcapital: Yet another reason to love New Zealand @pkedrosky: New Zealand bans software patents http://t.co/6ah7N84QtA Aug 29, 2013
  • Thanks @researchpuzzler @AndreCimini for being top engaged members in my community this week 🙂 | insight by http://t.co/sern3wLA13 Aug 26, 2013
  • @alisonforns And I see the glass as 70 fewer than 140. What a wonderful world! Aug 26, 2013
It’s Not What You Earn, It’s What You Keep

It’s Not What You Earn, It’s What You Keep

Posted on by David Merkel

I like questions from readers, if they are general enough for a blog post.? Here’s one for tonight:

Mr. Merkel,

Following reading your blog here:

http://alephblog.com/2013/01/30/how-to-become-super-rich/

It occurs to me that attaining money in the first place is only half the battle.? A well known fellow among engineers; Nicolai Tesla was great at this.? He made many millions in his life.? He also constantly reinvested most of his income into new inventions and new ideas.? When he died, he was pretty much destitute.

Starting a gas station requires about $300,000 ($150-200k to buy the store/land, 40k to furnish the store, 40k to buy the gas) in startup capital.? In technology, and in software; you can start making money with a good idea and next to no start-up capital… assuming you don’t get crushed by a larger company in the process.

How do the super rich store their massive income?? How do they invest it?? Buying up ever more companies and taking their profits off the top?? What is a minimum threshold amount of money that you need to start to do this?? Can you recommend any good books?

There are several classes of assets that the wealthy like to preserve their wealth.? Here are some examples:

  • Real Estate
  • Municipal Bonds
  • Businesses in necessary industries that throw off a lot of cash flow.
  • Businesses in which they have significant inside knowledge, and can continue to benefit from the knowledge.
  • Occasional equity investments in private ventures that seem promising.

After a certain amount of wealth is acquired, intelligent wealthy people tend to turn to things that have predictable cash flows, rather than take a large amount of business risk.? They’ve made their fortune.? Now it is time to conserve it, and receive what some consider to be rents — passive income that comes with little volatility.

Even Goldman Sachs did this with excess profits, buying safe securities, and throwing them into the BONY box. [BONY == Bank of New York, now BNY Mellon]

In essence, the wealth is converted to ownership in what is likely to be a growing income stream.? What is not used is reinvested.? That is how wealth is preserved during the life of the wealthy.

As for books, you can look at “The Millionaire Next Door,” and its series. Also, Rich Like Them.

But remember, not all rich try to preserve their wealth.? Some lose it through over-consumption, and others through bad investments.? The investments that I list above require a degree of humility, and thus, only wise rich people will follow such a strategy.

On Trading Illiquid Stocks

On Trading Illiquid Stocks

Posted on by David Merkel

Before I start for the evening, I would like to mention that Aleph Blog ranked #120 on Onalytica Indexes? Top 200 Influential Economics Blogs.? The post doesn’t mention it, but Aleph Blog was tied for #86 in terms of popularity.? More people read me than cite me or link to me.

This is more of a finance & investing blog than an economics blog, largely because I am a dissident in the land of neoclassical economics.? This blog is a melange of my varied interests, and is a bit of an acquired taste.? This will be true tonight as well, because tonight’s topic is trading illiquid stocks.

I regard a stock or bond as illiquid if dollar volume traded is low relative to the market capitalization of the security.? Why would I want to own such a security?? Neglect.? There are few eyes analyzing a security that cannot be sourced in size.? Thus, if you have a strong opinion on the security, and it is neglected, you have the opportunity for some strong returns.

In the portfolios I manage for clients, roughly 10% of the assets are illiquid, as I define it.? I have generally had good results with neglected stocks, but many stocks are neglected for a reason, typically a management team that is unfair to outside passive minority shareholders.? Who wants to put cash into a “roach motel?”

In dealing with illiquid stocks, I typically use discretionary reserve orders.? A discretionary order displays the price at which you want to buy or sell, and what degree of latitude you are willing to compromise on the price.? Here’s an example:

Bid: 10.40 Ask: 10.50

A discretionary order might say, “Buy 1000 shares @ 10.39, with 0.06 latitude.”? Any sell order flashing through at 10.45 or lower would trigger the discretionary buy order.

A reserve order says, “I want to sell a large number of shares, but I only want to display a small number, to avoid scaring the market.”? It could be “Buy 1000 shares, show 100 @ 10.40.”? If someone comes in with a larger order than 100 @ 10.40, it will execute up to 1000 shares.? Makes you look small to everyone but the market makers and specialists, who know how much you really want to do.

And that is a difficulty, and I learned it the hard way — I tried a trade where? was offering 20,000 shares and showing 100 on a NASDAQ stock, and the market for the stock went down on what was an otherwise calm day.? Other retail investors couldn’t see my size, but the market maker could, and he adjusted his bid down considerably.? So now I break up my trades, and don’t exceed a certain normal size for the liquidity of a given stock.

A discretionary reserve order combines the two.? For less liquid stocks, I use it frequently, because it erases some of the advantages that high frequency traders have.? My example would be: “Buy 1000 shares, show 100 @ 10.39, with 0.06 latitude.”

So for an illiquid stock was buying lately, I was doing the following (using the same market as before):

  • Buy 1000 shares, show 100 @ 10.40, and,
  • Buy 1000 shares, show 100 @ 10.39, with 0.06 latitude

The idea is to be ready to buy the sell orders that flash through the market at 10.45 or less, while being ready to buy shares cheap if someone decides to lift the bid.? The combination allowed me to buy 20% of the volume across two days, and not budge the stock price — it declined until the seller exhausted himself, after which, the stock started to rise, and I could get nothing more done.? I got 80% of the position on and will wait for a better opportunity for the balance.

Moving from Micro to Macro

So I have my own techniques for coping with market complexity.? I don’t complain about high frequency trading [HFT]; I fight back.? I don’t trade much, so trading is not a core way in which I add value.? That said, I do what I can to minimize the total costs of trading, which is a balance between paying up and getting the stock, and not paying up and the stock gets away from you.

As this article points out HFT is the result of squeezing market makers & specialists through decimalization and a few other regulatory changes.? Intermediaries lost margins and large traders lost the ability to do large trades without revealing their intentions to the world.? Thus in a free market, alternative execution sites come into existence.? Providing liquidity deserves some sort of reward, because it is a good.? HFT is one way for a liquidity provider to get paid, even if some of the tactics are questionable.

The competition to trade the same stocks in different venues led to complexity, such that data exchanged across execution venues must all run on the same clock.? If that is not so, it can lead to the “Flash Crash,” or the recent shutdown at NASDAQ, which ostensibly happened to avoid a repeat of the “Flash Crash.”

Complex systems require some degree of cooperation or regulation in order to operate well.? I have suggested that we don’t need microsecond liquidity to make things work.? Liquidity once per second, or even once per minute would do.? Having one central order book for each stock also would do it, together with tiny fees on orders that get cancelled.

Willingness to offer liquidity deserves a reward, and the more so for orders of size and duration.? They act similarly to what market intermediaries do, so let us come to a market system where such offers of liquidity, whether to buy or sell, get properly rewarded.? That might bring stability to the markets, together with a reduction in complexity.

A Different Look at Industry Attractiveness

A Different Look at Industry Attractiveness

Posted on by David Merkel

While doing some work today, I ran across this resource from Morningstar. Morningstar values stocks by projecting the free cash flows of the companies, and discounting those free cash at a rate that reflects the riskiness of the company.? Free cash flows are the amount of cash you can take from a corporation over a period, an leave it equally well off as it was at the beginning of the period.? Some analysts summarize it as:

  • Earnings then add back
  • Interest, Taxation, Depreciation, Amortization, and subtract
  • Maintenance Capital Expenditure

When you see firms talk about their non-GAAP earnings, this is what some are trying to approximate, showing the true earnings power of the assets.

They project the free cash flows in three phases:

  • Phase 1, the analyst projects the next five years
  • Phase 3, every company is the same, growing at the same rate with no competitive advantage
  • Phase 2 grades from Phase 1 to Phase 3, with wide moat companies having a transition period of 20 years, narrow moat companies 15 years, and “no moat” companies a lesser amount.

What does Morningstar use for its free cash flow discount rates?? They started with CAPM, and moved to something more simple, where companies are divided into four buckets, with rates of 8, 10, 12, and 14%.? I’m no fan of CAPM, but it would be a lot smarter to have a system that reflected:

  • the bond yields of the companies, if any, and
  • the relative riskiness of the enterprise without reference to the market as a whole.? The implied volatility of the stock could play a role.

At the end, Morningstar calculates the ratio of the current market price to the discounted value of the free cash flows per share.? If it is greater than one, is is overvalued.? If it less than one, undervalued.

Morningstar does the calculation company by company, but then aggregates the results by super sector, sector, industry, aize of moat, fair value uncertainty, and equity index.

What I particularly found interesting were the aggregations by industry.? I decided to look at the industries that? were overvalued and undervalued by at least 15%.? Here they are:

Undervalued

  • Aluminum
  • Asian Banks
  • Coal
  • Gold
  • Latin American Banks
  • Pollution & Treatment Controls
  • Steel

Overvalued

  • Auto & Truck Dealerships
  • Auto Parts
  • Broadcasting ? Radio
  • Business Services
  • Computer Systems
  • Electronics Distribution
  • Financial Exchanges
  • Footwear & Accessories
  • Home Furnishings & Fixtures
  • Insurance Brokers
  • Internet Content & Information
  • Long-Term Care Facilities
  • Luxury Goods
  • Marketing Services
  • Medical Distribution
  • Regional US Banks
  • Regulated Gas Utilities
  • REIT – Hotel & Motel
  • Scientific & Technical Instruments
  • Semiconductor Memory
  • Solar
  • Trucking

Morningstar as 147 industries, of which only two did not have fair value estimates.? Seven industries were undervalued (5%), 22 industries were undervalued (15%).? The undervalued industries were mostly cyclical in nature, while the overvalued industries were not, supporting the idea of this Wall Street Journal article, which argues that cyclical stocks are looking relatively cheap.? It is possible to overpay for certainty, just as it is possible to overlever companies with reliable cash flow.

At this point you might be asking, “Okay, this is nice, but what companies does this imply I should buy or sell?”? Can’t tell you for sure, but I can show you this.? This table is interesting enough, but what you can get are the companies behind each industry group if you click on them.? Note that Morningstar is global in its orientation, so many of the companies that it uses are not US-domiciled.? Some may have nonsponsored ADRs that trade infrequently.

My main point is that you can look at the underlying companies of each industry for buy or sell ideas of of their own discount or premium to fair value.? Morningstar’s fair value analysis is not perfect, but it is a straw blowing in the? wind, and is adequate for some relative value judgments.

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