Portfolio Management – Page 46

Risk Control Upfront, Redux

Posted on 28 June 2013 by David Merkel

Each of the situations I used as examples yesterday, I have personally run into, and I could write about more of them.? Good investment and risk control shops do their home work in advance.? They ask questions on what could go wrong with a given investment or product; they are willing to negatively but not unreasonably imaginative.? Buffett has said something to the effect of, “We’re paid to think about the things that can’t happen.”

What I said about life & commercial insurers goes double for the banks.? Those insurers have long liabilities, which gives them more time to bounce back from asset disappointments.? The short liability structures of the banks give them less time to deal with asset problems.

All of this implies having disciplines for buying assets, and re-evaluating assets in any portfolio.? My discipline evaluates these at mid-quarter, when few others are doing their evaluations.

The idea is to be ever and always forward-looking.? The past doesn’t matter, except to serve as grist for the mill, showing us what can happen.

Good investing does not care about entry prices.? Good investing is like the great Wayne Gretsky, who did not care about where the puck was, but where it would be.? This is why when I invest I am always comparing the assets in my portfolio versus alternatives.? I look for what will do well in the future.? I do not care about past gains and losses.

Good investing cares about trading what is good for what is better.? This is easy for bond managers.? A bond manager with skill, and freedom to execute can make many wise trades to improve a portfolio.? All he has to do is buy bonds with yields that compensate for the risks, and sell bonds that don’t compensate.

For equity investors the calculus is more vague, but it still exists.? Look to where you can earn returns on average.? Find enough of those areas so that diversification works.

I have never run an index-like portfolio, unless it was an accident.? I will occasionally throw a company in for diversification reasons, but my main goal is owning cheap assets that will earn far more than the index.

Good investing involves business knowledge.? That means you understand how money is made across the set of companies that you invest in.

Whether you are an investor or not, if you want to make greater progress in your career, you should try to learn the financial aspects of your company.? That will stand you in good stead for those that look for managers, because those who understand the profit model are far more valuable than those that don’t.

I stand with Buffett, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”? Outside money and inside money can learn from each other, leading to a better investing result.

Summary

I offer to all investors this simple idea, trade what is less good for what is better. It will improve your returns.? Continually improve your portfolio, and do not be married to any ideas.? The idea of relative improvement of the portfolio has aided me greatly in portfolio management.? It is easy to swap bond for bond, and relatively easy to trade stock for stock.? Asset allocation decisions are more difficult.? Figuring when to trade stocks, bonds and cash between one another is far more difficult.

Risk Control Upfront

Posted on 25 June 2013 by David Merkel

In my career as an asset manager, and as a manager of financial risk, I have learned that all good risk management is done upfront, before the first purchase is made or product is sold.? Secondarily, good risk management relies on the concept of feedback, i. e., are the results expected at inception happening?? If not, are they happening in a way that makes us doubt the margin of safety that we thought we had?

I’ll give you some examples:

1) There are two ways to offer disability insurance (this applies to high-end P&C products for the wealthy, and other financial products):

Rigorous underwriting that does not cover groups & individuals that could be high risk.
Underwrite freely, and then attempt to deny claims that happen with higher than expected frequency.

2) After designing a living benefit for an annuity, you notice that one option is being chosen by policyholders, and the rest not.? Do you:

Retest the option being chosen, to see that you are not giving away the store?
Do nothing.? After all, it’s the only product of its class selling, and marketing is off your back for now.? Why spoil the party?

3) You discover that you are the only company willing to offer a certain type of reinsurance, or a certain type of coverage.? Do you:

Try to analyze why? your competitors don’t do it.? If there’s no special and durable barrier to entry that you possess, make the pricing jump through harder hoops.
Congratulate yourself for your unique perspective, and willing to take risks that others won’t.

4) On your new insurance product, the claims area sends you early claims data, showing you reasons for the claims.? They reasons aren’t what you would have expected from the quality of the clientele that you thought you were marketing to.? Do you:

Begin analyzing marketing data, to see if the product is being offered more to those less intended.? Analyze what agencies are doing who sell a disproportionate amount of the product.
Attribute the claims to the “Law of Small Numbers.”? Hey, it’s a weird world, and odd stuff happens.

5) You’re part of a team of value investors.? A news event hits, showing that the company will be less profitable than expected by a wide margin.? Do you:

Analyze what the company is worth presently.? If it is no longer safe or cheap, sell.? If the market has over-reacted, buy.? Oh, and feed back the lessons from this episode into the process for evaluating new investments.
Automatically sell, because it has breached your loss limits.
Just hang on, because we have more than enough capital versus investable ideas.
Complain about the event, the potential dishonesty of management, and the analyst that recommended purchase.? Ask why we didn’t sell this last week.? Decide to go activist on the company, because it obviously the assets would be managed better in hands that you select.

6) The credit cycle has gotten long in the tooth, and securities that offer a decent yield versus risks undertaken have become few.? You manage money for income seeking investors.? Do you:

Edge away from risky bonds, slowly upgrade quality, and pare yields.? Communicate to clients why you are doing this, even if it means you might see assets walk.
Stay fully invested in the best quality bonds you can find, subject to a given yield hurdle.
Just facilitate the demands of clients, and invest as if you faced normal yield tradeoffs for risks undertaken.? After all, they want you to take risks.? If clients lose, that is their problem.

7) As a value manager, you have been underperforming for clients.? Though you have tested and re-tested your processes, you can’t? find anything wrong.? You think there is a speculative mania going on.? Several other managers that do things your way have been fired.? Do you:

Stick to your guns.? Safe and cheap will eventually win out.? Communicate that to clients.
Tweak your portfolios to make them more index-like.
Switch to growth or momentum investing.? If you can’t beat them, join them.

There will be a part 2 to this piece.? I will finish up and summarize there.

On Researching Industries

Posted on 22 June 201323 June 2013 by David Merkel

From a reader:

Hi David,

I’ve been a classic “bottom-up” investment advisor for a few years now, but I agree with your assessment that industries, in general, are under-analyzed by the masses.

What is the best way to learn about a particular industry? Are you aware of any comprehensive publication that sheds light on both the qualitative characteristics of an industry and the appropriate valuation methods?

Thanks!

There are several ways to learn industries.? I’ll try to explain:

1) You can choose a bunch of companies in an industry, email the investor relations area, and ask for packet equivalent to what they send buy-side analysts.? I’ve done that at various points in time for industries I wanted to learn.? Compare and contrast.? Who is doing well, badly and why?? In the mid-90s, I did this for the trucking industry, and learned a ton of information.? I also talked with some trucker friends of mine who gave me on the ground data.

2) You can read industry publications.? When I was a buy-side analyst for the insurance industry, I read those regularly.? They exist for almost every significant industry.

3) You can go to industry meetings.? Almost every industry has meetings where they discuss industry conditions.? Just don’t be too pushy in trying to get information.? Be interested in the industry as a whole, and don’t try to gain material nonpublic information.

4) Value Line & Morningstar both provide industry analyses.? So do most major investment banks.? You can review those and compare and contrast.

5) You can use the quality screen to look at what industries have a rising ratio of gross profits from operations, versus a falling ratio of gross profits from operations.? Here is a chart from the last seven years:

The colored field reading “Chg” is the difference between the average of years 1-3 and years 5-7.? Profits are noisy, that’s why I did an average.

Gross profits from operations as a fraction of assets [GP/A] is a good measure of the quality of an industry, and whether their sustainable competitive advantage is is improving or declining.

Now, when I look at a measure like that, I do one of two things:

I buy cheap companies with strong balance sheets among those industries where GP/A has fallen hard, and buy them, knowing that they are survivors, and will rebound.
I buy moderately strong companies in industries where GP/A has been improving, and after research, the trend is not well understood.? It helps if the industry is dull, and few people follow it.

That’s what I do.? Whatever you do, size it to your own abilities, or the abilities of your firm.? Beyond that, look at cheapness of a company relative to normalized earnings, i.e., average earnings over a full market cycle.

Sorted Weekly Tweets

Posted on 22 June 2013 by David Merkel

Bernanke press conference (reverse order)

It’s over!
FOMC Participants Central Tendency of PCE inflation @ Year-End 2013-5, LR 1.22% 1.68% 1.88% 2.00% change -0.33% -0.07% -0.05% 0.00%
Bernanke gives an odd answer to Nikkei reporter, particularly given the Fed’s adoption of failed Japanese economic & monetary policies $$
Yeah, weird answer. RT @Matthew_C_Klein: “Volatility is linked to the BOJ’s efforts. Seems logical.” Um…
BB shows his ignorance on the topic of money market funds, a floating NAV will destabilize, and lead to runs on funds
FOMC Participants Central Tendency Unemployment Rate @ Year-End 2013-5, LR 7.23% 6.60% 6.02% 5.57% Change -0.12% -0.17% -0.19% 0.00% $$
FOMC Participants Central Tendency Change in GDP @ Year-End 2013-5, LR 2.40% 3.14% 3.19% 2.43% Change -0.13% -0.03% -0.07% 0.00% $$
BB, markets do not care about the past, they care about the future. Stock levels of bonds r the past, future behavior affects markets now $$
FOMC Participants Target Federal Funds Rate at Year-End 2013-5, LR 0.26% 0.58% 1.78% 4.01% Change from prior -0.03% 0.03% 0.47% 0.00% $$
Overview of FOMC participants’ Appropriate Timing of Policy Firming central tendency shrinks by 2 months to 2.3 years
Bernanke questioned on MBS holdings, denies that the Fed is having a big effect on the market. If so, why buy there for policy reasons? $$
BB is confused think that holding securities will keep rates low; yields react to changes in expectations of future actions $$
Cutting off asset purchases at 7% unemployment further clouds the market view of Fed policy; the Fed is far more flexible than that. $$
BB also refuses to talk about his future at the FOMC, after being asked by a Washington Post reporter. $$
Bad question from Bloomberg reporter suggesting that the unemployment trigger should be lower. BB gives no much of an answer. $$
Good question on the rise in real rates from the FT reporter. BB says that he doesn’t get why that happened. $$
Question on long term interest rates — BB says that is is an improving economy. Points to housing again (the dead cat bounce) $$
Hilsenrath asks a decent question on punk economic growth. BB responds with housing and State govs & 2 small of a deficit (!) $$ #pleasego

Book Review: Investing in Municipal Bonds

Posted on 16 June 2013 by David Merkel

In my life, I have been a mortgage bond manager, and a corporate bond manager.? I have enough overall experience that I have played in most bond and loan categories, including municipal bonds.

Municipal bonds are one place where the competition level is low, and additional knowledge can pay off.? This is particularly true in an era where municipal bond insurance is less prevalent, and as such credit analysis has more value.

This book gives you the basics on municipal bonds.? The most basic idea is economic necessity.? Who will be harmed if the municipality in question can’t perform?? If the the answer is “few,” that might not be a good municipal bond to buy, unless there are significant covenants requiring a municipality to raise taxes to pay for the debt service.

Municipal bonds are an unusual market because there are many issuers, purposes, and bond styles.? The dominant non-taxable bonds are only bought by Americans, and sometimes only by those in a given state.

Municipal bonds are also different because most of the bonds issued have long maturity dates.? Municipalities want predictability in borrowing costs; they also match the borrowing term to the length of what is funded, which is typically long.

The book will take you through:

Bond types
Covenants
Types of bonds that are more risky
How bonds pay off
Taxation of bonds
The ugliness of trading municipal bonds
The challenge of analyzing municipal economies
Basic yield calculations
Portfolio management
Derivatives — though that was more of an issue in the past

I would highlight one big issue here.? Most small municipal issues rarely trade.? Assembling your own portfolio of municipal bonds is a tough proposition.? Flexibility is required to assemble your own ladder of municipal bonds.

Quibbles

None.? Good book.

Who would benefit from this book: If you are willing to put in the time to analyze what municipal bonds are worthy to be bought, this book will help you.? If you want to, you can buy it here: INVESTING IN MUNICIPAL BONDS: How to Balance Risk and Reward for Success in Today?s Bond Market.

Full disclosure: The publisher sent me a copy of the book for free.

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

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

Book Review: Quantitative Value

Posted on 15 June 2013 by David Merkel

This is a book that gets everything right in broad, but is too insistent on the details.? How should you approach value investing from a purely quantitative standpoint?? Easy:

Screen out stocks that have relatively high accruals
Avoid companies that may go bankrupt
Margin of safety: choose companies with strong balance sheets and profits
Look for long-term strength in profits.
Buy them cheap.
Buy when informed investors are buying.

But here’s the problem.? Like the book What Works on Wall Street, Quantitative Value suffers from over-optimization.? You pass through the data too many times, and you show great returns from the past, should someone have done it that way.? But how much of the result is signal, and how much is an accident?

The broad principles are unavoidably true.? Even the measure of quality, Gross Profits as a fraction of Assets, was new to me, but when I read it, I realized that it was a proxy for having a moat, a sustainable competitive advantage.? I added it to my screening framework.

With all of that said, I have simple advice to the readers.? Follow the broad outlines of what the book teaches, but don’t follow it in detail.? It is good to own companies that are sound, cheap, and improving.

I would also add this: use quantitative screening and scoring as a first step.? I often note that companies that score well in my screens have accounting issues.? So, be wary, and realize that value investing primarily means having a margin of safety. I.e., you won’t lose much if you are wrong.? Purely quantitative value investing can be improved through company and industry knowledge.

Quibbles

Already expressed.

Who would benefit from this book: Amateur value investors will benefit from this book; if the reader does not want to put the effort into learning value investing, this book will be of no use to him.? If you want to, you can buy it here: Quantitative Value, + Web Site: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors.

Full disclosure: The publisher sent me a copy of the book for free.

Book Review: Value Investing: From Graham to Buffett and Beyond

Posted on 14 June 2013 by David Merkel

Several months ago, I was walking in my bedroom, and in a stack of books that we frequently give as gifts, I saw the book Value Investing: From Graham to Buffett and Beyond.? I said to myself, where did this come from?? I looked at it, and realized that hadn’t read it.? I looked at the copyright date, and realized that 2001 is a relatively old book.

So I read the first chapter, decided it was good stuff, and added it to the reading pile.? As some might know, I am a value investor, and recently I wrote an article called ?Value Investing Flavors.?? In it, I took a broad view of value investing, because there are many common principles to value investing employed by all, but many variations on implementation. [Note to those reading at Amazon; they don?t me post links, but if you Google ?Aleph From Graham to Buffett and Beyond? you will find it.]

The book begins with unified principles of value investing: margin of safety, buy ing an asset cheap, etc., but moves on to different ways to implement value investing, depending on the types of companiesthe investor wants to analyze.

There are three ways to do the analysis for value investing:

Re-estimate the fair value of the assets and liabilities on the balance sheet.? This applies best to companies where converting resources to a better use would be compelling.
Estimate the normalized earnings power of a slow growing company.
For a company with a moat, a sustainable competitive advantage, conservatively estimate the path of growing earnings.

I listed the three of them in the order of increasing aggressiveness of analysis, and the amount of work that would need to be done to be assured that there is an opportunity.

After this, the book writes about eight notable value investors, who come from the various camps inside value investing, and puts more flesh on the bones as to the implementation of each method.? I immediately recognized the names of 6 of the 8 value investors.

But what I found most useful were the insights of the investors that would buy small companies.? You can buy ugly situations that are misunderstood, and wait for management to turn the ship around.

This book was a good balance between theory and practice.? I enjoyed this book.? I think most amateurs wanting to learn about value investing would benefit from it.

Quibbles

None.

Who would benefit from this book: Amateur value investors will benefit from this book; if the reader does not want to put the effort into learning value investing, this book will be of no use to him.? If you want to, you can buy it here: Value Investing: From Graham to Buffett and Beyond (Wiley Finance).

Full disclosure: I have no idea where I got this book.

Book Review: The Art of Value Investing

Posted on 6 June 2013 by David Merkel

Note to readers: I plan on doing a series of book reviews over the next few weeks.? I may do more than a dozen.? I hope you enjoy them.

I am a value investor.? That’s what I do for a living, and I do it well.? One month ago. I wrote a piece called “Value Investing Flavors.”? In it, I took a broad view of value investing, because there are many common principles to value investing employed by all, but many variations on implementation. [Note to those reading at Amazon; they don’t me post links, but if you Google “Aleph Art of Value Investing” you will find it.

The Art of Value Investing takes a similarly broad view, quoting well over 100 value investors (I lost count) on topics where professional value investors agree & disagree.? The authors have interviewed the grand majority of those cited, and have useful historical quotes from well-known figures familiar with the subject.? Better known and more accomplished value investors tend to get more play in the book — I think the authors chose well.

The book is organized by topic.? It covers these questions:

The importance of a margin of safety
Buy high margin quality businesses, or cheap low margin businesses?
What attention should be paid to growth opportunities? (Controversial)
What is your circle of competence? (I.e. what opportunities do you rule out because you don’t get how to value them?)
How small of a company would you consider buying?
How much do you incorporate top-down macroeconomic considerations?
What countries would you not consider buying a company within?
The advantage of being able to buy and hold for years.
How careful research often conquers uncertainty.
Do you buy turnarounds or not? (Controversial)
How do you generate good buy ideas?
How do you create a firm that ignores the conventional perspective, and generates correct ideas that few know?
How do you analyze what could go wrong with a company?
Do you look for catalysts to unlock value or not? (Controversial)
Do you analyze value through one framework or many?? Cheap going concern or transformation of underused assets? Both?
Do you manage for absolute value or relative value?? I.e., what is the value of safe assets, or even gold?
When do you establish an position?? How do you size it?
How diversified do you want to be?? How do you weight positions?
How much do you care about stocks being correlated within the portfolio?
How long are you willing to wait to see if an idea works?? When do you admit that you are wrong?
Are you willing to advise management?? Are you willing to fight management?? When does it make sense?
Do you short bad stocks or not?
When do you sell?? Do you do it never, gradually or rapidly?
How do you maintain a sound mind and humility amid all of the clamor of the markets?
How do you admit mistakes, so as to avoid them in the future, and show humility to your clients?

If you want to understand the nuances of how a firm doing value investing works, I can’t think of a better book, because this book implicitly goes over all of the choices that a value investor has to make.? What factors will I focus on, and what will I ignore?? How detailed will my analysis be?? How much will I diversify?? How will I make choices among so many stocks vying for my attention amid all of the news noise?

I have strong views on value investing myself, but I questioned my own ideas as I read the replies of those more successful than me.

Quibbles

Initially, as I read the book, I wondered if a better book could be made by organizing by each firm, rather than topic.? By the end of the book, I realized I was wrong.? Not all firms have opinions on many questions, and doing the book by topic highlights the variation in opinions across a wide spectrum of organizations.

Who would benefit from this book: Amateur and professional value investors will benefit from this book; if the reader does not want to put the effort into learning value investing, this book will be of no use to him.? If you want to, you can buy it here: The Art of Value Investing: How the World’s Best Investors Beat the Market.

Full disclosure: I received a free copy from the publisher.? I personally know a few of the value investors cited.? I would like to meet more of them.

Advice for Aspiring Advisor

Posted on 2 June 20133 June 2013 by David Merkel

From an email from a reader:

Dear David

My name is YYY, an I am from Ecuador. I am the owner of ZZZ. ZZZ is a business that is focus on wholesaling construction machinery to the whole country. Before my business, I study and graduated from University of St. Thomas in Houston with? a BA in Business administration and Finance. After graduating, I became a an admirer of value investing.

While doing some research of the the book “The Aggressive Contratian Investor” I run into your blog. Currently, I want to invest while I ran my business. I have read The Intelligent Investor, The snowball, The Essays of Warren Buffet, Financial Statement Analysis by Ben Graham and by Warren Buffet, Phil Fisher, Poor Chalie’s Almanack, etc. I just started reading Security Analysis 6th edition. However, with all this knowledge, I still feel that I dont know

“How to valuate a company”

I dont know if I should take MFA course in Austin University, or read a book, what to do whatsoever. Do you have any advice? What do I need to learn or research to be able to valuate business/analyze a security?

Sincerely,

YYY

Dear friend, I have several answers for you.

1) You can learn how to value companies the way I did: start as an amateur, and compare and contrast companies.? Build up knowledge over time.? Pick an industry and get the data from a lot of companies.? I remember when I did Trucking in 1994.? That was fun for my kids to see all the trucks in the annual reports.? I eventually bought one firm, MTL, and it doubled in a year, and got taken private.? What was interesting was that company had a reputation for safety, quality, and doing things right.

2) You can read books by Aswath Damodaran.? His books are overkill, in my opinion, but he gives the right theory, just with too many bells and whistles.? Most good valuation work is simple.? Focus on the big issues.

3) Rather than estimate the value of a company, look at the earnings yield of the company versus alternatives.? Buy companies that offer good returns off of current market prices.

4) Compare the company and it peers on current valuations and past valuations versus earnings, EBITDA, free cash flow, etc.

5) Look at a history of prior M&A activity for public and private companies within that industry.

There are many ways to learn how to value companies, but I would encourage you to learn by doing.? Have at it, and prosper.

How Competition Drives Pricing, Yield and Risk Cycles

Posted on 1 June 2013 by David Merkel

The usually good Felix Salmon wrote a piece that I disagreed with called: Don?t worry about cov-lite loans.? This is what I wrote as a response:

Ask a loanholder, ?All other things equal, would you rather have a cov-lite loan or a normal one?? The answer will always be ?Normal, of course. Why are you asking such a dumb question??

Loanholders would prefer more defaults with lesser severity than fewer with higher severity. What is flexibility to the borrower is a higher degree of expected credit costs to the lenders.

To make this general, I have to explain to you the four phases of competition in uncertain outcomes. I know I?ve written about this before, but I can?t remember where. It applies to a wide number of phenomena, including insurance underwriting and fixed income investing.

Phase 1: the market is offering a bargain in yields relative to normal default costs, and terms & conditions are firm. More competition causes prices to rise & yields to fall.

Phase 2: the market is fully priced in yields relative to normal default costs, and terms & conditions [covenants] are firm. More competition causes terms & conditions to erode. Conservative firms end new purchases. Assets with good terms get premium pricing.

Phase 3: the market is fully priced in yields relative to normal default costs, and terms & conditions [covenants] are soggy. More competition causes some to speculate that ?maybe things won?t be so bad, besides, we have money to put to work.? Conservative firms sell existing positions.

Phase 4: Market crashes, defaults are realized. Lower quality assets lose more money. Conservative firms buy assets at a discount from posers who thought they knew what they were doing, some of which are now broke.

So, no Felix, the presence of cov-lite loans indicates that we are in phase 2 at minimum. I think we are in phase 3. I have sold my loan funds for clients last year ? we are on borrowed time now.

The same sort of thing happens with insurance underwriting, and I even think bull markets in stocks.? After a disaster, insurance surplus levels are low, and pricing is generous, with terms & conditions tight.? Additional competition lowers profitability to levels that justify the cost of capital employed.? After that, pricing stays at that level, and terms and conditions deteriorate, until they can decline no more. After that, pricing deteriorates further until the next disaster uncovers their folly.? Conservative insurers drop out before the disaster, and return capital to shareholders rather than writing bad business.

With bull markets in stocks the first phase is disbelief, the next phase is belief.? During that phase, parties lessen risk controls and buy what is hot.? In the last phase, valuation plays little role for the marginal decision-makers, until the bull market peaks.

Maybe I am overgeneralizing here, but to me there seems to be an inflection point in bull markets where in order for equity managers to compete, they toss away risk discipline.? After that, managers stretch their willingness on valuations.

In closing, two articles that relate to this:

Both of these articles make me think we are in the last phase of a bull market.? Valuation is getting ignored.? Be wary, and play some defense, but avoid the idea that traditional defensive stock types will be defensive, particularly with low volatility and dividend paying stocks.