Quantitative Methods – Page 11

Sorted Weekly Tweets

Posted on 5 October 2013 by David Merkel

US Government Shutdown

To Lead Is to Negotiate http://t.co/AJTjPESgiI Elements of an interview w/James Baker describing Reagan the pragmatic dealmaker $$ Oct 04, 2013
Pig Sales Fly Blind as Data Cut by Shutdown Hampers Firms http://t.co/MHHnn29XXH Guess what? That’s the way most markets operate $$ Oct 04, 2013
Troops Forage for Food While Golfers Play On in Shutdown http://t.co/Y9HV5IpF3A “the appropriations process has completely failed” $$ Oct 04, 2013
Obama Rewrites Debt-Limit History http://t.co/BIRNHLH7Pm D&R Congresses have used the borrowing limit as political leverage w/a president $$ Oct 04, 2013
US banks fearing default stock up on cash http://t.co/tYXMlQXcIe If money markets freeze, currency will be needed to mediate exchange $$ Oct 04, 2013
Loose monetary policy needed to counter Washington gridlock: Fed officials http://t.co/AmJqqcMQPQ Fed enables intransigence of congress $$ Oct 04, 2013
Republicans Are No Longer the Party of Business http://t.co/Vwa5U0pENS Case not proven; as if the Democrats think of any biz but big biz $$ Oct 04, 2013
Frustrated Republicans Pressure Boehner to End Shutdown http://t.co/m6eSEtXQ5n Likely endgame: Democrats & liberal GOP ally in House $$ Oct 03, 2013
US Stocks Rise as Investors See Limited Shutdown Impact http://t.co/nB5WCCcsd4 Will they say the same thing today off neg mkt action? $$ Oct 02, 2013
Behind the Noise, Entitlement Reform http://t.co/Ed2ug8HoCN This is the elephant in the room; the economic problem behind all the rest $$ Oct 02, 2013
More Than 800,000 Federal Workers Are Furloughed http://t.co/GP0XdAxugH Oddly, this helps point out what true priorities of the govt r $$ Oct 01, 2013
In Government Shutdown, Few Parallels With Most Recent One http://t.co/RmJ7X3iL0Q Maybe shutdown is an alternative mode of running govt? $$ Oct 01, 2013

Companies & Industries

Twitter Look-Alike Ticker Triggers 684% Advance in Penny Stock http://t.co/hLf2VRP6Hs Big difference btw Twitter $TWTR & Tweeter $TWTRQ $$ Oct 04, 2013
Mars Repays $4.4B of Berkshire Bonds Tied to Wrigley Deal http://t.co/U5uSgTXBd8 Now Buffett has tough job of redeploying capital $$ #cash Oct 04, 2013
Twitter Sends Different Message Than Facebook in Filing http://t.co/azMDDPHVwz 32 pages of risk factors, no classified stock, refreshing $$ Oct 04, 2013
Blackstone Opens Europe Spigot as Distressed Deals Surge http://t.co/yYQl2dwhzS As EU banks get reasonable, $BX sees opportunity 4 deals $$ Oct 04, 2013
Alcoa on ?low risk financiers? and parallel metal markets http://t.co/ganjSH2aZg With low interest rates, cheaper to store metal $$ Oct 03, 2013
Beanie Baby Creator Pleads Guilty to Swiss Bank Tax Dodge http://t.co/V8PrsbKEAO He’ll make up the $$ w/a line of Ty the Jailbird dolls Oct 03, 2013
We Are Googling the New York Times to Death http://t.co/OLJ0XsSCRA Use Google 2get free access to the $NYT – broken media revenue model $$ Oct 02, 2013
OGX Upheaval Portends Deeper Bond Loss for Pimco http://t.co/m9Do3MALyM BK is tough on creditors in Brazil; long process, low recoveries $$ Oct 02, 2013
How BlackBerry blew it:The inside story http://t.co/4K7Kw4Y5bL Long article as $BBRY focuses on core biz, misses threat from new entrants $$ Oct 01, 2013
Schwarzman Says Selling BlackRock Was ?Heroic? Mistake http://t.co/G8ZKjxNOZ0 Missed out on 79%/yr returns compounded over 19 years! $$ $BLK Oct 01, 2013
BlackBerry Rare Breakup Fee Seen Deterring Bids http://t.co/uyo9Ra1zzA Watsa gets a free look, while others effectively locked out $$ $BBRY Oct 01, 2013
Why Anglo American Walked Away From Pebble Mine Gold Deposit http://t.co/QwqmjykuD9 Interesting, but only speculations on y $AAUKY left $$ Oct 01, 2013
Commodities ?Super Cycle? Is Seen Enduring by McKinsey http://t.co/Jnj1XwZNKO Marginal costs keep rising as lower costs ores deplete $$ Oct 01, 2013
Storage Wars Seize Metals Market http://t.co/WkX0fsOx3o Aiming 2end games that lock up metal in storage as collateral for loans, I think $$ Oct 01, 2013
Falcone?s Funds Sell Harbinger Group Shares to Leucadia http://t.co/2l8dSyEPKP $HRG funds sell shares 2 $LUK @ a 20% discount 2 mkt price $$ Oct 01, 2013
Of course $LUK has 2 hold onto the shares 4 a while, but still that’s a pretty stiff price 2 pay 4 liquidity $$ $HRG Oct 01, 2013

Finance, Pensions, Etc.

More Than 5,000 Stockbrokers From Expelled Firms Still Selling Securities http://t.co/E5lczvdLJP Don’t buy what someone wants 2 sell 2u $$ Oct 04, 2013
How to Look Under a Hedge Fund’s Hood http://t.co/oKy6ZQWo1q There’s more 2ask than this, but these 7 questions r a good start $$ Oct 04, 2013
Hedge Funds Used Obscure Bond Bet to Win in GM Bankruptcy http://t.co/SaLKh7sg9Q They did hard work with their brains, & won $$ #distressed Oct 04, 2013
8 Incredible Shares On StockTwits About Hedge Fund Market Wizard Ray Dalio http://t.co/tjQ9ecAF1A I added two more resources $$ Oct 04, 2013
Time to Ditch the Yale Endowment Model?http://t.co/aYWfleXE7R Similar to an article I wrote 4 years ago http://t.co/2ox3Zzdaac $$ @M_C_Klein Oct 04, 2013
S&P 500 Pension Status Continues to Improve in September http://t.co/tyL1fqCivB Rising prices for risky assets & more contributions help $$ Oct 03, 2013
Peak-population investing http://t.co/0I5s49iBBC Demographics affect inflation – goods inflation w/many young asset inflation w/many old $$ Oct 03, 2013
10 Terms Investment Pros Use to Raise Money @Reformedbroker http://t.co/cHivwK8uvh Points @ 10 buzzwords w/fuzzy meanings & little truth $$ Oct 02, 2013
Option-Selling Is Not Income http://t.co/zdiP91nKsK Well written,& it needs 2b said. Option “income” vs capital losses & opportunity costs $$ Oct 02, 2013
Eric Schneiderman, Wall Street Time-Machine Sheriff http://t.co/trSBh80ObO Dig deep enough in2 any multiparty trnsctn & u will find dirt $$ Oct 02, 2013
In multiparty transactions, u have 2b careful. Who has more info than u? How r incentives aligned? Y r u lucky one invited 2play w/them? $$ Oct 02, 2013
Student-Loan Straitjacket http://t.co/1keTvDykpV They should look at income-based repayment plans; in many cases they would pay far less $$ Oct 02, 2013
Fab Tourre Wants Another Chance to Explain http://t.co/X4H8b70hVi Did Tourre withhold mind-chging information deal players were entitled2 $$ Oct 02, 2013
Inter-dealer brokers? inside information @FelixSalmon http://t.co/cCcVMM3foF What is fraud vs making/arbing a mkt? http://t.co/6aKN6t0Abw $$ Oct 02, 2013
Top 20 Films about Finance: From Crisis to Con Men http://t.co/nDv0Rz4P4P I added on the film “The Billion Dollar Bubble” Equity Funding $$ Oct 01, 2013
Gibraltar Seen as Europe-Beater for Finance Professionals http://t.co/YzHgQRv82A Perhaps more money per hectare than any other place $$ Oct 01, 2013
Commodity Trader Didn’t Really Believe in Market Prices http://t.co/qVEC4lQB8u Citi mismarked illiquid exchange-traded ethanol contracts $$ Oct 01, 2013
This Sociological Theory Explains Why Wall Street Is Rigged 4 Crisis http://t.co/ff6NWs1GOO Technological efficient w/odd feedback loops $$ Oct 01, 2013

PPACA / Obamacare

Overwhelming Demand 4 Obamacare Shows Potential Success http://t.co/4i3Kb6P8SN Success?? Show you what happened 2me http://t.co/vlrqUxFXzr Oct 04, 2013
How ObamaCare Wrecks the Work Ethic http://t.co/3U2z8PKPwR Saw this a month ago, subsidies raise marginal tax rates 4 lower middle class $$ Oct 03, 2013
The Republicans Fighting Obamacare Aren?t Crazy http://t.co/A61poB4ArU PPACA *can* b repealed, but would take a GOP swing in 2016 2do it $$ Oct 01, 2013
Why must the American people suffer when even so many Democrats don’t want Obamacare? http://t.co/uJfncEetS7 Congress exempts itself $$ Sep 28, 2013

Civil Liberties in Cyberspace

NSA chief admits misleading numbers, adds to Obama administration blunders http://t.co/wsS2qrIW74 Politicians overstate metadata value $$ Oct 04, 2013
NSA Involvement in NIST Encryption Standards Could Make Companies Less Competitive http://t.co/RzRVSYVtiv Does NSA demand backdoors? $$ Oct 03, 2013
On NSA’s encryption defeating efforts: Trust no 1 http://t.co/afq1Fjngzv Big companies r in cahoots w/NSA, can’t b trusted, r lying 2us $$ Oct 02, 2013
NSA Gathers Data on Social Connections of U.S. Citizens http://t.co/oVIYLWdHFi The NSA endangers our civil liberties; we need to end it $$ Sep 30, 2013

Monetary Policy

Will Unconventional Monetary Policy Be the New Normal? http://t.co/nN00ta4UIM Fed is hopeless; they don’t get they r inflating assets $$ Oct 04, 2013
Aluminum Prices: Blame It on the Fed http://t.co/kgjOTbNeqd Low interest rates lead to loans collateralized by aluminum $$ Oct 03, 2013
Don?t Cry for Me, Ben Bernanke http://t.co/unN01G8N8K Developing Countries should get ready for the eventual Fed tightening, if they can $$ Oct 01, 2013

Banking

The Bailout That Never Came http://t.co/cROhzGqjYB Bailout for homeowners was half-hearted at best; 4 banks it was a warm friendly hug $$ Oct 04, 2013
Banks abandon mortgage preapprovals http://t.co/ro6NE8T5Yb Makes the purchases of homes more complex b/c likelihood of financing down $$ Oct 03, 2013
Are Banks Forward-Looking in Their Loan Loss Provisioning? http://t.co/1V6ytChwB2 I would be more inclined to think it is a “cookie jar” $$ Oct 02, 2013
The JP Morgan apologists of CNBC http://t.co/HJgOH3NGvT Media often panders 2 power or they lose access to the powerful people $$ Oct 01, 2013

Other

Duke to NYU Missteps Abroad Lead Colleges to Reassess Expansion http://t.co/1ZoHGD2CeP Have 2 make sure of a good cultural fit first $$ Oct 04, 2013
Freak Grape-Razing Hail Crushes Burgundy Winemakers? Dreams http://t.co/rxSiKaRpvl 2years of hailstorms destroy the prospects of vintners $$ Oct 04, 2013
Migrant Ship Sinks Off Italian Island, Killing Dozens http://t.co/KCYgVt0Bx8 Europe is Elysium 4 these migrants; US is the same 4 others $$ Oct 03, 2013
NFL Free-Agent Lawyer to Unlock $16B in NCAA Athletes http://t.co/nfitchpsSt Free student labor may disappear; may hit big programs hard $$ Oct 03, 2013
Moon walker demo lets wannabe astronauts feel 0.17G http://t.co/BsenBrl8ck Cool. Could b used 4physical therapy after severe leg injuries $$ Oct 02, 2013
Educators in the art of life must have chance of their own http://t.co/HxiCZUOyP3 Certain college depts survive on low paid p/t academics $$ Oct 02, 2013
Worried About Cancer? Get Married http://t.co/PQFp8Q67SD A man & a woman who get & stay married tend to take care of each other $$ #healthy Oct 01, 2013
Gangnam-Style Nip and Tuck Draws Tourists to Seoul?s Beauty Belt http://t.co/2nC182RWtV Plastic surgery becomes a tourist draw 2 Seoul $$ Oct 01, 2013

US Politics & Policy

Small town, big impact: Supreme Court case could define religion’s role in public http://t.co/oD09WqaOaT Govt Ceremonial deism may end $$ Oct 04, 2013
Who Do You Believe: The White House and Wall Street ? or the American People? http://t.co/ZIRZDU1i5p Economic Confidence continues 2drop $$ Oct 03, 2013
Bankrupt Stockton Plan Favors Retirees Over Creditors http://t.co/yZ80M5s5lz Will b difficult 2get thru BK city, unless emplyee benes cut $$ Oct 01, 2013
‘Strings Attached’ Co-Author Offers Solutions for Education http://t.co/BMF9zPqMU6 I learned the most from teachers that were hard on me $$ Oct 01, 2013
Panel Finds Planes Can Handle Use of Electronic Devices http://t.co/hCnZNFfR98 At last, the bad science crumbles & freedom increases $$ Oct 01, 2013
The most predictable economic crisis? http://t.co/XAqVj9QZ9S Implicitly, entitlement reform lies behind almost all our problems in DC $$ Oct 01, 2013
Why I Am Cancelling My Documentary on Hillary Clinton http://t.co/oKxLjUwRDZ No openness from the Clintons dooms a documentary from CNN $$ Oct 01, 2013

Replies, Retweets & Comments

2 all who follow me on Twitter, my account was hacked, & someone sent out a bunch of spam tweets & DMs that I would never send. My apologies Oct 01, 2013

@kltblom when the amount of range for premium variation is only three, it is not a workable system. Anti-selection will occur. Oct 05, 2013
@M_C_Klein I started out as an Asset-Liability Management actuary, and I have traded in illiquid securities, makes me think differently Oct 05, 2013
@kltblom Removed deduction for employer-paid healthcare. Encouraged HSAs, and try to move to predominantly first-party payer model Oct 05, 2013
@TheUncorrelated I willprobably write an article on this next week. Will sound like the one I cited b4 & like: http://t.co/Y8CA0LX9Qi Oct 05, 2013
@kltblom I’m an actuary; since the PPACA was proposed, the health actuaries I have talked with have said tht PPACA won’t work Oct 04, 2013
‘ @JonathanWeil Say run rate EBITDA for 2013 is $50M. If Market Cap of $TWTR is $12B, that is an astounding EV/EBITDA of 240 $$ #nosebleed Oct 04, 2013
@_DM0_ I can confirm that, they have taken down the slides. Pity, quickest way to absorb the material Oct 04, 2013
@Kitsune808 It is not infrequent that @BloombergNews Headlines are misleading, or quirky. They march to the beat of a different drummer Oct 04, 2013
@PlanMaestro I know, but given attention to the video, I thought I would show the PDF that better fleshes out his position. and the slides Oct 04, 2013
Thanks @onlineawards @TightTalk @valuetakes for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Oct 04, 2013
“”Spain?s public debt in 2014 is expected to be the equivalent of 98.9 percent of total economic?” ? David_Merkel http://t.co/HPR50Rjijp $$ Oct 04, 2013
“Two more: 9) And for those that want to read Ray Dalio’s economic template book, it is free here:” ? David_Merkel http://t.co/QLWdRs1odG $$ Oct 04, 2013
@ToddSullivan A computer could do it anywhere by minimizing the distance of internal boundaries subject to equal popoulations. Not hard. Oct 04, 2013
@ToddSullivan We need structural reform 2 end that given gerrymandered districts. A lot of people want change, but districts not competitive Oct 04, 2013
@kltblom If PPACA were mere risk pooling, I might agree. It is a messy ugly law that ignores basic actuarial principles & will not work well Oct 04, 2013
@volatilitysmile They give us different pieces of the puzzle (insight by http://t.co/sern3wLA13) Oct 04, 2013
#FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Oct 04, 2013
@ReformedBroker The Baby Boomers gray, and money socked away, let finance guys play, make dough every day. Thus so many wealthy $$ managers. Oct 04, 2013
Thanks @ToddSullivan @ReformedBroker for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Oct 03, 2013
Thanks @TightTalk @BabyFreshNuggz @X9T_Trading for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Oct 01, 2013
Thanks @moneyscience @TopInvestBlogs for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Sep 30, 2013
@RexHuppke You are a real man, unlike many today. You may be stupid, but at least you are taking action, rather than compromising w/losers Sep 28, 2013

The Education of an Investment Risk Manager, Part IX (The End)

Posted on 3 October 2013 by David Merkel

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.? Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.? How much implicit equity exposure do we get from our variable annuities?”? The idea was this: as the equity markets go up, so does our fee stream.? If the equity market goes up or down 1%, how much does the present value of fees change?? I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.? At a small broker-dealer, all sorts of charlatans bring their ideas for financing.? The correct answer is usually no, but that conflicts with hope.? Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.? I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.? Go variable by variable, on a long term basis, and ask:

At what level does this bring line profits to zero?
At what level does this bring company profits to zero?
At what level does this imperil the solvency of the company?

5) This story is a little weird.? One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.? You are our representative.? They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.? Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.? He didn’t want to get stuck with losses.? I told him the persuasion was not my forte, but I would do my best.? I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.? Use it.”

A few days later, I was on the Metroliner down to DC.? I tried to understand both sides of the argument.?? I even prayed about it.? Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?? What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.? We had worked together, and AIG didn’t like the idea either.? In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.? Not promising.? We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.? I raised my hand and said something like, “You have to think of the law of unintended consequences here.? What will be the impact on competition here?? What if one us, a large company decides to be more aggressive as a result of this?? What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance??? The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.? The next day I told my boss we had won against hard odds.? He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.? This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.? I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.? Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.? What I found was that I did best buying strong companies in damaged industries.? That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.? In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?? Not many, and even I did not anticipate the intensity of the bust.? At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.? We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.? It is not what you earn, but what you keep that matters.

The Education of an Investment Risk Manager, Part VII

Posted on 1 October 2013 by David Merkel

In late 2007, I was unemployed, but had a line on a job with a minority broker-dealer who would allow me to work from home, something that I needed for family reasons at that point.? The fellow who would eventually be my boss called me and said he had a client? that needed valuation help with some trust preferred CDOs that they owned.

Wait, let’s unpack that:

CDO — Collateralized Debt Obligation.? Take a bunch of debts, throw them into a trust, and then sell participations which vary with respect to credit risk.? Risky classes get high returns if there are few losses, and lose it all if there are many losses.
Trust preferred securities are a type of junior debt.? For more information look here.

I got to work, and within four days, I had a working model, which I mentioned here.? It was:

A knockoff of the KMV model, using equity market-oriented variables to price credit.

Uncorrelated reduced discrepancy point sets for the random number generator.

A regime-switching boom-bust cycle for credit

Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

It was a total scrounge job, begging, borrowing, and grabbing resources to create a significant model.? I was really proud of it.

But will the client like the answer?? My job was to tell the truth.? The client had bought tranches originally rated single-A from three deals originated by one originator.? There had been losses in the collateral, and the rating agencies had downgraded the formerly BBB tranches, but had not touched the single-A tranches yet.? The junk classes were wiped out.

Thus they were shocked when I told them their securities were worth $20 per $100 of par.? They had them marked in the $80s.

Bank: “$20?! how can they be worth $20.? Moody’s tells us they are worth $85!”

Me: “Then sell them to Moody’s.? By the way, you do know what the last trade on these bonds was?”

B: “$5, but that was a tax-related sale.”

Me: “Yes, but it shows the desperation, and from what I have heard, Bear Stearns is having a hard time unloading it above $5.? Look, you have to get the idea that you are holding the equity in these deals now, and equity has to offer at least a 20% yield in order attract capital now.”

B: “20%?! Can’t you give us a schedule for bond is worth at varying discount rates, and let us decide what the right rate should be?”

Me: “I can do that, so long as you don’t say that I backed a return rate under 20% to the regulators.”

B: “Fine.? Produce the report.”

I wrote the report, and they chose an 11% discount rate, which corresponded to a $60 price.? As an aside, the report from Moody’s was garbage, taking prices from single-A securitizations generally, and not focusing on the long-duration junky collateral relevant to these deals.

In late 2008, amid the crisis, they came back to me and asked what I thought the bonds were worth.? Looking at the additional defaults, and that the bonds no longer paid interest to the single-A tranches, I told them $5.? There was a chance if the credit markets rallied that the bonds might be worth something, but the odds were remote — it would mean no more defaults, and in late 2008 with a lot of junior debt financial exposure, that wasn’t likely.

They never talked to me again.? The bonds never paid a dime again.? I didn’t get paid for running my models a second time.

The bank wrote down the losses one more time, and another time, etc.? How do you eat an elephant?? One bite at a time.? It did not comply well with GAAP, and eventually the bank sold itself to another bank in its area, for a considerably lower price than when they first talked to me.

So what are the lessons here?

Ethics matter.? Don’t sign off on an analysis to make a buck if the assumptions are wrong.
Run your bank in such a way that you can take the hit, rather than spreading the losses over time.? (Like P&C reinsurers did during the 1980s.)? But that’s not how GAAP works, and the CEO & CFO had to sign off on Sarbox.
A model is only as good as the client’s willingness to use it.? There are lots of charlatans willing to provide bogus analyses — but if you use them, you know that you are committing fraud.
Beware of firms that won’t accept bad news.

I don’t know.? Wait, yes, I do know — I just don’t like it.? This is a reason to be skeptical of companies that are flexible in their accounting, and that means most financials.? So be wary, particularly when financials are near or in the “bust” phase — when the credit markets sour.

The Education of an Investment Risk Manager, Part VI

Posted on 29 September 201329 September 2013 by David Merkel

My boss walked in and said that we needed to terminate our annuity reinsurance treaty with an entity that I will call Bigco (this happened in July).? Senior management had deemed that we should do it, and in days we visited Bigco, assuming that the actuary in question would approve a termination of the treaty where:

There was no termination provision.
There was a guaranteed minimum return to the reinsurer.
The reinsurer had participation in the upside of profits.

Who negotiated such a treaty?? Very one-sided, and Bigco needed to deploy capital, not contract it.

Could a negotiating position be worse?? Yes, it could, just wait.

When we got to Bigco, we talked with the actuary for a little while, and then he handed us over to the head of M&A.? Uh-oh, he sized up the situation perfectly, and denied our request, unless we were willing to pay considerably above book value to repatriate the assets.

We went home depressed, and a few months after that my boss was summarily fired.? In those days, September was the firing time.? You can imagine what that did for morale.? Personally, I expect my boss was fired because he was most similar the the CEO, and had done things well in managing his line of business.

One day the chief actuary came to me and said, “We have to terminate that treaty.”? I explained to him the backstory, that we had offered to buy it back at an ROE of 9%, and Bigco was demanding 6%.? I said to him, “I’ve already compromised the 10% ROE objective of our company, I don’t want to go further.? I’m free to walk away, right, if we can’t get a decent price?”? He said, “No, the deal must be done.? Under no circumstances can you walk away.”

The sad thing was that any termination of the treaty would positively affect management bonuses.? (That was the real target.)

I had a strong sense that I should always serve the ultimate owners of the firm — the dividend receiving policyholders.? But this was at variance from that.

So, with the weakest bargaining hand that I can imagine, I used the following strategy.? I did nothing.? Nothing. Nothing until early December, where I called the M&A guy at Bigco and and told him, “I’ve had a change of heart.? I’ll accept an ROE of 6.9%.? That’s my final offer!”? This was ticklish because I *had* to get the deal done.

He bit on the offer, and I pressed him saying that between this time and the closing, my market value adjustment formula would rule.? He agreed.? (He probably had a profit goal as well, which was what I was counting on.)

But, he didn’t look closely at the Market Value Adjustment formula.? I gave him one that was volatility-loving, that would adjust of the greater of the absolute value of the yield changes in 3-month T-bills or 30-year Treasury Bonds.? Don’t criticize the guy too much, the Federal Reserve fell for the same tactic on GICs they bought from us.

Before the deal closed, the Fed started tightening monetary policy, and the Market Value Adjustment got us out at an ROE of 9.1%.? What a win, and for the policyholders.? Management got more as well, and I got almost nothing.

I took risks trying to do the right thing, praying the God would help me, and in this case, it worked.? Can you be more righteous than your management team?? In most cases, no, but in this case I succeeded.

I would say to all, try to serve the interests of owners rather than management.? Act like an owner, not like a manager hauling down a fat salary.

It Works, But It Doesn’t Work All The Time

Posted on 21 September 201322 September 2013 by David Merkel

One of the constants in investing is that investment theories are disbelieved, prosper, bloom, overshoot,? die, and repeat.? So is the only constant change?? That’s not my view.

There are valid theories on investing, and they work on average.? If you pursue them consistently, you will do well.? If you pursue them after failure, you can do better still.

How many times have you seen articles on investing entitled “The Death of ____.” (fill in the blank)? Strategies trend.? There is an underlying kernel of validity; it makes economic sense, and has worked in the past.? But any strategy can be overplayed, even my favorite strategy, value investing.? My style of value investing tries to adjust for that, but it is not perfect there.? (And to tell the truth, September has been a bad month for me, though 2013 has been a very good year.)

So what are valid strategies?

Value
Price Momentum
Long-term mean reversion
Insider Buying
Neglect (Low volume relative to market cap)
Accounting Quality (Net Operating Accruals)
Low Equity Price Volatility (which isn’t working now, because it became too popular)
Shrinking Assets
Shrinking Shares (Buybacks)
High Gross Margins as a Fraction of Assets (“Quality,” a quantitative measure of moats.)

This list is not exhaustive, but it is what I use.? The main idea here is to be aware of what is out of fashion, and to be ready to invest when that which drives a strategy to be out of fashion stops getting worse.

So, don’t lose confidence in winning strategies.? Rather, trade out of winning strategies when they are too good, and revisit them when you see the “The Death of ____” articles, or things like them.? This can apply to sectors and industries as well.? Be willing to pick over industries that have underperformed, and buy strong companies that can survive the downturn.? As I have said before, failures occur in weak industries, and after they do, the remaining companies gain pricing power, and thus you invest in survivors.

Value investing is emotionally hard.? You have to be willing to take short-term pain in the interests of long-term gain, if there is a sufficient margin of safety.? No strategy works every month or year.? Returns from valid strategies are most often lumpy.? The markets are almost always lumpy.

Prepare yourself for volatility.? It is the norm of the market.? Focus on what you can control — margin of safety.? By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.

Finally, don’t give up.? Most people who give up do so at a time where stock investments are about to turn.? It’s one of those informal indicators to me, when I hear people giving up on an asset class.? It makes me want to look at the despised asset class, and see what bargains might be available.

Remember, valid strategies work on average, but they don’t work every month or year.? Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.

On Alternative Investments

Posted on 6 September 2013 by David Merkel

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

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

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

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

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

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

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

There are two matters affecting any investment:

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

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

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

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

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

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

A Different Look at Industry Attractiveness

Posted on 24 August 201325 August 2013 by David Merkel

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

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

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

They project the free cash flows in three phases:

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

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

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

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

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

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

Undervalued

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

Overvalued

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

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

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

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

Ben Graham Did Not Give Up on Value Investing in Theory

Posted on 14 August 201314 August 2013 by David Merkel

Hi David,

Love the blog. I am an MBA student and obsessed with the value investing philosophy. There are two points that? could use clarification.

There are so many value investors today, does that mitigate potential rewards? Does value investor competition create less value?

Towards the end of Grahams career he said ” I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities”? This was disheartening to read, but I saw that Jason Zweig commented that Graham was only referring to passive investors.Graham seems to imply otherwise. Any thoughts?

I would really appreciate a response.

All the best.

So wrote one of my readers.? I’ll try to answer both of the questions.

The answer to the first question is relatively simple.? Any strategy can be overused relative to the degree of mispricing in the market.? There can be too many value players.? There can be too many momentum players.? There can be too many investors aiming for dividends, low volatility, high quality, etc.

If you are the only one with a strategy, you can make a ton off of it.? Think of Ben Graham back in the 30s, 40s & 50s… there were few people kicking the tires on seemingly troubled companies that had a lot of unused assets.? It was easy to make a lot of money in that era, for the few that were doing it.

Phil Fisher was a growth investor with a singular insight — look for sustainable competitive advantage, or in the modern parlance, a moat.? He racked up quite a track record in the process.

Or think of Sam Eisenstadt who developed the core of Value Line, building on the ideas of Arnold Bernhard.? He was way ahead of GARP investing by incorporating price momentum, earnings momentum, earnings surprise and valuation into one neat method.? It took a long time before those anomalies were exhausted.? It worked for 50 years or so.

Or think of Buffett, who synthesized many strands of value investing together with an insurance holding company, levering up value investing with an aim of rapid compounding of profits.

Any valid strategy with few users will reap relatively high rewards.? When lots of people pursue it, relative rewards fall.

Value investing has two things going for it that tends to reduce the tendency for the rewards to be played out.? It takes effort, and it’s not sexy.

Value investing can be taken to as deep of a level as one wants.? Sometimes I read the analyses of other value investors, and I say to myself, “This is either masterful, or he had a lot of time on his hands.”? I tend to be more simplistic, realizing that the first 20% of the analysis releases 80% of the value.? I am also a better portfolio manager than I am an analyst, though I’ve had people say to me that my intuition is sharper than many.? (I don’t know.)

The “not sexy” aspect of value investing partly stems from a desire to invest in things that are growing rapidly, because there have been notable growth companies that have made their investors a lot of money.? Why else do you see articles “This stock is the next Microsoft, Apple, Google, etc?”? Creating the next Chevron, IBM, or Berkshire Hathaway would take a lot of time, relatively.

Every now and then, value investing gets crowded, but the advantage never fully goes away for a long time.? Besides, market events like 1973-4, 1979-82, 1987, 1998, 2002-3, and 2008-9 shake up things so that there are a crop of new opportunities.? As I said to my boss in 2007 when he was giving me a bad review, “When I came here in 2003, it was as if the applecart had been knocked over, and easy values were easily picked up, like apples.? Today, there are no easy pickings.”

Okay on to question 2.? Part of the problem here is the famous part of what Graham had to say is well-known but the whole article is not well-known.? Here is the whole article.? And here is the famous quote, again:

In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

On the face of it, to a value investor, this is rather disheartening.? Who wants to see the founder abandon the heritage? But I mostly agree with Jason Zweig, because this has to be taken in context with the other things he said in the FAJ article.? Let me explain:

First, since Ben Graham, we have discovered a wide number of anomalies in investing: earnings quality, momentum, distress, asset shrinkage, share shrinkage, neglect, etc.? We haven’t been impoverished because we no longer have net-nets (cheap companies with unused assets) to invest in.? We’ve sharpened the discipline beyond what Ben Graham could have imagined.

Second, if you read the full article, Ben Graham still defends value investing:

Turning now to individual investors, do you think that they are at a disadvantage compared with the institutions, because of the latter’s huge resources, superior facilities for obtaining information, etc.?

On the contrary, the typical investor has a great advantage over the large institutions.

Why?

Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations — and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.

What general rules would you offer the individual investor for his investment policy over the years?

Let me suggest three such rules: (1) The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase–in other words, that he has a margin of safety, in value terms, to protect his commitment. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase–say 50 to 100 per cent–and a maximum holding period for this objective to be realized–say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.

This is value investing.? What Graham is suggesting won’t work is that big investors who have a lot of money to put to work will be forced into big names that are over-analyzed.? He is not saying that analysis of less followed names won’t work; the small size of the individual investor is an advantage, not a curse.

Then Ben Graham says:

What general approach to portfolio formation do you advocate?

Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.

Can you indicate concretely how an individual investor should create and maintain his common stock portfolio?

I can give two examples of my suggested approach to this problem. One appears severely limited in its application, but we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds. The second represents a great deal of new thinking and research on our part in recent years. It is much wider in its application than the first one, but it combines the three virtues of sound logic, simplicity of application, and an extraordinarily good performance record, assuming–contrary to fact–that it had actually been followed as now formulated over the past 50 years–from 1925 to 1975.

Some details, please, on your two recommended approaches.

My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net-current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. We used this approach extensively in managing investment funds, and over a 30-odd year period we must have earned an average of some 20 per cent per year from this source. For a while, however, after the mid-1950’s, this brand of buying opportunity became very scarce because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In January 1976 we counted over 300 such issues in the Standard & Poor’s Stock Guide–about 10 per cent of the total.? I consider it a foolproof method of systematic investment–once again, not on the basis of individual results but in terms of the expectable group outcome.

Finally, what is your other approach?

This is similar to the first in its underlying philosophy. It consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months.? You can use others–such as a current dividend return above seven per cent or book value more than 120 percent of price, etc. We are just finishing a performance study of these approaches over the past half-century–1925-1975. They consistently show results of 15 per cent or better per annum, or twice the record of the DJIA for this long period. I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public.

So, no, Ben Graham did not give up on value investing.? One could easily say that he was arguing for value indexing.? He knew what characteristics of cheapness would lead to superior returns.? He also thought there was room for value investing outside of the largest 400 companies available for investment.

He did recognize that the easy days were gone.? Analyzing liquid assets net of liabilities no longer paid off.? But value investing, buying assets with a margin of safety, and buying them cheap to their intrinsic value was not dead, at least for small investors.? What Ben Graham would have learned had he lived longer was that value investing would adapt, and find new ways of seeking value.? We are you heirs, Ben, and we have built upon your work.

As a final note, though Ben Graham sought “the good life” and was often more concerned with the arts than investing, he was the original quantitative investor.? He recognized aggregate behavior of stocks relative to valuation criteria, and saw that such value investing still worked.? But with individual issues, the “Happy Hunting Ground” of the 30s, 40s and 50s no longer existed, aside from ’74-76.? That’s what Ben Graham meant when he no longer believed in individual security selection for value investing.

PS — When I initially inclined to write this piece, I did not think I would write this.? I thought I would support the mainstream opinion — that Graham gave up on value investing. I can now tell you that that view is wrong. :D? Very wrong.

Full disclosure: Long BRK/B, CVX

Best of the Aleph Blog, Part 22

Posted on 9 August 2013 by David Merkel

These articles appeared between May 2012 and July 2012:

On Distribution Formulas

Most formulas for distributing income from an endowment or a a savings/investment fund are too liberal.? If you want the purchasing power to last, distribute less.

Correlating Risky Assets

How do correlations come into existence with risky assets.? This piece explains.

Simple Stock Valuation

An exploration of Eddy Elfenbein’s simple stock valuation model.

Don?t Become the Market

When any firm becomes the dominant provider of a good or service, it should ask whether it has mispriced.? A veiled critique of JPM’s whale trade in the credit markets.

In Defense of Nothing

Manufacturing is overrated.? We’ve got enough things, now we need services to make our lives richer.

Little Things are Important

When leverage is high, little things failing can lead to large and bad results.

High Profits

Labor is not scarce, so profit margins are high.? Will that last forever?? No, but it might be a while.

23,401 Auctions

391 Auctions

A pair of pieces suggesting that the markets could be better off if we held auctions once a second, or once a minute.

The Rules, Part XXXII

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.? The process cannot work in reverse, except by accident

The Rules, Part XXXIII

When politicians don?t have answers, they blame speculators, financiers (Wall Street), or foreigners.? They do anything to take the spotlight off their culpability or ineptitude.

Aim for the Middle

Very basic advice that tells you that the best returns come from taking moderate risk.

Works if Small, Fails if Large

Another bogus theory of asset allocation that works today, because markets favor it, and not enough people are using it.

Strong Hands

On the value of long-term investors holding stocks that you hold.

Logical Links

If there are a lot of links in a chain of reasoning, it is likely to be wrong.

Modified Glass-Steagall

I suggest a number of reforms that would be more effective than reinstating Glass-Steagall.

Don?t Blame Money Market Funds

On the hypocrisy of the SEC and the banking regulators

Do Insurance Stocks Do Better than Average Over the Long-Run?

The answer is probably, but not certainly.? Really, it is a mess.

On Life Insurance and Life Reinsurance

Explains why I like the life reinsurance oligopoly

On Bond Ladders

The most robust strategy for interest rates; always second-best, and never the worst.

On Internal Indexes, like LIBOR

An Analysis of Three-Month LIBOR 2005-2008

On Floating Rates

In most scandals, not enough attention is paid to those who should have been questioning the situation and did not.? There were parties angling for higher LIBOR and lower LIBOR.? Anytime you borrow or lend using an index, you assent to the method of the index.? What, you didn’t analyze it?

The Failure of Government-Provided Prosperity

The government has almost no control over prosperity, and yet it tries to take credit for it, and ends up ruining prosperity through deficits and loose monetary policy.

Grow Embedded Value

The main idea in investing is finding investments that will compound your money at an above average rate, with a margin of safety.

The Education of a Mortgage Bond Manager, Part I

The Education of a Mortgage Bond Manager, Part II

The beginning of my eight-part series on mortgage bonds.? I did it well for three years.

Packages! Packages!

A tale of my younger investing days, when I would mail companies for data.

Missing Earnings Estimates

Why occasional earnings misses are desirable.

Forget Your Cost Basis

All good investment decision-making is forward looking.? Whether you are buying or selling, it doesn?t matter where prices have been in the past.

Concentrated Interest

This piece generated a lot of heat, but I still stand behind it.? The concentrated interest of a profit motive is a good thing, and all of the government services do not affect what you have done at all.? The entrepreneur is a hero, whether in business, government, or elsewhere.

Advice to Two Readers

Posted on 3 August 2013 by David Merkel

I get a lot of requests for advice.? Here are two of them.

David,

?I really appreciate you discussing your trading/haggling strategies in the Education of a Corporate Bond Manager. ?It’s definitely given me new ideas and helped me get better pricing in my purchases the last couple of years. ?I still refer to them every few months or so.

I have a question about changing jobs in the fixed income industry – I work in a treasury division, managing my company’s cash and short-term investments. ?I’ve done well, but we use yield-based benchmarks, as part of the portfolio is used to immunize short term liabilities. ?When I interview with asset management shops, they want previous total return portfolio management experience. ? ?

Do you know any particular types of firms or sub-industries that use yield-based benchmarks? ?Does managing to a yield benchmark stunt my learning growth compared to a total return mandate?

Yield-based benchmarks exist when:

The liability structure being invested against is short (We could need this cash at any moment for business use!)
The liability structure is long, but well-defined, such as a bank or insurer that wants predictable income versus their liabilities, and so the game becomes maximize spread net of default costs, subject to matching asset and liability durations (and maybe partial durations if the liability stream is long).

You are doing the first of these.? Truth, what you are doing could be measured on a total return basis, but it wouldn?t make a lot of difference.

The second one applies to banks and insurers, and can be done on either basis as well.? The difficulty comes with trying to calculate the total return of the liabilities. ??If that it too hard to do, they create a bond benchmark that they think represents when they think the liabilities may pay out.? If the liabilities possess some degree of optionality, like that of residential mortgage prepayment, the benchmark could include bond options (long or short).

The yield on the bond benchmark is easy to calculate, as is the total return.?? Thus relative performance can be calculated either way.? I had to do this for an insurance client once who insisted that our performance was poor when we had returned more than 0.70% year more than single-A corporate, which was quite good.

Thus, one place you could try working is for is an insurer, bank, or other financial intermediary.? But what of those that manage funds for retail.? What then?

Aside from unconstrained funds, even a mutual fund has a liability to invest against ? the expectations of the client.? In that sense, most mutual fund managers aren?t doing full total return either ? they have to stay within a certain range for interest rate sensitivity. They also could be evaluated on the basis of yield realized versus that of a generic portfolio meeting their interest rate sensitivity targets.? More commonly, they would be ranked against their competitors on a total return basis.

In closing, it you don?t want to manage money for a bank or insurer, you?ll have to try to wedge your way into work in a total return environment ? taking a junior level position, and showing competence.? Believe me, most firms would love to promote from inside, if possible.

Sincerely,

David

Dear Mr. David Merkel,

I really appreciate your hard work you are putting in your site and I am an avid reader of it. I would like to seek your advice regarding a decision I am facing. My goal is become a value investor and establish my own asset management firm to manage my own money and other people’s money. Right now, I have the opportunity to pursue partnership in my family business and be able to run it along with my father. I am 23 years old, and I am a freshman student at the _+_+_+_+_.? If I am to be a partner in my family business, I have to drop out from the university and travel to +_+_+_+_+_+_+_, where the business is. I am still a freshman student because when I was 19 years old, I dropped out to establish my own business in the same industry as my family in +_+_+_+_+_. I had an experience running a business and I had the opportunity to sell my business after two years of operation to my cousins, and, thankfully, it was a profitable venture.

My family business is somehow facing sales shrinkage and cash flow problem due to low capital (my family made terrible mistakes in managing it) and economic downturn. They are specialty contractors and manufacturers of fenestration products (windows, doors, kitchens, curtain walls, and rolling shutters). If I am to work with them, I can be able to help them in reorganizing the company. It might be risky for me, but if everything worked out well enough, I will have earnings that I believe is better than being an employee.

I am facing a decision that I need to make. You might not be able to advice me, but whatever advice you give me, I appreciate it. If my goal is to manage my own money and other people’s money by establishing my own asset management firm, is it helpful to have a university degree or the experience of having ran a business? Shall I drop out and pursue my family business opportunity? If I am to continue studying, I will incur student loan debt which I won’t prefer. But, alas, I will do it if it need be to accomplish my goal. Thank you a lot.

You have my sympathies on two fronts:

1) Choosing between family obligations and personal goals is never easy.? I have had to face that in deciding what jobs I could take while raising my family.? I was recruited for a managing director position in an investment bank in the mid-90s, but passed it up because I could not peel away that much time from my family and church.? It took a lot of time for me to become an institutional investor as a result.? I became an investment actuary at the age of 31, started working in an investment department at age 37, started work at a hedge fund at age 42, and started my own firm at age 49.? By 49, I had more than enough assets to care for my family if my business failed, at least to put the kids through college.?? After that, I could be stretched.

2) Good operational businessmen can be very good investors.? There are synergies between the ability to operate a business, and the ability to make good investment decisions.? Don?t think that building another business is a waste of your time.? It will sharpen you in ways that most institutional investors never grasp.? I benefited a great deal from building profitable business within insurance companies, and it sharpened my knowledge on how to invest.

Now, all that said, if you take time out to rebuild your family?s business, don?t neglect your education.? Read good books on value investing, and study those who have been great.? I?m not saying that college is useless, but I am saying that much of the knowledge that academics teach on economics is deficient.? In some ways, it is better to be a clever businessman than an academically trained man.? The latter will not gain much insight into how to invest.? The businessman has a better chance.

Perhaps a good compromise would be to study for the CFA credential in your spare time.? I did that.? Along with that, invest some of your money in ideas that you think are worthy.? I did that from 1992-2003, before I began investing in stocks professionally, and I did very well.

You need to find out whether you have significant insights versus the rest of the markets.? Academic learning will not help that.? Operational business experience *might* help that.

Don?t give up your goal of managing your own value investing firm, but realize that there are many paths to getting there, and the most important thing is trying to develop insight into the markets that others don?t have.? Typically, academic study does not develop that.

I hope things work out for you.? Let me know how you do.

Sincerely,

David