Category: Quantitative Methods

Where to Find Data

Where to Find Data

Posted on by David Merkel

Here’s another letter from a reader:

Hi David,

I have been a long time reader of your blog but writing for the first time. To me a key part of the investment process for a generalist investor has to be a way to efficiently screen stocks to generate? investment ideas and also measure historical returns and fundametals for various industry groups under various economic conditions. I am curious as to what data sources you use in your own work for historical stock market and fundamental data? Do you pull this into your own database and do you use Excel or? a statistical package for any quantitative backtests for your screens?

In a previous job I used FactSet to pull historical monthly pricing and quarterly fundamental data for a universe of over 100 regulated utility stocks (both current and past public firms). I also taught myself a fair bit of statistics along the way including logistic regressions and discriminant analysis in order to backtest different models for identifying outperformers, dividend growth/cuts etc. Unfortunately I had to do this all in Excel, which made the whole process pretty painful right on from cleaning up outliers, sorting etc. I guess for simple queries of stock performance and tracking various fundamental metrics over time it would work touse Excel.

One motivation for asking is that I hope to one day become an investing blogger myself, and am wondering if there are low cost ways of accesing this kind of data. Additionally I am always interest in real world methods people follow to prune the thousands of possible stocks to invest in to a smaller more promising subset that people can invest more time analyzing on a fundamental basis. To me the hallmark of a successful investor is the willingness to unturn many investing stones until a promising idea is found.

I am a tightwad when it comes to paying up for data or software.? I use the following:

  • FRED
  • Yahoo Finance
  • Value Line via my local library
  • AAII Stock Investor (A screening package, but more than that)
  • The Wall Street Journal
  • Bloomberg.com
  • FINRA TRACE — bond data
  • Bureau of Labor Statistics
  • Federal Reserve (but not FRED)
  • Microsoft Excel
  • If I need to do something complex, I can use the open source statistics package R.

AAII Stock Investor and Value Line are my main screeners.? I pay $100/year for AAII, and nothing for Value Line.? Oh, my library gives me Morningstar for free as well.? Both subscriptions are very full, and very useful as well.

Now all that said, though it is important to be able to access the data, developing the ability to interpret it is far more important.? There can be too much rigor in trying to analyze quantitative data.? You need to identify the three most significant variables that affect the result being analyzed and focus on analyzing them.? Most investment questions can be analyzed through the three most important variables.

Though I do backtests occasionally, I am happier to stick with theory, and base my actions off that.? Backtests are fraught with all sorts of bias, and basically say that the future will be like the past, only more so.

It would be great to have Bloomberg, FactSet, and some off-the-shelf statistics/programming package that integrates with them.? But life is tough, and we don’t always have that luxury, so we have to seek out data on the cheap, and analyze it cheaply also.

That’s how I do it now, but if I get more clients, I will start paying up for data and software.

Book Review: Rule Based Investing

Book Review: Rule Based Investing

Posted on by David Merkel

Everyone would like a “money machine.”? Follow simple rules, and “Wow, this makes money.”? This is that kind of book but it has better foundations than most in its class.

The book examines three types of investing, most of which are foreign to average investors.? Most investors don’t invest in equity by shorting it, and most investors are not currency traders.

But that is what the book encourages.? I’m going to digress here, because I have to explain some salient matters, and say what I think, so that my later critique makes sense.

Volatility and credit are cousins.? After all when markets go nuts, and everything is in disarray, those that have been trying to borrow at low interest in one currency, and invest at higher interest in another currency get hosed.? Why?? Because in volatile times, the riskier currencies face capital flight versus safer currencies that have the confidence of the markets.

All of the methods mentioned in this book as a result are making bets on volatility/credit, and try to control the bet by monitoring implied volatility, credit spreads, and momentum.? They limit when they are in the market and when they are out.

I don’t have a problem with the theory here, but with the ability of average people to carry it out.? This book would be good for quantitative hedge fund managers; I am less certain about individuals here.

As an aside, what the book describes is how PIMCO has done so well at bond investing over its history — shorting volatility to pick up yield.

But the main criticism is this: the author optimized the book to fit her full data set.? When you read the last chapter, and see that you could have earned 30%+/year for 13 years, if you were as clever as the author, you should think, “Yes, if I had 20/20 foresight.”? The methods will not do as well in prospect as in retrospect.

Quibbles

There is little that I disagree with in the book on a theoretical basis.? Where I differ comes in two areas: individual investors will not have the fortitude to carry out what is a complex method of investment.? Secondly, when enough hedge fund money adopts these strategies, the pricing in the market will shift, and the hedge funds will no longer have easy money.

Who would benefit from this book:?If you are willing to do the work of a volatility-selling hedge fund manager, this is the book for you. ?If you want to, you can buy it here: Rule Based Investing.

Full disclosure: The publisher sent me the book after he offered me a review copy.

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

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

 

Why Buy Convertible Bonds?

Why Buy Convertible Bonds?

Posted on by David Merkel

I sometimes answer questions for those at Klout.com that ask basic investing questions. ?Usually I point to old articles of mine, but this time someone asked a question that I have not answered before, and here it is:

What’s a convertible note? I’ve Googled for the answer but can’t find a simple answer. Why would one take a note when investing rather than equity?

Some people want the best of both worlds. ?I want upside potential, but I want a guaranteed downside where I still make money. ?That’s a convertible bond (or note, same thing). ?The convertible bond promises to pay you income though interest payments, but allows for the possibility that you will want to exchange the bond for a fixed number of shares in the company. ?When would you want to do such an exchange? ?You would exchange when the stock price rises to the point where the bond is worth more converted into stock.

Let’s look at this question from the other side for a moment. ?Why would a company issue a convertible bond? ?There are several reasons:

  • Typically, companies that issue convertible bonds have credit ratings that are junk or low investment grade. ?They want a low interest payment for a company of their credit quality, and so they trade potential issuance of more stock at a time where it would hurt, for lower current interest payments.
  • Often, the companies that offer convertible bonds are growth companies that need capital, but they might have a hard time doing an ordinary junk bond. ?Convertible bonds have a ready buyer base.
  • Convertible bonds can be the “financing of last resort” for companies that are in financial trouble. ?(Article one, article two)

Now, many convertible bonds are issued by companies that subsequently don’t do well, and the bonds get bought by junk bond managers who buy them as junk bonds — they are called “busted converts.” ?They trade as if there is no conversion option, and some clever junk bond managers buy them, knowing that if a few of them have stocks that rally significantly, they will make enough extra money to aid their performance.

For what it is worth, the same ideas apply to convertible preferred stock, except that is bought primarily by individuals, while the bonds are bought by institutional investors. ?Also note that preferred stock has weaker credit quality than bonds. ?In liquidation, bonds get paid before preferred stock.

Final Notes

Convertible bonds changed when hedge funds emerged to invest in cheap convertible bonds, because the conversion option was frequently undervalued. ?As they became a larger force in the market convertible bonds rose in value, until they were largely not attractively priced.

Prior to that era convertible bond funds regularly outpaced other bond funds. ?They behaved kind of like a funny type of balanced fund.

As an investment grade corporate bond manager, I bought a convertible bond once, where it was “busted,” and was attractive just for the income alone. ?As it was, after I left the firm, the stock rallied to the point where converting to stock made sense.

This is tough: convertible bonds make sense for those that want the possibility of extra income if the stock price rises, but are willing to take a lower income on the convertible bond versus straight debt.

Oh, one more thing, again, generally only lower rated companies issue convertible debt, so you have to live with a higher level of default risk. ?Yes, convertible bonds offer the best of both worlds… so long as the issuer doesn’t default.

Unconstrained Will Get Overdone

Unconstrained Will Get Overdone

Posted on by David Merkel

Maybe I’ve just had a couple of unusual random draws from the information urn, but it seems to me that unconstrained mandates are getting more favorable investment attention from investment consultants than they used to. ?The “style box” is breaking down a little, and I think that is a good thing.

My view of the investing world starts with industries, not market cap size, and not even growth/value. ?Much as I end up on the value side, I am flexible on what constitutes value in different industries. ?I range from growth at a reasonable price to deep value. ?It depends on the state of the industry.

All that said, let me talk a little about what it takes to be a good unconstrained manager. ?Organizationally, you have to understand a lot of things better than the rest of the world. ?Do you understand the market, factor, and industry cycles, as well as asset level misvaluations? Investors have the choice of the informationless index, which typically does well versus the average active manager.

As consultants analyze unconstrained managers, their models will get stretched. ?The more degrees of freedom a manager has, the tougher it is to evaluate them. ?If an unconstrained manager made a brilliant tactical move once, can he do it twice? ?Three times? ?More?

Think of the few market players that got short prior to the 1987 crash. ?Aside from Elaine Garzarelli, none were heard from again, and Garzarelli never had a second episode like that in 1987.

It is really tough to come up with significant ideas that will make a huge difference in security returns. ?Home run hitters usually do not hit for average.

What I suspect will happen is this: the initial unconstrained managers will do well, but they will reach capacity limits, and lesser managers will put out “me too” products. ?Consultants will buy into those products to some degree, and a decent number of them will fail to meet expectations. ?The investors hiring the consultants will wonder why they hired them. ?If there is no skill to picking unconstrained managers, then why not pick them directly themselves, or just go back to indexes?

I write this as one that mostly manages equities, long-only. ?I like having no constraint on market cap, value factors, industry, and country selection. ?I like to roam the world in search of value. ?I like to concentrate on industries when I have a good thesis. ?Why should I have non-economic criteria limiting my choices, if I reason well?

That’s why I like unconstrained mandates. ?I run one for upper-middle class individuals, and small institutions. ?But every manager will not do well with it, because most investment organizations are not designed to think that broadly.

Thus I expect that investment consultants will revert to the “style box” (or something new like it) once they realize that few managers can consistently generate alpha over a full market cycle whether unconstrained of constrained. ?At least with constrained, the variation when they do badly is more limited, which protects the consultant, who also does not want to end up in the fourth quartile, where business is lost.

Book Review: Why Stocks Go Up and Down, Fourth Edition

Book Review: Why Stocks Go Up and Down, Fourth Edition

Posted on by David Merkel

Book Cover

This is a good book to help the inexperienced learn about investing.? It begins by teaching the rudiments of accounting through the adventures of a man and his company who have built a better mousetrap.

He starts the business on his own, but needs more capital.? In the process of growing, he taps bank loans, private investors, public investors, bonded debt, and preferred stock.? All of this is done with simple explanations in a step-by-step manner.

The book then explains bonds and preferred stocks.? At first I was a little skeptical, because this is supposed to be a book about stocks, and the authors made a small initial error in that section.? That was the last error they made.? I became impressed with their ability to explain corporate bonds and preferred stocks, even some arcane structures like trust preferred securities, and other types of hybrid debt.

Now, if I were trying to shorten the book, a lot of those sections would have been cut.? For those that do want to learn about bonds in the midst of a stock book, you get a free bonus.? If you don’t want to spend the time on bonds, you can skip those sections with little effect on your ability to understand the rest of the book.

Then the book turns to trickier aspects of accounting, explaining cash flow from operations, and free cash flow.? It’s all good stuff, but here is my first problem with the book: what is the most common way of giving a distorted picture of earnings?? Revenue recognition policies.? The book does not talk about revenue recognition, and the most basic idea of Generally Accepted Accounting Principles [GAAP], which is revenue gets taken into earnings proportionate to the delivery of goods and services.? With financial companies, revenues are earned proportionate to release from risk.

That brings up another point.? The book is very good for describing the analysis of an industrial company, but does little to describe how to deal with financial companies.? Financial companies are different, because most of the cash flow statement has no meaning.

Then the book moves on to valuation of common stocks, and that is where I have my biggest problem with the book.? Though they mention other means of valuing stocks, their main valuation method is earnings.? The book does not mention price-to-book as a metric, which is a considerable fault.? Price-to-book is the main way to value financials versus ROE, while price-to-sales is a very good way to measure industrials relative to relative to profit margins.

Further, it suggests that P/E multiples should remain constant as a company grows.? I’m sorry, but P/E multiples tend to shrink as a company grows.? This is because the highest margin opportunities are exploited first, and then lesser opportunities.? For the P/E to remain constant, or even expand means that new opportunities are being exploited that have higher margins.? Investors should not count on that.

These mistakes are minor, though, compared to the good that the book does for an inexperienced investor.

Quibbles

Already expressed.

Who would benefit from this book: This is a classic book that will aid inexperienced investors to learn the basics.? Just remember, it is only the basics, and it covers most things, but not all things. It would be an excellent book for one of your relatives or friends that think they know what they are talking about in investing, but really doesn’t know.? If you want to, you can buy it here: Why Stocks Go Up and Down.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

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

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

Two More Good Questions

Two More Good Questions

Posted on by David Merkel

I had two more good questions in response to my piece Why I Resist Trends.? Here we go:

I think you have some idea which ones are the best by the discount to intrinsic value. If you were running a business (which you are when you are investing) and you had 10 projects with lets say a minimum return of 5% but a spread of 20% to 5% wouldn?t you first invest in the 20% return project and fund each project in descending order of return. By equally weighing aren?t you equally investing in the 5% and 20% projects? If you were a CEO shouldn?t the shareholders fire you? I know the markets have more volatility than projects due to the behavioral aspects of investing but in my view equally weighting is more important when you do not know much about your investment and less important when you do. I think you know a lot about the companies you invest in. Why not try an experiment. Either in real time or historically take a look at what would have happened overtime if you would have weighed you selections by discount from intrinsic value. I think you will be pleasantly surprised. I and John Maynard Keynes have been pleasantly surprised.

I do this in a limited way.? In the corporate bond market we have the technical term “cheap.”? We also have the more unusual technical term “stupid cheap” for bonds that are very undervalued.

When I have a stock that is “stupid cheap” I make it a double weight, if it passes margin of safety and other criteria.? On one rare occasion I had a triple weight.

But I meant what I said? in Portfolio Rule Seven — “Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best.”? I have been surprised on multiple occasions as to what would do best.? Investing is not as simple as assessing likely return.? We have to assess downside risks, and possibilities that some things might go better than the baseline scenario.

I don’t use a dividend discount model, or anything like it.? I don’t think you can get that precise with the likely return on a stock.? My investing is based on the idea of getting very good ideas, as opposed to getting the best ideas.? I don’t think one can get the best ideas on any reliable basis.? But can you find assets with a better than average chance of success?? My experience has been that I can do that.

So, I am happy running a largely (but not entirely) equal-weight portfolio.? It is an admission of humility, which tends to get rewarded in investing.? Bold approaches fail more frequently than they succeed.

By the way, though Keynes was eventually successful, he cratered a couple times.? I have never cratered on a portfolio level, because of my focus on margin of safety.

On to the next question:

What are the tests you use to check if accounting is fair?

Start with my portfolio rule 5, here’s a quick summary:

Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

  1. For nonfinancials, review the difference between cash flow from operations and earnings.? Companies where cash flow from operations does not grow and? earnings grows are red flags.? Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.? The latter portion of that rule can be applied to financials.

  2. For nonfinancials, review net operating accruals.? Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.??? The values of assets on the balance sheet are squishier than most believe.? The accruals there are not entirely trustworthy in general.

  3. Review taxable income versus GAAP income.? Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.? b) management is clever in manipulating GAAP earnings.? It is the job of the analyst to figure out which it is.

  4. Review my article ?Cram and Jam.?? Does management show greater earnings than the increase in book value plus dividends?? Bad sign, usually.? Also, does management buy back stock aggressively ? again, that?s a bad sign.

Then add in my portfolio rule 6, here’s a quick summary:

Cash flow is the lifeblood of business.? In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

  • I want to avoid companies that do big scale acquisitions.? Large acquisitions tend to waste money.

  • I also want to avoid companies that do acquisitions that are totally unrelated to their existing business.? Those also waste money.

  • I want to avoid companies that buy back stock at all costs.? They waste money by paying more for the stock than the company is worth.

  • This was common in the 50s and 60s but not common today, but who can tell what the future will hold?? I want to avoid companies that pay dividends that they cannot support.

Portfolio rule 6 does not deal with accounting per se, but management behavior with free cash flow.? Rules 5 and 6 reveal large aspects of the management character — how conservative are they?? How honest are they?? Do they use corporate resources wisely?

On Ethics in Business and Investing

I would add in one more thing on ethics of the management team — be wary of a company that frequently plays things up to the line ethically and legally, or is always engaged in a wide number of lawsuits relative to its size.

I know, we live in a litigious society — even good companies will get sued.? But they won’t get sued so much.? I realize also that some laws and regulations are difficult to observe, and interpretations may vary.? But companies that are always in trouble with their regulator usually have a flaw in management.

A management team that plats it “fast and loose” with suppliers, labor, regulators, etc., will eventually do the same to shareholders.? Doing what is right is good for its own reasons, but for investors, it is also a protection.? A management that cheats is in a certain sense less profitable than they seems to be, and eventually that reality will manifest.

All for now, and to all my readers, I hope you had a great Thanksgiving.

On Investment Ideas, Redux

On Investment Ideas, Redux

Posted on by David Merkel

Would I disclose proprietary ideas of mine?? I’ve done it before.? Why would I do it?? Because it would take a lot to make the ideas usable.? Remember my commentary from when I was a bond manager: I was far more open with my brokers than most managers, but I never gave them the critical bits.

So a reader asked me:

Any chance you could expand on what quantitative metrics you are using to compare potential investments? Could you also name a few of the 77 13fs you track? Thanks

I will go above and beyond here.? You will get the names of all 78 — here they are:

  • Abrams
  • Akre
  • Altai
  • Ancient Art
  • Appaloosa
  • Atlantic
  • Bares
  • Baupost
  • Blue Ridge
  • Brave Warrior
  • Bridgewater
  • BRK
  • Capital Growth
  • Centaur
  • Centerbridge
  • Chieftain
  • Chou
  • Coatue
  • Dodge & Cox
  • Dreman
  • Eagle Capital
  • Eagle Value
  • Edinburgh
  • Fairfax
  • Farallon
  • Fiduciary
  • Force
  • FPA
  • Gates
  • Glenview
  • Goldentree
  • Greenhaven
  • Greenlight
  • H Partners
  • Hawkshaw
  • Hayman
  • Hodges
  • Hound
  • Hovde
  • Icahn
  • Intl Value
  • Invesco
  • Jana
  • JAT
  • Jensen
  • Joho
  • Lane Five
  • Leucadia
  • Lone Pine
  • M3F
  • Markel
  • Matrix
  • Maverick
  • MHR
  • Montag
  • MSD
  • Pabrai
  • Parnassus
  • Passport
  • Pennant
  • Perry
  • Pershing Square
  • Pickens
  • Price
  • Sageview
  • Scout
  • Soros
  • Southeastern
  • SQ Advisors
  • Third Point
  • Tiger Global
  • Tweedy Browne
  • ValueAct
  • Viking Global
  • Weitz
  • West Coast
  • Wintergreen
  • Yacktman

What I won’t tell you is what I do with their data, because it is different from what most do.? But you can play with it.

Then you asked about factors.? Here are my factors:

  • Price change over the last year
  • Price change over the last three years
  • Insider buying
  • Price-to-earnings, both current and forward
  • Price-to-book
  • Price-to-sales
  • Price-to-free cash flow
  • Price-to-sales
  • Dividend yield
  • Neglect (Market cap / Trading volume)
  • Net Operating Assets
  • Stock price volatility over the last three years
  • Asset growth over the last three years
  • Sales growth over the last three years
  • Quality (gross margins / assets)

Now that I have “bared all,” I haven’t really bared all, because there is a lot that goes into the preparation and analysis of the data that can’t be grasped from what I have revealed here.? To go into that would take more time than I can spend.? That’s one reason why as a corporate bond manager, I would share more data with my brokers than most would do, because I knew that the last 20% that I reserved was the real gold.? That I would not share.

Beyond that, there are my industry rotation models, which I share 4-6x per year, and then my qualitative reasoning, which makes me reject a lot of ideas that pass my quantitative screens.

That’s what I do.? It’s not perfect, and my qualitative reasoning has its faults as well.? I encourage you to develop your own theories of value, as Ken Fisher encouraged me to do back in early 2000.? Develop your edge, with knowledge that you have that few others do.? I’ll give you an example.

I understand most areas in insurance.? I don’t get everything right, but it does give me an edge, because insurance accounting and competition is a “black box” to most investors.? Insurance has been one of the best performing industries over time, but many avoid it because of its complexity and stodginess.

Behind the hard to understand earnings volatility, there is sometimes a generally profitable franchise that will make decent money in the long run.? But few get that, and that is an “edge” of mine.? Develop your own edge.

That’s all for now.? Invest wisely, and be wary, because the market for risk assets is high, and what if the Fed stops supporting it?? Make sure your portfolio has a margin of safety.

On Liabilities in Asset Allocation

On Liabilities in Asset Allocation

Posted on by David Merkel

From an e-mail from one of my readers:

I?m not sure if you have the time to respond to this, but figured I?d send to you and just see!…

(Just FYI, I?m not an investment professional of any sort, so I don?t have any ?skin in the game? as they say, just a geek who follows the markets and DIY financial-planning issues and long-time reader of the Aleph blog)

I recently read an FP article by a guy I?ve read a lot (Alan Roth).? He suggested that, when your analyzing an investment portfolio and making asset-allocation decisions, you need to treat mortgage debt as an ?inverse-bond? or an ?anti-bond??such that any mortgage debt held would dollar-for-dollar negate or reduce your actual bond investment holdings.? And the result is that this made the investor?s actual portfolio risker than they realized, since their ?true? bond allocation was smaller than they had considered.

I thought it was a novel concept, but I found some problems with that approach, within the context of asset-allocation.? My main point was that the primary purpose of analyzing a portfolio?s asset allocation is to manage risk through diversification of assets (generalizing here in interests of being concise).?? The pinnacle of diversification is non-correlation: generally in economic environments where equities soar, bonds will underperform, and vice versa.? However, classifying a debt as an ?anti-bond? doesn?t actually provide any portfolio diversification, or introduce any non-correlation.? It won?t actually negate the amount that your bonds would rise, and it won?t actually offset the amount your bonds would fall, in those respective market environments.? And even if you consider that the real value of the debt is decreased if inflation rises (as the NPV calculation would be using a greater discount rate), that doesn?t have any real-world effect on the portfolio and it?s risk and return behavior.? Since borrowers aren?t allowed to ?mark-to-market? their mortgages, that debt holding value does not fluctuate?it is fixed, and amortized from its historical cost, regardless of any market conditions or any theoretical NPV/DCF changes. ?Therefore, the inverse- or anti- bond holding in the portfolio has zero impact on the portfolio?s actual risk/return behavior, and so it seems to me it doesn?t add any functional value to frame debt as an ?anti? portfolio holding of some sort.

Also, if you were going to do that, to be fair and complete, you must apply that same principle to every single debt the client has (otherwise, it would be rather arbitrary just selecting the mortgage debt).? This adds unnecessary complexity in the asset allocation analysis.

Instead, the appropriate (and only) way to analyze debt is, separate from investable portfolio assets, on the cash-flow side of things.? Simply asking what is the ?optimal? use of the available capital; i.e. what net ?return? do you earn by using capital to eliminate debt, versus what net return could you earn if you kept the debt and employed the capital elsewhere (this will be different for each investor and their unique situations).? This is the way to analyze and evaluate debt, not to mingle it in with your invested assets and classify it as an ?anti-bond? holding within your portfolio.

I was just curious your take on this, and if I am misunderstanding or missing something.? Do you ever consider client?s debt as ?inverse-? or ?anti-? bonds in the context of asset allocation?

Thanks!

When you manage money financial firms, if you do it right, you consider the promises that your firm needs to fulfill.? When will cash be needed to pay obligations?? That helps drive asset allocation, because assets should broadly match liabilities.

Now, I am not a financial planner.? That said, the same principles apply to personal asset allocation.? If someone has a large mortgage or other debts, and he can’t invest his fixed income assets at levels that exceed the yields on those debts with reasonable risk, he should not invest in bonds — he should pay down his debt.? In the case of 401(k)s or IRAs, where there might be matches or tax advantages, the calculation becomes more complicated.? You have to weigh the match and tax deferral vs the negative arb on bond yields vs the mortgage and personal debts.

There is another factor here — how stable is your job?? If stable, it is bond-like, and you can take more equity risk with investments.? If your job has payoffs that vary a great deal with the market — commissions, bonuses, etc., it is stock-like, and you should take less risk in your investing — take excess earnings and pay down the mortgage.? I did that when I went from being a bond manager inside an insurance company, to being an equity analyst inside a hedge fund.? I paid off my mortgage in full, so that I would be free to take risks for my new employer.

As for the article, the concept is not novel.? It is well-known and practiced by institutional asset managers who manage money to the horizons needed by their clients.? As an example, the cash flows of a pension plan are relatively determinate, and the discount rate calculates the value of the liability.? The portfolio should throw off cash when needed in order to minimize risk.

In some cases, where bonds don’t offer enough yield, and equity prices are depressed, it might make sense to tactically mismatch, betting that equities will offer better returns versus the liabilities than bonds would on a risk-adjusted basis.

This argument has made its rounds for the last 20 years in insurance and pension management?? Do we match asset and liability cash flows, or do we trust in the equity premium, and invest in risk assets?? The correct answer is hybrid.? In general, match assets and liabilities, but if there is a significant tactical advantage to not match, then do that.? Think of buying junk bonds in late 1998.? Time to throw matching out the window.? And then in mid-1999, buy equities.

Now, not all clients will allow for that much risk-taking.? Many institutional investors will not let the asset manager take advantage of temporary dislocations.

In general, I think Mr. Roth is correct, but with an adjustment.

  • In extraordinary times, where bonds yield more than the earnings yields of stocks (think 1987 & 2000), buy bonds heavily, even if you have mortgage and other debts.
  • In extraordinary times, where stocks earnings yields are much higher than bonds, mismatch and own more stocks relative to bonds.? Just beware deflation, with falling future earnings.
  • In normal times, an indebted investor should not add to his leverage, but should invest in bonds, or better, pay down his debt.? Being debt-free is an excellent thing, and allows the investor to take more risks when the market is offering bargains.

Debt is either something to be funded by bond assets, or funds a margin account where you outperform the yield, or die.? All of this depends on where the market is in its risk cycle.? Only take risk where it is rewarded.

 

A New Look at Endowment Investing

A New Look at Endowment Investing

Posted on by David Merkel

I’ve written at least two significant pieces on endowment investing:

Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project.? This was partially in response to Matthew Klein’s excellent article,?Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.

The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions.? If you are interested, it is worth a read.? The remainder of this piece expresses ways that I think their views could be sharpened.? Here goes:

1) Don’t Think in Terms of Time Horizon, but Time Horizons

2008-9 proved that liquidity matters.? The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.

Choose a length of time over which you think you have a full market cycle, with a boom and a bust.? I like 10 years, but that might be too long for many.?? As I said in Managing Illiquid Assets:

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.? Invest that much in short to intermediate bond investments.? You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

I include all risk assets in illiquid assets here.? The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell.? There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.

2) Look to the Underlying Drivers of Value

Hedge funds aren’t magic.? They are just limited partnerships that invest.? Look through the LPs to the actual investments.? It is those actual investments that will drive value, not the form in which they are held.? Get as granular as you can.? Ask: what is the margin of safety in these endeavors?? What is the likely return under bad and moderate conditions?

3) Ignore Correlations

It is far more important to focus on margin of safety than to look at diversification benefits.? Correlation coefficients on returns are not generally stable.? Do not assume any correlation benefits from risky investments.? Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.

4) On Leverage & Insurance

Unless they are mispriced, borrowing money or getting insurance does not add value.? Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.

Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).

5) Mark-to-Market Losses Might Matter

Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.

6) Insource Assets

The best firms I have worked for built up internal expertise, rather than outsource everything.? The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced.? As you gain experience, insource more.

7) Thematic Investing is Usually Growth Investing

Avoid looking at themes.? Unless you are the first on the scene, themes are expensive.? Rather, look at margin of safety.? Look for businesses where you can’t lose much, and you might get good gains.

8) Look to the Underlying Value of the Business, or Asset Class

Cash flows are what matter.? Look at he likely internal rate of return on all of your investments, and the worst case scenario.? Buy cheap assets with a margin of safety, and don’t look further than that.? Buying safe assets cheap overcomes all diversification advantages.

Those are my differences on what was otherwise a good paper.? I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.

With Jeremy Siegel at CFA Institute Baltimore

With Jeremy Siegel at CFA Institute Baltimore

Posted on by David Merkel

At the CFA Institute at Baltimore, we had the pleasure of having Jeremy Siegel come speak to us this past Thursday.? He was lively, engaging, and utterly convinced of his theses.? Thanks to Wisdom Tree for helping fund the endeavor.

He openly asked us to poke holes in his theories.? This article is an effort to do that.

1) Stock tends to get bought in when it is undervalued, and sold via IPOs when it is overvalued.? Thus the time-weighted rate of return exceeds the dollar-weighted rates of return by a few percent.? This dents the main premise of ?Stocks for the Long Run.?? Buying and holding is not possible, because valuable stocks are lost at the troughs, giving us cash, and we are forced to buy more near peaks, of overvalued stocks.

Dollar-weighted returns are what we eat, and they don?t vary much versus time-weighted returns when considering bonds or cash.

Also, in the present day, private equity plays a larger role, and they exacerbate the degree to which stocks get IPOed dear, and acquired cheap.

2) He spent a lot of time defending the concept of the CAPE Ratio, but not its execution.? He began a long argument about how accounting rules for financials were behind the drop in earnings for the S&P 500, and that AIG, Bank of America, and Citi were to blame for all of it.

Sadly, he seems not to know financial accounting so well.? What was liberal in the early and mid-2000s was corrected 2007-2009.? In aggregate the accounting was fair across the decade.? Remember that accounting exists to try to measure change in value of net worth across short periods, and net worth at points in time.

Really, if we were trying to be exact, when a writedown occurs, we would spread it over prior periods, because prior accounting was too liberal ? the incidence of the loss occurred over many years prior to the writedown.

Thus I find his argument regarding specialness of financial company accounting to be bogus ? he is just searching for a way to justify valuations off of current earnings, rather than off of longer term measures.

3) The longer?term measures agree with CAPE:

  • Q-Ratio
  • Market Cap/ GDP
  • Price-to-Resources
  • Financial Stress indexes
  • Eddy-Elfenbein?s Stock Market if valued like a bond measure

All of these point to an overvalued market.? But markets can be overvalued for a while.? Why might that be in this case?

4) Because profit margins may remain high for some time.? In an era where the prices for labor and resources are cheap, should it be surprising that profit margins are high?? Those conditions will eventually change, but not soon.

With that, I would simply say that:

  • Stocks do outperform bonds and cash over the long run, but not by as much as Dr. Siegel thinks.
  • Stocks are overvalued by long-term balance sheet-oriented measures at present.
  • But stocks may stay high because profit margins are likely to stay high ? there will be regression to the mean, but not now.

Finally I would note that he was one of the most graceful and generous speakers to come speak to us in some time, took a long Q&A, staying longer than he needed to, and happily signing the books he had written.? I showed him my First Edition version of his book, signed by him after speaking to the Philadelphia AAII chapter in 1995, and said, ?We were much younger then.?? He smiled and said, ?Yes, we were.?

I may disagree with him on some points, but he is one very bright and personable guy.

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