Portfolio Management – Page 8

Estimating Future Stock Returns, September 2016 Update Redux

Posted on 15 December 2016 by David Merkel

Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less…

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My last post on this generated some good questions. ?I’m going to answer them here, because this model deserves a better explanation. ?Before I start, I should say that in order to understand the model, you need to read the first two articles in the series, which are?here:

If you are curious about the model, the information is there. ?It includes links to the main article at Economic Philosopher’s blog ( @jesselivermore on Twitter).

On to the questions:

Is this nominal or real return? Where can I find your original blog post explaining how you calculate future returns? Similar charts using Shiller PE, total market cap to gdp, q-ratio etc. all seem to imply much lower future returns.

This is a nominal return. ?In my opinion, returns and inflation should be forecast separately, because they have little to do with each other. ?Real interest rates?have a large impact on equity prices, inflation has a small impact that varies by sector.

This model also forecasts returns for the next ten years. ?If I had it do forecasts over shorter horizons, the forecasts would be lower, and less precise. ?The lower precision comes from the greater ease of forecasting an average than a single year. ?It would be lower because?the model has successively less power in forecasting each successive year — and that should make sense, as the further you get away from the current data, the less impact the data have. ?Once you get past year ten, other factors dominate?that this model does not account for — factors reflecting the long-term productivity of capital.

I can’t fully explain why this model is giving higher return levels, but I can tell you how the models are different:

This model focuses in investor behavior — how much are investors investing in stocks versus everything else. ?It doesn’t explicitly consider valuation.
The Shiller PE isn’t a well-thought-out model for many reasons. ?16 years ago I wrote an email to Ken Fisher where I listed a dozen flaws, some small and some large. ?That e-mail is lost, sadly. ?That said, let me be as fair as I can be — it attempts to compare the S&P 500 to trailing 10-year average earnings. ?SInce using a single year would be unsteady, the averaging is a way to compare a ~~outdated~~ smoothed income statement figure to the value of the index. ?Think of it as price-to-smoothed-earnings.
Market Cap to GDP does a sort of mismatch, and makes the assumption that public firms are representative of all firms. ?It also assumes that total payments to all factors are what matter for equities, rather than profits only. ?Think of it as a mismatched price-to-sales ratio.
Q-ratio compares the market value of equities and debt to the book value of the same. ?The original idea was to compare to replacement value, but book value is what is available. ?The question is whether it would be cheaper to buy or build the corporations. ?If it is cheaper to build, stocks are overvalued. ?Vice-versa if they are cheaper to buy. ?The grand challenge here is that book value may not represent replacement cost, and increasingly so because intellectual capital is an increasing part of the value of firms, and that is mostly not on the balance sheet. ?Think of a glorified Economic Value to Book Capital ratio.

What are the return drivers for your model? Do you assume mean reversion in (a) multiples and (b) margins?

Again, this model does not explicitly consider valuations or profitability. ?It is based off of the subjective judgments of people allocating their portfolios to equities or anything else. ?Of course, when the underlying ratio is high, it implies that people are attributing high valuations to equities relative to other assets, and vice-versa. ?But the estimate is implicit.

So?I?m wondering what the difference is between your algorithm for future returns and John Hussman?s algorithm for future returns. For history, up to the 10 year ago point, the two graphs look quite similar. However, for recent years within the 10-year span, the diverge quite substantially in absolute terms (although the shape of the ?curves? look quite similar). It appears that John?s algorithm takes into account the rise in the market during the 2005-2008 timeframe, and yours does not (as you stated, all else remaining the same, the higher the market is at any given point, the lower the expected future returns that can be for an economy). That results in shifting your expected future returns up by around 5% per year compared to his! That leads to remarkably different conclusions for the future.

Perhaps you have another blog post explaining your prediction algorithm that I have not seen. John has explained (and defended) his algorithm extensively. In absence of some explanation of the differences, I think that John?s is more credible at this point. See virtually any of his weekly posts for his chart, but the most recent should be at http://www.hussmanfunds.com/wmc/wmc161212e.png?(DJM: the article in question is here.)

I’d love to meet and talk with John Hussman. ?I have met some members of his small staff, and he lives about six miles from my house. ?(PS — Even more, I would like to meet @jesselivermore). ?The Baltimore CFA Society asked him to come speak to us a number of times, but we have been turned down.

Now, I’m not fully cognizant of everything he has written on the topic, but the particular method he is using now was first published on 5/18/2015. ?There is an article critiquing aspects of Dr. Hussman’s methods from Economic Philosopher. ?You can read EP for yourself, but I gain one significant thing from reading this — this isn’t Hussman’s first model on the topic. ?This means the current model has benefit of hindsight bias as he acted to modify the model to correct inadequacies. ?We sometimes call it a specification search. ?Try out a number of models and adjust until you get one that fits well. ?This doesn’t mean his model is wrong, but that the odds of it forecasting well in the future are lower because each model adjustment effectively relies on less data as the model gets “tuned” to eliminate past inaccuracies. ?Dr. Hussman has good reasons to adjust his models, because they have generally been too bearish, at least recently.

I don’t have much problem with his underlying theory, which looks like a modified version of Price-to-sales. ?It should be more comparable to the market cap to GDP model.

This model, to the best of my knowledge, has not been tweaked. ?It is still running on its first pass through the data. ?As such, I would give it more credibility.

There is another reason I would give it more credibility. ?You don’t have the same sort of tomfoolery going on now as was present during the dot-com bubble. ?There are some speculative enterprises today, yes, but they don’t make up as much of the total market capitalization.

All that said, this model does not tell you that the market can’t fall in 2017. ?It certainly could. ?But what it does tell you versus valuations in 1999-2000 is that if we do get a bear market, it likely wouldn’t be as severe, and would likely come back faster. ?This is not unique to this model, though. ?This is true for all of the models mentioned in this article.

Stock returns are probabilistic and mean-reverting (in a healthy economy with no war on your home soil, etc.). ?The returns for any given year are difficult to predict, and not tightly related to valuation, but the returns over a long period of time are easier to predict, and are affected by valuation more strongly. ?Why? ?The correction has to happen sometime, and the most likely year is next year when valuations are high, but the probability?of it happening in the 2017?are maybe 30-40%, not 80-100%.

If you’ve read me for a long time, you will know I almost always lean bearish. ?The objective is to become intelligent in the estimation of likely returns and odds. ?This model is just one of ones that I use, but I think it is the best one that I have. ?As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzlies.

That is my defense of the model for now. ?I am open to new data and interpretations, so once again feel free to leave comments.

[bctt tweet=”As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzly Bears.” username=”alephblog”]

Estimating Future Stock Returns, September 2016 Update

Posted on 10 December 201610 December 2016 by David Merkel

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Are you ready to earn 6%/year until 9/30/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the third quarter, I would have said 6.37% — but with the run-up in prices since then, the returns decline to 6.01%/year.

That puts us in the 82nd percentile of valuations, which isn’t low, but isn’t the nosebleed levels last seen in the dot-com era. ?There are many talking about how high valuations are, but investors have not responded in frenzy mode yet, where they overallocate stocks relative to bonds and other investments.

Think of it this way: as more people invest in equities, returns go up to those who owned previously, but go down for the new buyers. ?The businesses themselves throw off a certain rate of return evaluated at replacement cost, but when the price paid is far above replacement cost the return drops considerably even as the cash flows from the businesses do not change at all.

For me to get to a level where I would hedge my returns, we would be talking about?considerably higher levels where the market is discounting future returns of 3%/year — we don’t have that type of investor behavior yet.

One final note: sometimes I like to pick on the concept of Dow 36,000 because the authors didn’t get the concept of risk premia, or, margin of safety. ?They assumed the market could be priced to no margin of safety, and with high growth. ?That said, the model does offer a speculative prediction of Dow 36,000. ?It just happens to come around the year 2030.

Until next time, when we will actually have some estimates of post-election behavior… happy investing and remember margin of safety.

[bctt tweet=”Are you ready to earn 6%/year until 9/30/2026?” username=”alephblog”]

A Cautionary Tale on Municipal Pensions

Posted on 10 December 201610 December 2016 by David Merkel

Photo Credit: ajehals || Pensions are promises. Sadly, promises are often broken. Choose your promiser with care…

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If you want a full view of what I am writing about today, look at this article from The Post and Courier, “South Carolina’s looming pension crisis.” ?I want to give you some perspective on this, so that you can understand better what went wrong, and what is likely to go wrong in the future.

Before I start, remember that the rich get richer, and the poor poorer even among states. ?Unlike what many will tell you though, it is not any conspiracy. ?It happens for very natural reasons that are endemic in human behavior. ?The so-called experts in this story are not truly experts, but sourcerer’s apprentices who know a few tricks, but don’t truly understand pensions and investing. ?And from what little I can tell from here, they still haven’t learned. ?~~I would fire them all, and replace all of the boards in question, and turn the politicians who are responsible out of office~~. ?Let the people of South Carolina figure out what they must do here — I’m a foreigner to them, but they might want to hear my opinion.

Let’s start here with:

Central Error 1: Chasing the Markets

Much as inexperienced individuals did, the South Carolina?Retirement System Investment Commission [SCRSIC] chased the markets in an effort to earn returns when they seemed easy to get in hindsight. ?As the article said:

It used to be different, before the high-octane investment strategies began. South Carolina?s pension plans were considered 99 percent funded in 1999, and on track to pay all promised benefits for decades to come.

That was the year the pension funds started investing in stocks, in hopes of pulling in even more income. A change to the state constitution and action by the General Assembly allowed those investments. In the previous five years, U.S. stock prices had nearly tripled.

Prior to that time, the pension funds were largely invested in bonds and cash, which actually yielded something back then. ?If the pension funds were invested in bonds that were long, the returns might not have been so bad versus stocks. ?But in the late ’90s the market went up aggressively, and the money looked easy, and it was easy, partly due to loose monetary policy, and a mania in technology and internet stocks.

Here’s the real problem. ?It’s okay to invest in only bonds. It’s okay to invest in bonds and stocks in a fixed proportion. ?It’s okay even to invest only in stocks. ?Whatever you do, keep the same policy over the long haul, and don’t adjust it. ?Also, the more nonguaranteed your investments become (anything but high quality bonds), the larger your provision against bear markets must become.

And, when you start a new policy, do what is not greedy. ?1999-2000 was the right time to buy long bonds and sell stocks, and I did that for a small trust that I managed at the time. ?It looked dumb on current performance, but if you look at investing as a business asking what level of surplus?cash flows the underlying investments will throw off, it was an easy choice, because bonds were offering a much higher future yield than stocks. ?But the natural tendency is to chase returns, because most people don’t think, they imitate. ?And that was true for the SCRSIC,?bigtime.

Central Error 2:?Bad Data

The above quote said that “South Carolina?s pension plans were considered 99 percent funded in 1999.” ?That was during an era when government accounting standards were weak. ?The?standards are still weak, but they are stronger than they were. ?South Carolina was NOT 99% funded in 1999 — I don’t know what the right answer would have been, but it would have been considerably lower, like 80% or so.

Central Error 3: Unintelligent Diversification into “Alternatives”

In 2009, I had the fun of writing a small report for CALPERS. ?One of my main points was that they allocated money to alternative investments too late. ?With all new classes of investments the best deals get done early, and as more money flows into the new class returns surge because the flood of buyers drives prices up. ?Pricing is relatively undifferentiated, because experience is early, and there have been few failures. ?After significant failures happen, differentiation occurs, and players realize that there are sponsors with genuine skill, and “also rans.” ?Those with genuine skill also limit the amount of money they manage, because they know that good-returning ideas are hard to come by.

The second aspect of this foolishness comes from the consultants who use historical statistics and put them into ~~brain-dead~~ mean-variance models which spit out an asset allocation. ?Good asset allocation work comes from analyzing what economic return the underlying business activities will throw off, and adjusting for risk qualitatively. ?Then allocate funds assuming they will never be able to trade something once bought. ?Maybe you will be able to?trade, but never assume there will be future liquidity.

The article kvetches about the expenses, which are bad, but the strategy is worse. ?The returns from all of the non-standard investments were poor, and so was their timing — why invest in something not geared much to stock returns when the market is at low valuations? ?This is the same as the timing problem in point one.

Alternatives might make sense at market peaks, or providing liquidity in distressed situations, but for the most part they are as saturated now as public market investments, but with more expenses and less liquidity.

Central Error 4: Caring about 7.5% rather than doing your best

Part of the justification for buying the alternatives rather than stocks and bonds is that you have more of a chance of beating the target return of the plan, which in this case was 7.5%/yr. ?Far better to go for the best risk-adjusted return, and tell the State of South Carolina to pony up to meet the promises that their forbears made. ?That brings us to:

Central Error 5: Foolish politicians who would not allocate more money to pensions, and who gave?pension increases rather than wage hikes

The biggest error belongs to the politicians and bureaucrats who voted for and negotiated higher pension promises instead of higher wages. ?The cowards wanted to hand over an economic benefit without raising taxes, because the rise in pension benefits does not have any immediate cash outlay if one can bend the will of the actuary to assume that there will be even higher investment earnings in the future to make up the additional benefits.

[Which brings me to a related pet peeve. ?The original framers of the pension accounting rules assumed that everyone would be angels, and so they left a lot of flexibility in the accounting rules to encourage the creation of defined benefit plans, expecting that men of good will would go out of their way to fund them fully and soon.

The last 30 years have taught us that plan sponsors are nothing like angels, playing for their own advantage, with the IRS doing its bit to keep corporate plans from being fully funded so that taxes will be higher. ?It would have been far better to not let defined benefit plans assume any rate of return greater than the rate on Treasuries that would mimic their liability profile, and require ~~immediate~~ relatively quick funding of deficits. ?Then if plans outperform Treasuries, they can reduce their contributions by that much.]

Error 5 is likely the biggest error, and will lead to most of the tax increases of the future in many states and municipalities.

Central Error 6: Insufficient Investment Expertise

Those in charge of making the investment decisions proved themselves to be as bad as amateurs, and worse. ?As one of my brighter friends at RealMoney, Howard Simons, used to say (something like), “On Wall Street, to those that are expert, we give them super-advanced tools that they can use to destroy themselves.” ? The trustees of?SCRSIC received those tools and allowed themselves to be swayed by those who said these magic strategies will work, possibly without doing any analysis to challenge the strategies that would enrich many third parties. ?Always distrust those receiving commissions.

Central Error 7: Intergenerational Equity of Employee Contributions

The last problem is that the wrong people will bear the brunt of the problems created. ?Those that received the benefit of services from those expecting pensions will not be the prime taxpayers to pay those pensions. ?Rather, it will be their children paying for the sins of the parents who voted foolish people into office who voted for the good of current taxpayers, and against the good of future taxpayers. ?Thank you, Silent Generation and Baby Boomers, you really sank things for Generation X, the Millennials, and those who will follow.

Conclusion

Could this have been done worse? ?Well, there is Illinois and Kentucky. ?Puerto Rico also. ?Many cities are in similar straits — Chicago, Detroit, Dallas, and more.

Take note of the situation in your state and city, and if the problem is big enough, you might consider moving sooner rather than later. ?Those that move soonest will do best selling at?higher real estate prices, and not suffer the soaring taxes and likely?diminution of city services. ?Don’t kid yourself by thinking that everyone will stay there, that there will be a bailout, etc. ?Maybe clever ways will be found to default on pensions (often constitutionally guaranteed, but politicians don’t always honor Constitutions) and municipal obligations.

Forewarned is forearmed. ?South Carolina is a harbinger of future problems, in their case made worse by opportunists who sold the idea of high-yielding investments to trustees that proved to be a bunch of rubes. ?But the high returns were only needed because of the overly high promises made to state employees, and the unwillingness to levy taxes sufficient to fund them.

[bctt tweet=”Seven central errors committed by the South Carolina Retirement System and politicians” username=”alephblog”]

The Beauty of Old Ideas

Posted on 6 December 20166 December 2016 by David Merkel

Photo Credit: Daniele Dalledonne || Ever been to a place where everything was a little past its prime, but showed that it was a beautiful place in its time?

One of the great draws in?reading investment writing is the lure of “hot tips.” ?Everyone wants an investment idea that they can put a lot of money into that will reward buyers (or shorts) with a quick and large score. ?Thus most publications try to lure you in with articles like these, whether they will work or not.

We live in an era where market players scour as much fresh data as possible to make money, because there is validity to the idea that only fresh, previously unknown information can produce excess returns. ?The grand majority of us will never receive that information for free, and can’t afford to pay up for services that promise to give such carefully researched ideas (whether true or not, and whether they work or not).

So what’s a humble value investor to do, professional or amateur? ?I can suggest five?things:

Take a look at old ideas that seemed promising but when the news hit the market, there was a price jump, then a fall, then nothing. ?Typically, I have lists of companies that I have looked at — maybe it is time for a second look?
Source your own ideas — particularly look at smaller companies that have low or no analyst coverage. ?As regulations have come over Wall Street, you might be surprised at the number of companies in seemingly boring industries that have little to no real coverage. ?Some of them are sizable. ?(By “real coverage” I mean a human being, not an algorithm. ?Don’t get me wrong, algorithms are often better than people, but the value of a human being ?here is that he/she is more representative of how human investors think — and we love exciting stories.)
Scan 13Fs for new positions and additions — my favorite ideas are when a number of clever investors are adding on net to their holdings (and the stock has done nothing), or two hedge funds buy a new name at the same time that none of the other bright investors hold at all. ?(not a spinoff)
Or, look at spinoffs. ?For a little while, there will be liquidity and small or no analyst coverage. ?Many large investors and indexers will toss out the smaller spinoff, often leaving a undervalued company behind.
Hold onto companies in your portfolio if they stumble, but you still think management is making the right decisions.

One of the main ideas behind this is that it takes a while for business ideas to work out. ?Most valid ideas will hit a couple of bumps along the way, and short-term earnings will disappoint occasionally with good companies. ?Companies that never have disappointing earnings may be manipulating their accounting.

Many if not most of the companies that I hold for years run into disappointments, become an unrealized capital loss in my portfolio for a while, and come back to greater success. ?The short-term disappointments sometimes allow me buy a little bit more, but the main thing to analyze is that the company’s management continues to behave rationally for the good of all shareholders.

Final Notes

This only applies to healthy companies. ?Do not try this with companies that have weak balance sheets that might be forced to try to raise funds (at unattractive levels) if their plans don’t go right. ?All good investing embeds a margin of safety.

Another way to phrase this is think differently. ?There is a lot of money out there chasing the most liquid companies. If you can take on a little illiquidity on a quality company that is not well-known, that could be a good idea. ?But remember, thinking differently is not enough if?your idea isn’t smart. ?It has to be smart and different.

With that, happy hunting. ?Sometime in the near term, I will do a post on underfollowed companies. ?Read it when it comes — it might have some good ideas.

[bctt tweet=”So what?s a humble value investor to do, professional or amateur? I can suggest five things” username=”alephblog”]

Stock Returns Versus GDP

Posted on 2 December 2016 by David Merkel

Picture Credit: Third Way Think Tank || Lousy name, but technology moves on and capital gets recycled

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Howard Simons said many other intelligent things, but there is one that has stuck with me:

These Aren’t GDP Futures You’re Trading (said with respect to stocks)

Now I’ve written at least one other article on this:?Numerator vs Denominator. ?(If you have time, it is a good summary article.) ?The basic idea is this: in the long-run stocks benefit from growth in the economy. ?In the short-run, growth in the economy can push up the demand for capital because new and existing businesses need investment, and the cost of capital rises as a result. ?Second, as the economy grows, sometimes resources other than capital are proven to be in short supply, e.g., labor and resources. ?GDP may grow, but in certain contexts, profits as a share of GDP can shrink, and the share going to wages, resources, and interest may grow.

I write this for a few?reasons:

It is by no means certain that the economy will grow more rapidly under President-elect Trump.
It is also not certain that profits will grow more rapidly.
Even if profits grow more rapidly, that does not guarantee that stock prices will rise.
There are often surprising second order effects when policies change.

After the election of Trump, the old economy stocks in portfolios that I manage for clients and me?did well, and the emerging market stocks did badly, aside from a Russian small cap ETF (which flew). ?At first I wondered about the emerging market stocks, but with rising interest rates in the US, the Volatility Machine kicked in, amplifying the effects of anticipated growth in demand capital in the US, and raised capital costs in the emerging markets, sending their stock prices down.

The same thing can happen to stocks in the US if there is enough demand for capital from the US Government to rebuild infrastructure. ?Let the US Government try to borrow more than $1 Trillion per year.? Watch interest rates rise, and watch stocks fall, as Government borrowing crowds out private investment.? On a related basis, higher interest rates make dividend-paying common and preferred stocks less attractive.

That doesn’t mean that the stocks supplying the needs of the government will do badly, but remember that the growth in demand for those goods and services might not persist. ?The prices of those stocks have already embedded higher growth rates into them — will the reality outcompete the expectations?

That’s the key question for all investors now and ever: reality versus expectations. ?Good investors make cold calculations of the expectations embedded in their investments versus likely reality, and as the situation changes, they keep adjusting.

That’s why I don’t think of the post-election period as a re-animation of “animal spirits.”? I do see it as?a rational response to likely changes. ?Does that mean that the likely changes are certain to happen? No. ?But it is likely for the economy and profits to grow faster in an environment where regulation is lower (for an example, consider the first term?of the Reagan Administration. ?It is also possible that interest rates could rise enough to erase the effect of higher profits on stock prices. ?Also, with a political neophyte in the White House, there could be significant volatility in all of the markets as the new President absorbs on-the-job training at our expense. ?Remember, volatility is risk in the short-run, but less so in the long-run. ?That can have a temporary effect on the prices of risky assets like stocks.

Permanent linear changes rarely happen in complex societies, so consider:

All sorts of things will get proposed, but what will get enacted?
Of what is enacted, will it have the expected effect?
Will there be other effects not presently expected, including a quick reversal or slowdown of policy changes because of public opinion changes and future electoral losses?
How will monetary policy react?

The election and its aftermath has not changed my investing plans in any major way. Tastes, demographics, and technology have not been radically altered. ?I am reacting to what the market is doing, but what is likely to get approved, and how regulatory efforts shift is likely to be moderate rather than revolutionary. ? Even if GDP grows faster, it is no guarantee of a rising stock market in the short run.

As such, my responses are?small, and I continue to watch and adjust.

Edging In, Edging Out

Posted on 30 November 201630 November 2016 by David Merkel

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Most days, I don’t trade. ?I study.? I model. ?I muse. ?I plan.

There are some clever traders out there. ?I am not one of them. ?What little trading I do is done efficiently and effectively to get the best prices for assets that I want to buy and sell, but that’s not where most of the money is made in investing.

I can be like a chef who goes out to the market in the morning and buys the best ingredients available that day at great prices, except that my period of analysis is years, not a day. ?The point is that I consider the deals that the market is offering, and choose attractive ones that will benefit my clients and me for years to come. ?(I am still the largest investor that I manage money for — I eat the exact same meal that I serve to clients.)

What trading I do divides into two categories, which are designed for two different time horizons. ?The first time horizon is long — 3-10 years in length. ?Can I find companies with good or better business prospects trading at prices more attractive than the businesses that I currently own?

This is mostly a patient thing, unless I conclude that I got something materially wrong, in which case I try to be quick to sell. ?Patience is needed, because investing is like farming. ?It doesn’t grow overnight. ?It will take time for value to be built, and time for people to recognize that the company is better than they thought it was. ?It won’t be a linear process, either, unless something unusually good happens. ?There are setbacks with almost every?winning investment. ?Keep your eyes on the main drivers of growth in value, and whether management is using excess cash to the best?ends, which will vary by company.

At least half of my winners spent time as an unrealized capital loss at some point. ?My timing is sometimes nonideal, but ideal timing is not required for great results if the time horizon is years. ?So I watch?and monitor, and occasionally trade away the position when I find something with materially better prospects.

As an aside, not all RIA clients would like this, because it looks like I’m not doing that much. ?I sometimes wonder how much better money management would be if clients were happy with portfolios that don’t change much and don’t have many of the current hottest and most recognizable companies in them. ?Portfolios filled with?unknown companies in boring but profitable industries… difficult to talk about at parties, but often more profitable.

What I have mentioned above is 85% of what I do. ?The shorter-run movements of the market provide the other 15% as ideas and companies go in and out of favor in the short run. ?I mentioned that my timing is often not the best. ?This gives me an opportunity to do a little better.

I’ve mentioned that I use a 20% band around my position weights for the companies that I own. ?As prices fall and hit the bottom of the band, I buy enough to come back up to the target weight. ?Vice-versa for when the price hits the upper band.

20% is a significant move — it’s enough to justify the trading costs. ?If the company is still a good one, the fall in price gives me the opportunity to lower my average cost modestly. ?Note that this is a modest change — I’m not trying to be a hero or a home-run hitter. ?I learned better when I was younger that making timing decisions on that level is too undisciplined. ?It is far better to edge in and edge out around a core position — with a good company, a lower price means lower risk, and a higher price means higher risk, so this method is always taking and shedding risk at appropriate levels.

Edge in, edge out — trades like this happen a few times a month — more frequently when the market is lively, less often when it is sleepy. ?Hey, don’t force things. ?This is gradual reallocation of money from less to more attractive homes for capital. ?The time horizon here is 3-12 months, and offers the ability to make a little more off of core positions.

Over 5 years, companies that I own might have a grand total of 5-10 trades from edging in and out. ?It will always be a mix of both buys and sells — few companies don’t have moves of 20%+ down amid growth. ?(As some will note, if markets are efficient, why is there such a large gap between 52-week highs and lows for individual stocks? ?Really, markets aren’t efficient — they are just very hard to beat.)

Now, others will come up with different ways of managing multiple time horizons in investing, but this method offers a decent balance between the short- and long-terms, and does so in a businesslike, disciplined way. ?And so I edge in and edge out.

[bctt tweet=”This balances the short- and long-terms, and does so in a businesslike, disciplined way.” username=”alephblog”]

When I was a Boy…

Posted on 29 November 2016 by David Merkel

Photo Credit: Jessica Lucia?|| That kid was like me… always carrying and reading a lot of books.

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If you knew me when I was young, you might not have liked me much. ?I was the know-it-all who talked a lot in the classroom, but was quieter outside of it. ?I loved learning. ?I mostly liked my teachers. ?I liked and I didn’t like my fellow students. ?If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.

I read a lot. A LOT. ?Even when young I spent my time on the adult side of the library. ?The librarians typically liked me, and helped me find stuff.

I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it. ?She would watch Wall Street Week, and often, I would watch it with her. ?2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.

Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest. ?The two were the conglomerate Litton Industries, and the home electronics company?Magnavox. ?Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares. ?We did worse on Litton. ?Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss. ?Don’t blame my mother for any of this, though. ?She rarely bought highfliers, and told me that she would have picked different stocks. ?Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.

At the library, sometimes I would look through some of the research volumes that were there for stocks. ?There are a few things that stuck with me from that era.

1) All bonds traded at discounts. ?It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.

In those days, some people owned individual bonds for income. ?I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s. ?Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals ?in the mid-to-late ’70s. ?My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.

When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons. ?Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost. ?Any recoveries will be off the par value of the bond, which is usually $100.

2) Many stocks paid dividends that were higher than their earnings. ?I first noticed that while reading through Value Line, and wondered how that could be maintained. ?The phrase “borrowing the dividend” was bandied about.

Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability. ?Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.

3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go. ?I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.

The “Death of Equities” came and went, but that reminds me of one more thing:

4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency. ?Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things). ?Low stock and bond prices made pension plans look shaky. ?A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.

Takeaways

The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in. ?We are so absorbed in the zeitgeist (Spirit of the Times)?that we usually miss that other eras are different. ?We miss the possibility of turning points. ?We miss the possibility of things that we would have not thought possible, like negative interest rates.

In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy. ?Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.

The Soviet Union will bury us.

Japan will bury us. ?(I’m listening to some Japanese rock as I write this.) 😉

China will bury us.

Few people can see past the zeitgeist. ?Many can’t remember the past.

Should we?be concerned about companies not being able pay their dividends and fulfill their buybacks? ?Yes, it’s worth analyzing.

Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow. ?Stocks will likely fall with bonds if real interest rates rise. ?And, interest rates may not rise much soon. ?Are you ready for both possibilities?

Average people don’t seem that excited about any asset class today. ?The stock market is at new highs, and there isn’t really a mania feel now. ?That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates. ?Those that held onto the Nifty Fifty may not have lost money, but few had the courage. ?Will there be a correction for the highfliers of this era, or, is it different this time?

It’s never different.

It’s always different.

Separating the transitory from the permanent is tough. ?I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it. ?As Buffett has said, (something like)?”We’re paid to think about things that can’t happen.”

Ending Thoughts

Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:

The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order. ?Sovereign default used to be a large problem. ?It is a problem that is returning. ?As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement. ?Hopefully we don’t get a lot of wars as they did in that decade.
I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things. ?I’m flat there now. ?I think you almost have to be a trend follower there.
The yield curve will probably flatten quickly if the Fed tightens more than once more.
The internet and global demographics are both forces for deflationary pressure. ?That said, virtually the whole world has overpromised to their older populations. ?How that gets solved without inflation or defaults is a tough problem.
Stocks are somewhat overvalued, but the attitude isn’t frothy.
DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
Eventually emerging markets and their stocks will dominate over developed markets.
Value investing will do relatively better than growth investing for a while.

That’s all for now. ?You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way. ?The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. 🙂

How do you Manage a Company when the Stock is Considerably Overvalued?

Posted on 26 November 201627 November 2016 by David Merkel

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I’ve thought about this problem before, but always thought it was more of a curiosity until I read this on page 66 of Jeff Gramm’s very good book, Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism. ?(Note: anyone entering through this link and buying something at Amazon, I get a small commission.)

I saw Eddie Lampert, a hedge fund manager who is chairman of Sears Holdings, make some interesting points at a New York Public Library event in 2006. When he was discussing the challenges of managing a public company, he raised a question few people in the room had considered. How do you run a company well when the stock is overvalued? What happens when management can’t meet investors’ unrealistic expectations without taking more risk? And what happens to employee morale if everyone does a good job but the stock declines? Lampert, of course, knew what he was talking about. Sears closed that day at $175 per share versus today’s price of around $35. In an efficient market, it’s easy to develop tidy theories about optimal corporate governance. Once you realize stock prices can be totally crazy, the dogma needs to go out the window.

The price of Sears Holding is around $13 now, though there have been a lot of spinoffs. ?Could Eddie have done better for shareholders? ?Before answering that, let’s take a simpler example: what should a the managers/board of a closed end fund do if it persistently trades at a large premium to its net asset value [NAV]? ?I can think of three ideas:

1) Conclude that the best course of action is to?minimize the eventual price crash that will happen. ?Therefore issue stock as near the current price level as possible, and use it to buy non-inflated assets, bringing down the discount. ?What’s that, you say? ?The act of announcing a stock offering will crater the price? ?Okay, good point, which brings us to:

2) Merge with another closed end fund, trading at a discount, but offering them a premium to their NAV, hopefully a closed end fund?related to the type of closed end fund that you are. ?What’s that, you say? ?Those that manage other closed end funds are financial experts, and would never agree to that? ?Uhh, maybe. ?Let me say that not all financial experts are equal, and who knows what you might be able to do. ?Also, they do have a duty to their investors to maximize value, and for those that?sell above net asset value this is a big win. ?In the meantime, you have reduced your effective economic discount for those that continue to hold your fund.

3) Issue bonds or preferred stock convertible into common stock at a level that virtually guarantees conversion. ?Use the proceeds to invest in your ordinary investment strategy, bringing down the effective discount as dilution slowly takes place.

Of all the ideas, I think 3 might work best, because it would have the best chance of allowing you to issue equity near the overvalued level. ?If the overvaluation was 50%, maybe you could get it down to 25% by doubling the asset base, in which case you did your holders a big favor. ?If it works, maybe repeat it in two years if the premium persists.

A closed end fund is simple compared to a company — but that added complexity may allow strategies one or two to work better. ?Before we go there, let’s take one more detour — PENNY STOCKS!

Okay, I haven’t written about those in a while, but what do penny stock managements with no revenues do to keep their firm alive? ?They trade stock at discount levels in order to source goods and services. ?This creates dilution, but they don’t care, they are waiting for the day when they can exit, possibly after a promotion. ?Also, they could issue their stock to buy up a small firm,?adding some value behind the worthless shares. ?One guy wrote me after my penny stock articles, telling me of how he foolishly did that, with the stock being restricted, and he watched in horror as the ?price sank 60% before he was allowed to sell any shares. ?He lost most of what he worked for in life, took the company to court, and I suspect that he lost… it was his responsibility to do “due diligence.”

So with that, strategy one can be to issue as much stock as possible as quietly as possible. ?Offer your employees stock in order to reduce wages. ?Give them options. ?Where possible, pay for real assets and services with stock. ?Issue stock, saying that you have big plans for organic growth, then, try to grow the company. ?In this case, strategy three can make more sense, as the set of buyers taking the convertible stock and bonds don’t see the dilution. ?That said, the hard critical element is the organic growth strategy — what great thing can you do? ?Maybe this strategy would apply to a cash hungry firm like Tesla.

In strategy two, merge with other companies either to achieve diversification or vertical integration. ?Issue stock at a premium to the value received, but not not as great as the premium underlying your current stock price. ?Ordinarily, I would argue against dilutive acquisitions, but this is a special case where you are trying to reduce the premium valuation without reducing the share price.

This brings us to another set of examples: conglomerates and roll-ups. ?Think of the go-go years in the ’60s where conglomerates bought up low P/E stocks using?their high P/E stocks as currency. ?Initially, the process produces earnings growth. ?It works until the eventual bloat of the businesses is difficult to manage, and?the P/Es fall. ?Final acquisitions are sometimes ugly, leading to failure. ?The law of decreasing returns to scale eventually catches up.

With roll-ups an aggressive management team buys up peers. ?The acquirer is a faster growing company, and so its stock trades at a premium. ?If the acquirer is clever, it can shed costs in the target, and continue to show earnings growth for some time until it finally slows down and has to rationalize the mess of peer companies that have been bought.

This brings up one more area for overvalued companies: frauds. ?This past evening, my wife and I watched The Billion Dollar Bubble, which was the largest financial fraud up until Madoff. ?One thing Equity Funding?did was use the funds that they had generated to buy other insurers. (That’s not in the movie, which kept things simple, and compressed the time it took for the fraud to take place.)

Enron is another example of a fraudulent company that used its inflated share price to buy up other companies. ?Not everything Enron did was fraudulent, but having a highly valued stock allowed it to buy up companies with assets which reduced some of its valuation premium, though not enough for the stock to go out at a positive figure.

Summary

It is an unusual situation, but the best strategy for a company with an overvalued stock is to try to grow their way out of it, usually through mergers and acquisitions. ? The twist I offer you at the end of my piece is this: thus, watch highly acquisitive firms. Not all of them are overvalued or fraudulent, but some will be. Avoid the shares of those firms.

[bctt tweet=”watch highly acquisitive firms. Not all of them are overvalued or fraudulent, but some will be. Avoid the shares of those firms.” username=”alephblog”]

The Band Travels Up

Posted on 26 November 2016 by David Merkel

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Three months ago, I bumped against my upper cash limit. ?After that, I put an additional 6% of funds into the market. ?Now cash is up to 18%, near my cash limit of 20%. ?As I look at my portfolio now, most of the portfolio is above the central band. ?I may buy another stock to bring cash levels down, but I am going to use?a different tool because everything?has moved up. ?I’m moving the band itself up. ?(Last time, if I had moved the band up, there were a lot of stocks near the lower edge of the band, and I don’t like moving the band when results are dispersed. ?I don’t want to buy or sell as a result of moving the band.)

I don’t adjust the trading bands often — maybe once a year or so. ?I leave them fixed in nominal dollar terms, adjusting for when clients add or remove?assets. ?When the market has moved so much that almost every?stock is above or below the central line of the band, rather than add or sell?a stock, I adjust the height of the band. ?I moved my band up 6%, which puts half of my stocks above and below the central line of band, from which if a stock is 20% over the central line, I sell down to the central line, and if a stock is 20% under the central line, I buy up?to the central line if I still believe that the stock is a good one to own. ?This is the way that Portfolio Rule Seven works.

This makes the sell points further away and makes the buy points nearer, which in turn makes it incrementally more likely that cash will be dispersed, not accumulated. ?Now, if the market keeps running up, particularly for value stocks, cash will still accumulate, but it will take more to make that happen.

Why do I do it this way? ?In this environment, I look at the height of the market, which is considerable, but I also look at the momentum, and conclude that I ought to let things run more, if they will. ?In my opinion, the stocks that I own for clients are undervalued, even if the market is not undervalued. ?Old economy stocks have lagged for years behind new economy stocks, and valuation differences are pronounced. ?I experienced much the same thing in 2000-2001 when growth got whacked, and value kept performing until everything went through the wringer in 2002.

Now, I’m hoping, but not saying that value is coming back, but it is certainly overdue. If this period is anything like the beginning of the 2000s, it will be very good for value investors. ?The challenge will be managing high absolute market valuations versus favorable relative valuations. ?It makes for a bumpy ride, but I like the stocks that I own, and will keep adjusting through all of the bumps.

[bctt tweet=”Now, I’m hoping, but not saying that value is coming back, but it is certainly overdue.” username=”alephblog”]

“Do Half” Applied

Posted on 22 November 2016 by David Merkel

Photo Credit: Attila Malarik?|| In many but not all situations, doing half is a smart idea!

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Four major stock indexes, the?DJIA, S&P 500, Nasdaq, Russell 2000 all closes at records on the same day. ?From that same article,?Ryan Detrick, senior market strategist for LPL Financial said that it was the?first time all of those indexes set records on the same day since December 31, 1999.

For those that missed the rally, do you feel bad about it? ?Regretful? ?Really, it’s too bad that the bear bug got you to the degree that you acted on it. ?Those who have read me for a long time know that I often sound bearish, because I am natively bearish. ?But, I don’t let it force me to take aggressive actions. ?There is a point where I will hedge everything, but that is around 2600 on the S&P 500 at present. ?I sit and worry a little, let?Portfolio Rule Seven?trim a little as my stocks hit new highs, but I won’t let cash go over 20% — we’re at about 16% now. ?After I?Bumped Against My Upper Cash Limit, I bought more stock — good thing too, at least in the short run.

If you think this is all a mirage, and there aren’t any structural reasons why the market should go any higher, and you are not going to do anything here — well, good for you. ?Maybe you are right, and you can buy lower someday. ?Just don’t get jumpy if the market continues to rise, and you don’t have much in the game. ?(To those so inclined, don’t be macho fools and try to short into new highs — wait until there is some blood on the sword before shorting, something that I almost never do because of the bad risk/reward tradeoff.)

But if you are feeling jumpy and think you should get in on the action, let me give you two words:??Do Half.?? If at normal valuations you would have 60% of your assets in stocks, and you have nothing in stocks now, don’t take position above 30%. ?Go up to half of a normal position. ?If things continue to go up, you will be happy you have something in the market.??If things go down you can bring it up to a full position on weakness, and be grateful you didn’t go up to 60% all at once.

Now, I’m not telling you to buy anything, invest with me, or anything like that. ?I just know that regret is one of the most powerful forces in the market, and lots of people make stupid decisions under its influence. ?Rules that I use, like “Do Half” and the portfolio management rules are designed to keep me from making rash decisions influenced by my emotions.

The same “Do Half” rule could be applied to lightening up on bond positions and other matters, like raising cash or edging into commodities. ?(I am doing neither of those now — they are just examples from others that I know.)

The main idea is to be self-controlled, and not let emotion drive you. ?Investing is a business; determine your policies, and act on them, whether you do it yourself, or farm it out to others. ?But if you?feel that you have to do something now, then my advice to you is “Do Half.” ?[bctt tweet=”But if you feel that you have to do something now, then my advice to you is ‘Do Half.'” username=”alephblog”]