Portfolio Management – Page 71

Individual Investing Can Be Tough

Posted on 16 February 2012 by David Merkel

I am glad I began investing 20+ years ago.? If I were considering starting now, I would likely not do it.? Why?

1) Too much data.? There are too many factors to consider in investing. That there is a wealth of data to consider is certain, but what are the right factors to look at?

2) Crowded.? More people and firms are investing.? The competition is higher.

3) There are more games in trading.? Makes it a lot harder to get good executions.? The low costs of transaction have created monsters.

4) ETFs affect the market as a whole.? They allow average people to speculate on broad trends, without telling most of them that they are noise traders, and are getting taken for a ride.? Dollar-weighted returns are far less than that for buy-and-holders in ETFs.? The traders are getting creamed.

5) Social media leads to groupthink, which lowers overall returns, at least for those that get there late.

6) ETFs allow investors to play well outside their circle of competence.? Beyond that, some ETFs don’t always do what they promise because of the derivatives that they use, roll, etc.

7) We are in a macroeconomic environment where we are delevering.? That is not the best environment for making money.

In general, I think most individual investors are cows for the institutions to milk.? But there are a few ways to immunize? yourself from this:

a) Hold very short or very long.? I lean toward the latter.? Don’t give up quickly on your investment ideas.? Buy and hold for years, not months.? Ignore the chatter, and read the data from the company and trusted third parties.

b) Use a value bias, and focus on companies where there is a margin of safety.? Buy the shares of companies with lesser growth prospects, that are selling cheaply.? Who cares if earnings aren’t growing if the earnings yield is over 15%.

Expensive High Yield

Posted on 11 February 201212 February 2012 by David Merkel

I’ve seen a number of articles recently arguing that high yield bonds are still cheap. Today I began an investigation to analyze this claim.

Here’s my bias: at the first investment shop I worked in, the high yield manager told me that there is a nominal yield for high yield bonds which reflects the risk.? It doesn’t matter where Treasury yields are, high yield bonds don’t care.? As a result, when people in the media, or writing blogs those argue that high yield is cheap because yield spreads are wide, it is time to disregard then when Treasury yields are artificially low, because of government interference.? (Financial Repression)

High yield bonds do care about credit conditions.? High yield bonds do care about the stock market.? From all of my research, high yield bonds are highly sensitive to credit conditions, particularly those of its industry.? They are also sensitive to the stock market.? After all, if the high yield bonds are doing badly, the stock is doing worse.

And here’s the rub: high yield bonds do not react to yields on Treasuries, except negatively, because when Treasuries rally hard, times are not good, and high yield bonds do poorly, with yields rising.

Here’s a graph to show how yields have done over the last 15 years for various corporate bond ratings.

My data this evening comes from the Federal Reserve Bank of St. Louis’ website FRED.? Been using it for 20 years, it is one of the best economic data repositories on the web.? Even used it during the bulletin board era, pre-web.

Merill Lynch has recently provided many of its bond yield indexes to FRED.? Previously, all that was there were two long yield series from Moody’s.

Now, if the concept of yield spreads is valid, when I do regressions of treasury yields on corporate index yields, I should see tight correlations of the yields versus Treasuries, and beta coefficients near one.? Here’s what I obtained:

AAA-CCC refer to ratings categories.? HYM is High Yield Master II, which is an average of high yield bond yields, and is usually very close to single-B yields, no surprise.

As you will note, spreads work reasonably to poorly for investment grade bonds.? The yields on investment grade bonds do not fall as much as yields on Treasury bonds do.? The yields on high yield bonds are barely affected when Treasury yields fall.? Look at the R-squareds on the regressions versus Treasuries only, high yield bonds do not have any economically significant relation ship to Treasuries alone.

Thus, it doesn’t make sense to talk about high yield bonds in terms of spreads over Treasuries.? High yield bonds react more to lending conditions, and derivatively, how well the stock market is doing.

But if we introduce credit spreads into the analysis, everything changes, and R-squareds skyrocket.

To me, BBB bonds are the touchstone for credit conditions.? Why?? They are on the edge of investment-grade creditworthiness.? They are also a large part of the corporate bond market.? When their yields rise or fall, it is a sign that financing rates for corporations are changing.

So, when I did regressions including BBB yields in addition to 5-year Treasury yields, guess what?

Junk yields were highly geared to BBB yields.
When Treasury yields fall, junk yields rise, and vice-versa.
These relationships are in general more statistically significant than those of high investment grade corporates versus Treasuries.

So what does this prove?

Yield spreads over Treasuries are not a good way to define value in bonds, and particularly not junk bonds.
Better to analyze high yield bonds versus BBB bond yields, and consider Treasury yields as a negative factor when rates are low.

So, is high yield cheap or dear at present?

Whether I look at the Merrill High Yield Master 2, BBs, or Bs, junk bonds look expensive.? CCCs look a little cheap.? The yields on the High Yield Master 2 look about 0.8% expensive in terms of yield (that’s the residual in the above graph).? I will be lightening credit bond/loan positions in the near term.? Of course this is just my opinion, so do your own due diligence.

And, please realize that movements in the stock market may swamp my observations.? If the stock market runs, high yield can run further… but there will be an eventual snap-back.?? The bond market is bigger than the stock market, eventually the stock market reacts to bond market realities.

On Multiple Asset Allocation Methods

Posted on 10 February 201210 February 2012 by David Merkel

From a reader who is a dear friend of mine:

There are obvious many disparate approaches to asset allocation.? Similar to the disparate approaches of any style of investing, each asset allocation approach has its own particular pitfalls.? Some of these you can plan for and perhaps hedge against or at least mitigate the potential negative impact from those pitfalls, while some booby traps spring up out of nowhere.? Risk Parity issues revolve around leverage, negative skew, and potential negative returns from certain levered asset classes.? Long-term strategic asset allocation may suffer from the quality of initial assumptions and typically relies on stable volatility profiles and correlations between asset classes.? And so on.? Every professional investor ? let?s take an endowment for instance ? diversified its portfolio among several asset classes and styles of management.? But what is interesting to me is that I?m not sure I?ve ever seen an institutional (or even HNW) investor diversify its portfolio among multiple asset allocation approaches.? Theoretically, splitting up a portfolio between 3-5 different AA approaches (strategic, risk-based, tactical with an opportunistic value lens, tactical with a momentum/trend-riding lens, etc.) mitigates the pitfalls of each one.? What are your thoughts here? ?I have a few of my own, but I don?t want to muddy your own intellectual waters ahead of time.? 🙂

My personal approach to asset allocation is similar to Warren Buffett, or Value Line.? I invest mostly in stocks, and keep a bunch of safe assets for liquidity.? As the market rises, I add to my safe assets.? As the market falls, I buy stocks.? In October of 2002, things were so bad that I depleted my safe assets, an everything was in stocks.

In general, I think most complex asset allocation strategies are overly complex.? In general, there are safe and risky assets.? Asset allocation should first focus on the division between the two.? Typically the safe assets are high quality bonds and cash equivalents.? Sometimes there are more opportunities, sometimes fewer.? Safe asset levels should reflect that.

The second focus of asset allocation should be liquidity needs.? Even if there are a lot of promising opportunities to deploy cash, if the liability that funds the assets needs cash, have cash ready for it.? If you invest in limited partnerships or private companies where the assets are locked up for a period of time, have a sense of what your maximum level of illiquidity is (what will you with certainty never need to tap?), and ladder the investments so that like a laddered bond portfolio, you always have some illiquid investments maturing each year, providing fresh cash for deployment where current opportunities are most promising.? These top two ideas are very basic, but even experts neglect them at times.

The third focus of asset allocation is choice of risk assets, which is how I view your question.? There my view of asset allocation is like that of GMO.? Forecast future returns off of free cash flow yields; invest accordingly.

Don’t pay much attention to volatility, but aim for what is most likely, and bend a little in the direction of what can go wrong.? Most of the time, over longer periods of time, what is most likely happens on average; that’s why it is most likely.

Maybe “Too many cooks spoil the broth.”? I have enough trouble trying to work with momentum versus mean reversion.? I would lean toward having one AA strategy that fits with my broader asset management practices.? But on the other hand…

Suppose we did have five asset allocation models, and what their results were encouraging various investors to do.? If we thought that one of the models had been too hot of late, and was attracting too much money, and distorting ordinary market relationships, maybe that could give us a signal to make sure our asset allocation de-emphasized the results of that method.? Timing of course would be difficult, it always is, but seeing the results of the five methods could provide a fuller view of choices faced by our competitors.

I’m not sure that using the average of a number of asset allocation models will provide the best result, but I think that understanding what other players in the market are doing could lead to better decisions.

I’m open to your thoughts, and the thoughts of other readers here.? Anyone have a better idea?

Against Risk Parity, Redux

Posted on 7 February 2012 by David Merkel

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.? For additional support consider my article Risks, Not Risk.? Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.? There are many risks.? Interest rate risk and credit risk are different topics.?? There are bonds that have interest rate risk but not credit risk — long Treasuries.? There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.? For fixed income, I described those in the two articles linked in the last paragraph.? During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.? But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.? The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.? The second moves in line with 5-year Treasury yields, and short senior bank spreads.? The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.? But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.? History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That?s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

?It?s called risk parity,? Gundlach says. ?There?s only two investors who seem to understand it?me and Ray Dalio,? the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.? I’ve run the regression of Treasuries vs junk bond index yields many times.? It’s barely significant for BBs, and insignificant thereafter.? Second, look at stock market indexes of industries that lever up and issue junk debt.? Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.? With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.? Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.? Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.? Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.? Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.? Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.? You can’t be certain that you will be able to ride through the storm.? The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.? But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.? If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.? I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.?? First in the hands of the master, last in the hands of a sorcerer’s apprentice.? Be careful.

PS — I have respect for the skills of Gundlach and Dalio.? I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.? And, here is a nice little piece about Bridgewater and its strategies.

Sorted Recent Tweets

Posted on 6 February 2012 by David Merkel

Trying a new format here, I think readers will like it better.? Most things are better after additional effort.? Think of this as a news links by subject post.

Economics

If you look in the back, it seems that there were 58 respondents. From page 13: Methodology & Panel Selection Invi? http://t.co/p8sVZl9g Feb 06, 2012
Will the great interest rate gamble pay off? http://t.co/hgj5XSKc People want to believe that you can get something for nothing; ain’t true. Feb 05, 2012
Central Planning at the Federal Reserve http://t.co/X8qmqU6C Fed: we can create prosperity by holding interest rates down, right? $$ #wishes Feb 05, 2012
Labor Force Participation Rate: 28-year Low http://t.co/kLgQ61iK Everyone still happy about the lower unemployment rate? $$ Feb 05, 2012
Bill Gross: Free Money Ain?t Really Free http://t.co/LXWxpxp5 It will lead to stagflation, IMO, depending on what fiscal policy does $$ Feb 05, 2012
Life & Death Proposition http://t.co/XuZS5Snn Where does credit go when it dies? Back where it came. It delevers, slows & inhibits ec growth Feb 02, 2012
US unemployment ?progress? http://t.co/WoIVZPGp If you add back the discoraged workers, all of the improvement in U-3 goes away $$ Feb 02, 2012
The Perniciousness of ZIRP http://t.co/dYlFMbLe Gonzalo Lira on how ZIRP loses effectiveness b/c people think it’ll b there a long time $$ Feb 01, 2012
Why Neoclassical Economics Doesn’t Work In The Age Of Deleveraging http://t.co/D3IAhTyv Steve Keen explains y Krugman & others r wrong $$ Feb 01, 2012
Warning: Goat Rodeo http://t.co/JQ2FV9LS Hussman makes his case that equities are overvalued and could pull back 25% $$ Feb 01, 2012
Who Owns World’s Financial Assets? & Why R US Households So Fascinated W/Stocks? http://t.co/5rp52OM4 American Exceptionalism in investing Feb 01, 2012
As an aside, that is one reason why the US net foreign debt hasn’t spiraled up. We own equities abroad & they own our debt. $$ declines + Feb 01, 2012
$$ declines reduce the value of our debts, but not the value of r foreign holdings. I think the US will come out of this crisis rel well $$ Feb 01, 2012

Housing

Home Prices Tumble http://t.co/N1gdNslr No surprise here with all of the dark supply; houses come onto mkt when ppl can bear loss $$ Feb 01, 2012
Too lazy to be knowns http://t.co/flXRR6fM I know many who understood what would happen if home RE prices fell, but none who got the size $$ Feb 01, 2012
Freddie Mac’s “inverse floater” allowed more loan origination http://t.co/5devKZ17 Other side to the Propublica story http://t.co/KjXJHU1x Feb 01, 2012
I’m no fan of the GSEs; I think they should be abolished, but the GSEs have always made a variety of bets on prepayment over time. $$ Feb 01, 2012

International

On China, Henry Kissinger and Fareed Zakaria see Domestic Tension and Risk of Geopolitical Conflict http://t.co/1bhvrI3U Ferguson is wrong. Feb 05, 2012
Tightening lending standards vary materially across the Eurozone http://t.co/ciWUK9cm Conditions tight in Italy & France, but not Germany $$ Feb 02, 2012
Japan Auto Sales Notch Record Jump http://t.co/0VzF4WST Another small bright spot. Of course, bouncing back from a low level $$ Feb 02, 2012
Socialist Hollande, Who Wants Full European Treaty Renegotiation, Increases Lead Over Sarkozy http://t.co/J3qCpZZ3 Eurozone Wild Card $$ Feb 01, 2012
Hong Kong Homes Face 25% Drop as Loans Fall in Year of Dragon http://t.co/ifg1146H And this is with wealthy mainlanders fleeing China. $$ Feb 01, 2012

Markets

RBC Takes On High Frequency Predators http://t.co/MfA5qdxm Where there is offense, there will b defense; nothing goes unanswered in the mkts Feb 05, 2012
Global Strategists Abandoning Bearish Views http://t.co/dOXCUMA7 Makes me think we r getting close to a turning point. Feb 02, 2012
Dividend stocks: Buyer beware http://t.co/SvMCHtCj Makes the valid & missed point: high qual div paying stocks r stocks & can lose $$ #yeah Feb 01, 2012

Credit

6 High-Yield Canaries-in-the-Coalmine http://t.co/4pz6SSQc 6 reasons y high yield is overheated http://t.co/fKnHmBqD & http://t.co/UPVev0iD Feb 02, 2012
QOTD: Regulators Watching Aggressive Yield Chasing http://t.co/iWimo3eg FINRA warns of undue risk in income seeking. Advisors take note $$ Feb 02, 2012
Contra: The Safest 7% Yield in America http://t.co/VrXoLEFH Poor analysis does not take into account the highish leverage on mtge repo $$ Feb 02, 2012
Shipping Loans Go Bad for European Banks http://t.co/y5Z0wt3R Highly glutted area w/many dead firms walking; how far down will the losses go Feb 02, 2012

Politics

Group lists top stock investments by members of Congress http://t.co/CarxUCjS Top 50 hldgs -> in top 100 cos by mkt cap. Hard2manipulate $$ Feb 05, 2012
Obama Re-Election Odds Versus the Stock Market http://t.co/F5EETcve Example of 2 variables that r correlated b/c they anticipate GDP changes Feb 05, 2012
RE: @abnormalreturns Gold is mostly political philosophy. How much control do you want the government to have over mo? http://t.co/hRxIkaoo Feb 03, 2012
Getting back to the gold standard http://t.co/pCk8Ij6j Gingrich & Ron Paul have said they would like to appoint James Grant as Fed Chairman Feb 02, 2012

Companies

Carlyle’s proposed IPO disaster http://t.co/OqGke8eN So there’s no board. Most boards don’t do much. Mgmt will have no board 2 shield them Feb 05, 2012
For These Fans, a Day With Buffett Offers Wealth of Photo Opportunities http://t.co/UpcwVKe7 I think Buffett is enjoying life more now. Feb 05, 2012
Buffett Railroad Boosts Capital Plan to $3.9B http://t.co/9XEw2gyT Buffett changes; organic investment in capital-intensive biz $$ #olddog Feb 01, 2012
Pep Boys Seen Gaining 27% as Cheapest Value Lures Bids http://t.co/GyfH7qRL Could a bidding war start? Company is undermanaged $$ Feb 01, 2012
Jefferies Allows Bonus Recipients to Swap Stock 4 Cash With 25% Discount http://t.co/pfGB3Vmc Fair way2 let employees disconnect from $JEF Feb 01, 2012

Financial Services

I’ve just started “Acts of God and Man,” by Michael Powers. In the intro, he goes through the various meanings of th? http://t.co/tX7uAlWl Feb 05, 2012
When evaluating Investment Funds, use Dollar-weighted Returns http://t.co/N5g7PI0d This is a neglcted concept that is enjoying a rebirth $$ Feb 02, 2012
After a Delay, MF Global?s Missing Money Is Traced http://t.co/4s6U8yOe Investigation moves to how to recover the $$ and who is at fault. Feb 01, 2012
http://t.co/wBbJTe3D FINRA Alert: Do you use complex products? What additional work do you do 2 assure that they are being used properly? $$ Feb 01, 2012
Banks Need Higher Interest Rates to Start Making Money http://t.co/SneRACCi Flat front end of yield curve squishes bank interest margins $$ Feb 01, 2012
401(k) Plans Step Into the Sunshine http://t.co/fvKeup2L But as with DB plans, as costs rise, companies will offer them less. $$ Jan 31, 2012

Value Investing

The SEC’s “90% Convergence” Fantasy http://t.co/bkWaAS5S US GAAP has many flaws, but we know them. IFRS will introduce abusable flexibility Feb 02, 2012
But on the bright side, value investors may do relatively better as financials become less trustworthy; the accruals anomaly will sing $$ Feb 02, 2012
Need to consider (Cost of goods sold)/user $$ RT @ErikSchatzker: Facebook gets $4.39/yr of revenue per user. ESPN gets $4.69/mo. Feb 02, 2012
Berkowitz: Fund Plunge ?Makes Little Sense? http://t.co/pcoPLahW BB, appoint someone in your group 2 seek out opinions contrary 2 yours $$ Feb 01, 2012
@ADayforRabbit I have argued in the past that BB is not paying attention to the delevering, which is a real headwind for the banks. $$ Feb 02, 2012
New Fund Hopes to Prove Outspoken Analyst?s Thesis http://t.co/cuVpRzvO I bet @rcwhalen does well like my friends @ Hovde or M3 Partners $$ Feb 01, 2012

Hedge Funds

Are Hedge Funds Worthwhile Investments? http://t.co/Lw2EhRPr Yet another “Hedge Fund Mirage” citation; the book is having a lot of influence Feb 02, 2012
Are the hedge fund and private equity boys pulling a fast one? http://t.co/TNXFJo62 Beginning 2c the args of “Hedge Fund Mirage” everywhere Feb 02, 2012
Did Hedge Funds Trigger the Financial Crisis? http://t.co/lNIb2dgF Secured asset classes can be overlevered; when they collapse, big mess $$ Feb 01, 2012

Miscellaneous

Do the Job You’re Meant to Do http://t.co/wR3OX20N LIfe is too short to work with people you don’t respect, or tasks unfit for you $$ Feb 02, 2012
Millionaire adopts girlfriend as daughter http://t.co/zffGCWbu Asset shelter. Does incest rely on consanguinity or on legal relationship? Feb 02, 2012
Charles Murray Reiterates Willpower http://t.co/smeXZKNh Lack of self-control can destroy relationships, jobs, firms & lives $$ Feb 02, 2012
I ran into @twitalyzer today. Lots of interesting analytics for tweeting. Here are some for me: http://t.co/HDdcFYaU & http://t.co/8uFFOMuP Feb 01, 2012
At the first blogger summit at the UST, I recommended to the powers that be that they issue floaters. I also recommen? http://t.co/R3U8OHSi Feb 01, 2012
California Faces Cash Shortfall by March on Low Receipts, Controller Says http://t.co/QxH1a6Re Could be interesting given the elections $$ Feb 01, 2012

Against Risk Parity

Posted on 4 February 20125 February 2012 by David Merkel

Many investment ideas are promising so long as few do them.? Yes, there is an opportunity, but it is limited.? “Shh, don’t tell everyone about it.”

Thus, the concept of “risk parity.”? Lever every asset class up until it has the same volatility as common stocks. Under theoretical conditions, one could make extra money doing this, and with less risk than just a common stock portfolio.

That makes sense when few are doing it, but not when many are doing it.? When I worked for Hovde Capital Advisors, I highlighted to the group how hedge funds were forcing every asset class to the same level of riskiness.? A Grants Interest Rate Observer article on Leveraged Non-prime Commercial Paper is etched on my mind as emblematic of that era.

Risk parity can work so long as the total riskiness of the system does not get too high, as it did in 2007-8.? But if it does get too high, the assets that are levered face disadvantages versus volatile unlevered assets.? Failures of leverage feed on themselves, and lead to a real washout.? Failures of growth stocks don’t do that to the economy.

Risk parity turns managers into bankers, or worse yet, asset managers that specialize in non-AAA investment grade portions of structured securities deals.? Most asset managers are not used to thinking like bankers, largely because they think in terms of total return, and because they don’t have a balance sheet.? Their capital can run at will, unlike banks that have deposit stickiness, savings accounts, CDs, ability to borrow from the FHLBs, etc.? The banks can hold the assets to maturity, they have a buffer against losses in their capital, and don’t have to mark to market in an assiduous manner (though they *should* have to do so).

Think of the mortgage REITs in the most recent crisis — the ones that did the best were the least levered and had the longest terms for their repo lines.? In the short run, that costs more than the vain idea that one can roll over their repo lines every night, and that repo haircuts won’t rise.? Crises lead to a failure of both ideas, together with a set of forced sellers driving down the price of assets being repo-ed, which sometimes leads to a cascade where repo terms get progressively tighter, and only those that were the most conservative at the start of the crisis survive.

There is a Wall Street aphorism, “The fool does at the end of a bull market what the wise man does at its beginning.”? Risk parity falls into that bucket.? Early adopters of new asset classes and liability structures typically do well, but when they become mainstream, the dynamics can be ugly, as we learned in 2007-present.

So ignore the idea of risk parity.? Risk managers are not bankers, they don’t have the capacity to play leveraged spread games to maturity.? Risk parity if practiced on a large scale will produce wipeouts akin to the recent crisis.

Industry Ranks February 2012

Posted on 4 February 2012 by David Merkel

I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and Reinsurance, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle ? I am not interested there even at present levels.? The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their ?regulators.?

I?m looking for undervalued and stable industries.? I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is pretty cyclical at present.? I will be very happy hanging out in dull stocks for a while.

P&C Insurers and Reinsurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.? Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.? Would I increase the overweight here?? Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.? Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.? One more note, I am still not tempted by banks or real estate related stocks.? I am beginning to wonder when the right time to buy them as a sector is.? As for that, I am open to advice.

Implications

So, given that the Industry Rank categories above come from Value Line, I went to their stock screener, selected the industries, and asked for all of the companies that:

are in their top 5 (of 9) categories for balance sheet strength, and
their horribly overworked analysts think can return at least 15%/yr over the next 3-5 years.

This combines safety, growth potential, valuation, and in my view, how promising industry prospects are.? Here are the results:

ABC ADM ADTN AKAM ALL AMAT AMX AOL APOL ARB ARRS BIDU BRKR BX CAH CBEY CECO CELL CKP CL CNQ CPB CPSI CREE CTRP DNR DRIV DV EBAY EDU EFX ERIC ESI FST GMCR GOOG HCC HRC IN INFA INTC ISIL ITRI IVC JNPR K KKR KR LIFE LRCX LTRE MASI MCHP MDCI MKC NFLX NIHD NILE NOK NTRI NVDA NXY ONNN OTEX QGEN QLGC QSII RAX RIMM RMD SHEN SOHU STM STRA SWKS SWY SYY T THG TMO TNDM TRH TRI TSM TSRA TUP TXN UNTD UPL UTHR VOD VOLC VZ WBMD WBSN YHOO ZBRA

When I do my next portfolio reshaping for clients in the next week or so, these stocks (and a few others) will compete against the 35 existing portfolio names for the 34-36 slots in the portfolio.

Full disclosure: Long HCC, INTC, THG, VOD

On Corporate Cash

Posted on 31 January 2012 by David Merkel

In human terms, we are most often best off with the via media, that is, the middle way.? So it is with corporate cash.??? The first article I wrote on the internet (in 2003) argued for the value of excess cash in the hands of intelligent management teams.

But there is a limit to that, and more so when many companies build up large slack cash balances.? Think of the converse: only one really intelligent company has a lot of slack cash.? That company starts buying up other companies like a clever private equity buyer, but taking account of synergies with existing companies in the process.

Such a buyer would understand the value of each company purchased, and how much fat could be cut out, synergies realized, etc.? But even as that one company acted, valuations would rise with each purchase, until the “intelligent company” stopped buying, because it was no longer reasonable to buy at the higher valuations.

If this is true with one clever buyer, it is true with many not-so-clever-buyers, but it takes longer, and there will be errors, failures even, and more.

It is hard to deploy cash effectively as a corporation, aside from the simple routes of dividends and buybacks.?? But companies that are good at doing small acquisitions that improve organic prospects can do far better than companies that blindly acquire for reasons of scale.

The company with a lot of cash will look for a scale acquisition, and will overpay, or, will overpay for an acquisition in an unrelated industry, creating a conglomerate that is hard to manage.

It would be far better to pay it out as a dividend, or buy stock back.? The shareholders as a group have a better idea of what is valuable in the public markets than the management team does, particularly aas public valuations get high.

Thus, I agree with Michael Santoli of Barron’s in his recent article.? The additional cash in the hands of many growth companies is depressing valuation measures, and should be paid out as dividends, or with an eye to the price, buy back stock.

And, I disagree with the fellow who wrote this article, that large corporate cash hoards are a reason to buy equities.? That might make sense if one knew what companies would get bought? out, but no one knows that.? In general, it is hard to pick acquisition targets profitably.? If major corporations can’t do it, odds are you can’t do it either.

For one more point on corporate cash generally, don’t pay much attention to it, because corporate cash often serves as collateral for futures positions, and other derivatives.? Cash on the balance sheet is often encumbered.? Maybe accounting standards should be modified to reflect that, because knowing the true liquidity of a company is valuable.

On Junk Bonds

Posted on 27 January 2012 by David Merkel

If someone were to ask me my opinion on Junk Bonds at present, fool that he would be to ask me because I know real experts elsewhere, I would say this: They are good for a speculative trade, but dumb money has arrived.? Be ready to sell when the momentum fails.

High yield ETFs sell at decent premiums which leads to the creation of more units.? High yield closed-end funds — 73% trade at a premium.? You could issue a new high yield CEF, and come out at a lower premium than the current average.? I think I smell smoke.

Hmm….? If I owned junk bonds I would hold, and wait for momentum failure.? Buying now seems risky to me.? Most of the risk stems from global conditions.? We don’t know what will happen in the Eurozone. The rest of the risk stems from speculation.

I am a fan of junk bonds when nobody likes them, but there are too many fans now, and for bad reasons, most of which boil down to “I am old and I need income.? The fed has eliminated good choices for income, but I need income anyway, so get me yield.”

I had a conversation with a friend of mine in her upper 70s today where she asked “why are you suggesting I sell my funds that provide the most income?”? I said that I did not trust junk bonds at present and would look to lighten up, besides, the fund she owned has underperformed over the last 10 years.? If she really wanted income from junk bonds, I would look for a new fund for her.? So I am looking for a new HY fund, with an arm twisted behind my back.? It’s not the right idea, but she won’t listen.? (She’s not paying me.? I help my friends as best I can.)

The illusion of yield drives many older investors; they need income, and the delusional Fed thinks that low yields will yield prosperity.? It may make some people take more risk, but it will not yield prosperity.? There will be a lot of impoverished old people at the end of this, and they will be angry — at themselves, their advisors,? and the powers that be.

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This is not to say say that junk spreads are low; they are moderate to high at present.? But the spread relationship is manipulated by the Fed at present, making spreads seem high.? No market is truly free, but the Treasury market is affected by the Fed to a high degree.? The high quality bond market follows Treasuries closely.? Junk bonds don’t.? Junk bonds follow a hybrid of what Treasuries and common stocks are doing.? With stocks doing well, junk bonds run as well.

But we are still in an environment where more things can go wrong than right.? Until the US government figures out how to finance itself, we are in dangerous territory.? Given present political conditions, I don’t see how that works out; everything looks like a stalemate at present.

So be wary, and don’t overcommit to risk assets.? I would be neutral on risk assets at presemt, but ready to be bearish if there are problems in Europe or China.

Against Simple Valuation Metrics

Posted on 24 January 2012 by David Merkel

There have been a lot of articles dealing with use of corporate free cash flow lately:

Dividends — get them, are they sustainable?
Buybacks — do they add value or not?
Acquisitions — are they overpaying?? What are the synergies?

But you never hear about the last one — internal investment for organic growth.? There is a simple reason why — it is silent as night.? No one makes announcements on it.? If done properly, it is as quiet as a plant growing.

Dividends are simple — is there enough free capital to issue them, and do the other three priorities?? It is useful to ask how much room there is to increase the dividend, and how well the company can grow its earnings at the present rate.? Companies that pay a dividend understand that equity deserves a return, and are more careful with their capital as a result.? They often grow faster than companies that do not pay dividends.

But I never analyze a company primarily on its dividend yield.? I would rather look at the full set of the drivers of value.

Buybacks are harder because we don’t really know what the company is worth, and buybacks add value when you buy below the value of the company, and lose value when you buy above it.? In the reinsurance industry, it is understood that buybacks above 1.3x tangible book destroys value.? The threshold will be different in other industries because the value of intangibles will differ — but for industries where intangibles mean little, that 1.3x tangible book can be a useful limit.

We can do pro-forma analyses on acquisitions to see if they add value or not.? The best simple proxy is how large the acquisition is relative to the acquirer.? Small acquisitions typically add value? because they add a complementary product, a new marketing channel or region, lower costs, or raise product quality.

Large acquisitions typically lose value because acquirers overpay and integration is difficult.? One exception: negotiated sales by large private sellers.? There is no auction, and no winner’s curse.

The best acquisitions are small, but lead to an increase in organic growth.? Also, the best acquisitions are early; the worst acquisitions are imitative and late.? Typically the best deals get done first.

But much as I like managements who think that the equity deserves a return, via dividends and intelligent buybacks, the hard stuff gets done in organic growth: how are last year’s profits being increased on the existing infrastructure?? In mature industries, this is tough, which is why they typically return free cash flow to shareholders.? But when you find a company that can eke out improvements in a mature industry, finding changes that no one else does, hang onto that company, because it is driving profitable change in the industry.? (And probably taking share from others…)

The less mature the industry, the more room for organic improvement, and thus more free cash flow is dedicated to internal investment, and less to rewarding current shareholders.? In such a situation, it pays less to look at dividend yields, and more at dividend growth, adjusted for ability of growth to be sustained.

-=-=-=- begin rant mode -=-=-=-

This is why I am not crazy about simple articles that say:

Here are the five highest yielding companies of this industry, or
Here are the seven highest yielding investments of [famous investor, or company], or
Here are the companies that are buying back stock rapidly, or
Look at the combined dividend plus buyback yield of these companies…

Everyone wants to squish value investing into one simple metric and from what I have seen, it does not squish well.? That is one reason why I try to view companies off of the competitive dynamics of the industry in question, and adjust the metrics accordingly.? After all, no matter how cheap a company looks in an industry that is obsolete, like newspapers, it is rarely a good idea to buy.

Thus, I am skeptical of the many articles that are spit out by inexperienced investors that have a computer and can crank out a few simple ratios, and spew out some canned facts about a company — these articles are widespread, and not limited to writers on Seeking Alpha, or Zacks, or those that submit to Yahoo! Finance, and they have some canned and wrong way of identifying competitors.

Avoid these articles, and instead, look for some degree of qualitative reasoning — some depth that shows genuine industry knowledge, and not an ability to automate the provision of web “content.”

-=-=-=- end rant mode -=-=-=-

Maybe I should be quiet.? After all, the provision of bad advice on the web is a good thing for me.? The more people are misled, the better value investors with broader skill sets do.

But that’s not why I started writing on investments.? I was not a professional investor until I turned 39.? I read widely, and spent a lot of time reading the works of many different investors as I worked to develop a theory that encompassed most of it.? No, I don’t see how to encompass all of it… and what I can encompass is understood with some amount of error.

My view as I write is not so much to give “buy this” or “sell this” ideas so much as to get people to think differently about investing.? I recently looked at the amount of business/economics/finance/investment books that I have read over the past 25 (post-academic) years, and it would fill 3-4 bookcases.

So try to think of the companies that you own, or might own, like businesses.? Look at the dividends, and to buybacks at bargain prices, and analyze sustainability and growth prospects, but also look at opportunities for growth.? Many aspects of value can’t be encapsulated in simple ratios or rankings, but sadly, the majority of articles touting stocks will do just that, and for the most part, they are useless.

There.? I said it.? But it needs to be said.? The practical question to me is whether I should stop submitting my content to sites like Seeking Alpha, which to me have become a lot of noise, and which I wish I could get Yahoo! Finance to allow users to filter out of the news stream.

I let almost anyone republish my content, so dropping anyone would be unusual for me.? Or, should I drop all external users of my content, and allow no republishing?? If you have a strong opinion, submit it in the comments.? I’ve been a nice guy with all of this, but if you have good reasons for exclusivity, let me know, and I will consider it.

But to close I will say, look at a full range of valuation and performance metrics when buying a stock, and consider the industry dynamics to understand what matters most given the maturity of the industry.? That takes some work, but guess what?? Working intelligently and hard leads to better profits in investing.