Quantitative Methods – Page 39

The Fundamentals of Market Bottoms

Posted on 7 August 200820 June 2017 by David Merkel

A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion? ? yes, residential real estate was near its top.? My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.

As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, ?Real Estate?s Top Looms?:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.

8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.

10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

11) Value investors find no lack of promising ideas, only a lack of capital.

12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.

14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

Changes in Corporate Behavior

1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.

3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??

4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.

5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

8 ) High quality companies keep buying back stock, not aggresssively, but persistently.

Other Indicators

1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.

2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:

Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.

Analyzing Growth in Firm Value

Posted on 2 August 20082 August 2008 by David Merkel

We’re nearing the end of second quarter earnings season, and I have have had my share of hits and misses, compared to the estimates that the sell side publishes.? What is the sell side?? The sell side is the analysts working for broker-dealers who publish research on companies, often estimating what they think they should earn in a quarter or year.? There is a buy side as well, which are analysts working for mutual funds, asset managers, etc., who analyze companies for their employers.

As investors, we are pelted with terms for corporate performance:

Comprehensive income — increase in net worth (approximately)
EBITDA? (Earnings before interest, taxes, depreciation and amortization) — what monies are the assets of the company generating in cash terms
Operating income — Net income, excluding one-time charges.
Net income — An attempt to show the repeatable increase in the value of the business, excluding the adjustments that operating income makes.? It also excludes “temporary differences” that are expected to reverse, which go into Accumulated Other Comprehensive Income on the balance sheet, and not through income.? An example would be unrealized capital losses on unimpaired credit instruments.

Which of these measurements should an investor use?

In takeovers, EBITDA is the most relevant, because it shows the cash generating capacity of the assets.
Operating income is the most relevant each quarter for companies that are going concerns.? It excludes “one time” events.
Over the long haul, accumulated net or comprehensive income is the most relevant, because all of the “one time” adjustments are aggregated.

In the short run, the adjustments that come from one-time events (mostly negative) can be tolerated.? But managements are supposed to try to control the factors that generate one-time events in the long run.? That part of their job.? If you have enough track record on a management team, you can sit down and calculate accumulated operating income less accumulated net income.? For good managements, that number is negative to a small positive.? For bad managements, it is a big positive.? I’ve seen estimates over a long-ish period of time, and the average difference between the two is around +5% — +10%.? That much typically goes up in smoke from operating earnings, never to reappear.

Now, some have toyed with adjusted dividend yield formulas, where they add back buybacks, and they use that as a type of true earnings yield.? After all, that reflects cash out the door for the benefit of shareholders.? True as far as it goes, but other uses of retained earnings aside from buybacks are valuable as well.

Buy/create a new technology, plant or equipment
Buy/create a new product line
Buy a competitor, or, a new firm that offers synergies
Buy/create a new marketing channel

In the hands of a good management team, these actions have value.? In the hands of bad management teams, little value to negative value.? So, I prefer earnings to these new measures based off dividends and buybacks for good management teams.? With a bad management team you want them to not have much spare capital for bad decisions, but would you trust the safety of the dividend and commitment to the buyback to a bad management team?? So, in general I prefer earnings, or, if calculable, free cash flow, to dividend/buyback metrics.

What is free cash flow?? The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.

Ideally, free cash flow generation is what we shoot for, but it is difficult to estimate in practice.? When I took the CFA exams, the accounting text suggested that the goal of earnings was to reflect free cash flow to the greatest extent possible.? I’m not holding my breath here; I don’t think that goal is achieved or achievable.? To do that, we would have to have managers expense maintenance capex, and we would have to reflect the capital requirements of financial regulators as a cost of doing business for financial companies, and there are many more adjustments like those.

So, I like accumulated net income in the long run and operating earnings in the short run for measuring financial performance.? I’ll give you one more measure to consider which might be better.? From a not-so-recent CC post (point 2, rest snipped for relevance sake):


		David Merkel
		Notes Before I Leave for ANother Series of Conferences
		11/9/04 5:44 PM?ET
1. Be sure and read Howard’s piece “Hurricanes and the Limits of Rebuilding .” He comments more extensively on something I touched on when Frances was threatening Florida. Recovery from disasters often makes GDP look better afterward, because the destruction is not captured in the GDP statistics as a loss, save for the reduction in insurance profits, whereas the work of rebuilding does get fully captured. 2. The same idea can be applied to equity investing. This is why I pay attention to growth in book value per share, ex accumulated other comprehensive income, plus dividends, rather than earnings. Nonrecurring writedowns, charges for changes in accounting principles, and other adjustments, if they happen often enough, it makes a statement about the way a company handles accounting. Companies that are liberal in their accounting may have good looking earnings, but growth in book value per share can be quite poor. I trust the latter measure.

Growth in fully diluted tangible book value (ex-AOCI) is a good measure of firm performance, if you add back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price. Why the current market price?? Some managements buy back stock indiscriminately, not caring about the price at purchase.? That’s rarely a good idea.? Good management teams wait until their shares are near or below their estimate of fair value before they buy back.

Good management teams are also sparing/judicious with share and option grants.? Measuring the cost of the issuance/grants/dilution at the current market price penalizes the financial performance appropriately for what they have given away from shareholders equity per share all too cheaply.

So, that’s my preferred measure for how much has the underlying value of the firm increased: growth in fully diluted tangible book value (ex-AOCI), adding back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price.

There are things that this measure does not capture, though.? Look for places where assets are misstated on the balance sheet. E.g., property may be worth more or less than the carrying value.? Plant and equipment may be worth more or less than the carrying value.? Having a feel for the appreciation/depreciation in value, however slow, can be an aid to estimating the true change in value for a firm.

Estimating the true value of a firm’s earnings is challenging.? There is no one good measure; it depends on the question that you are trying to answer.? But knowing the outlines of of the problem helps in analyzing the earnings releases as they pelt us each quarter.

PS — I know I have excluded EVA, NOPAT, and other measures here.? Perhaps another day…

Additional Tickers for the Reshaping

Posted on 5 July 20086 July 2008 by David Merkel

Readers have suggested some additional tickers for me.? Here they are:

GE, MSFT, BMY, BA, ANAT, KCLI, and DE

Beyond that, there was my country screen — cheap names in Taiwan and Korea that trade in the US?

WF SHG LPL KEP KB IMOS AUO

Then for the industry screen.? Here’s the most recent list of cheap industries; I used the ones labeled “Dig Through”:

Remember, this can be used in momentum mode (red) or value mode (green).? I’m using it in value mode, and it gave me a flood of tickers — remember, in this screen, Price-to-book times Price-to-next year’s earnings must be less than 10.? That’s usually a pretty strict criterion, but this time it turned out 121 tickers:

ABD ABG ACE ACGL AEG AEL AFG AGII AIG AMCP ASI AWH AWI AXA AZ BBI BBW BC BKI BWINA BWINB BWS BZ CAB CHB CINF CMRG CNA CNO CONN CPHL CRH DSITY EBF EIHI FFG FMR FNF GBE GIII GLRE GNW GT HALL HMN HSTX IHC INDM ING INT IP IPCR KGFHY KPPC LFG LGGNY LIZ LNY M MERC MGAM MHLD MIG MIGP MRH MRT MSSR MTE MW MYSZY NP NSANY NSIT NYM OB OSK OXM PAG PCCC PEUGY PL PMACA PNX PSS PTP PTRY RCL RE RNR ROCK RSC RT RUSHA RUSHB RUTH SAH SEAB SEOAY SIGI SMLC SSCC SSI SUR SWCEY SWM THG TI TRH TUES TWGP UFCS UFS UNM UPMKY USMO UTR VOXX VR WHR XL ZFSVY

Well, the quantitative ranking method will have its work cut out when I build the main spreadsheet — it will take some effort to scrub the accounting data, and come to some buy decisions, but that’s my next task.

Now, That Was Fast!

Posted on 6 June 2008 by David Merkel

From the RealMoney Columnist conversation yesterday:

		David Merkel
		Stealing a March; Next Comes the Pile-On
		6/5/2008 3:37 PM EDT

So yesterday Moody’s places MBIA and Ambac on Negative Watch. S&P grabs the ball and downgrades them, leaving them on negative outlook. I pointed out a while ago that the dike had been breached, and it was only a matter of time until the downgrades came.

And, as I pointed out yesterday, there will be new entrants to the market. Not only will Berky be there, with Assured Guaranty and Dexia, but Macquarie Group joins the party as well.

Even if Ambac and MBIA (the holding companies) survive, the business that used to be profitable for them will be occupied by others. I’ll throw this out as my next prediction in this space: they both go into conservation, and in runoff, claimants get paid off, senior debtholders get nicked, subordinated debtholders lose a lot, and the equity is a zonk.

Position: none

		David Merkel
		This Is a Great Country
		6/5/2008 3:41 PM EDT

One last note: the stocks rally after the downgrade. Probably short covering and other derivative-related activity, but you have to admit it is amazing for the stock to go up when the franchise gets destroyed.

Position: none

-=-=-=-=-=-=–==–==-=–=-=-==–=

Okay, after yesterday’s piece, there was a fast, opportunistic reaction by S&P. Moody’s action gave them cover to downgrade, and S&P took the ball and ran with it. Now that action gives Moody’s the cover to downgrade freely. There is no longer any reason for them to stay at Aaa. There is no money in it, and their reputation can only take further his from here. Rating agencies are like wolf packs — there is safety in the pack. Don’t be an outsider.

From one of my old RealMoney pieces (12/1/2004): Many of the conflict-of-interest problems still exist today. One more example: Could the ratings agencies downgrade MBIA (MBI:NYSE) or Ambac (ABK:NYSE) even if they wanted to? MBIA and Ambac rely on their Aaa/AAA ratings to the degree that they would have a difficult time operating without the rating. Much of the bond market relies on enhancement from MBIA and Ambac. The loss of a Aaa/AAA rating would be a jolt to the guaranteed bonds.

In addition, MBIA and Ambac structure their risks according to models provided by the ratings agencies. It is the models of the ratings agencies that tell the guarantors how much equity must stand in front of the debt that is being guaranteed. The ratings agencies are an inherent part of the business model of the financial guarantors. MBIA and Ambac can’t get along without them.

The ratings agencies derive so much income from these major financial guarantors that their own financial well-being would be affected by a downgrade. I’m not saying that either should be rated less than Aaa/AAA, but there is a cliff here, and I am wary of investing near cliffs.

Well, we came to the cliff, and S&P shoved MBIA and Ambac to the edge. Now Moody’s can push them over the edge. It should come soon. As with the rating agencies actions on the other financial guarantors, once a guarantor is pushed below AAA, the rating no longer matters as much. There are dedicated “AAA only” investors that care about this, and they will be forced sellers now, or, they will modify their investment guidelines. 🙁

Now, as I have mentioned before, stable value funds will have their difficulties here. Some have positioned themselves as “AAA only” funds, and that led to large holdings of MBIA- and Ambac-guaranteed debt. What they do now is beyond me. I suspect they try to modify their investment guidelines. 🙁

Well, at this point, we have to contemplate life without the old guarantors. They will shrink and disappear, while new guarantors, who are all currently skeptical of doing much more than Municipal bond insurance, will grow, and make it impossible for the old guarantors to return, because they are much better capitalized. Once you lose your AAA as a guarantor, you will rarely get it back.

Don’t Do It!

Posted on 5 June 2008 by David Merkel

Fifteen years ago, when I was still pretty much a novice investor, I went to an AAII meeting to hear Jeremy Siegel speak about his new book, “Stocks for the Long Run.”? I brought my copy to have him sign it.? I hung around after the talk to? listen to some of the more informal things he might say, and in a dead moment, I asked him (something to the effect of),? “You suggest that young people should lever up to buy stock; do you really mean that?”? His answer was and unreserved “Yes.”

Dr. Siegel is brighter than me.? The guys who write the CXO Advisory Blog are brighter than me as well.? Felix Salmon is clever, and he puts up this supporting piece.

I am here to disagree.? Why?? It is all very well and good for academics to assume that returns occur randomly, but returns occur in streaks.? Think of all of the “lost decade” articles you have seen in the recent past.? Here’s my main reason for not levering up while young: It won’t work well about? one-third of the time, because young people will take humongous losses during a “lost decade,” and in the panic, they will sell at the wrong time.? My secondary reason, is that in really bad markets, such as 1929-32, 1973-4, and 2000-2002, you could be wiped out.

Don’t trust the results that rely on the veracity of Modern Portfolio Theory, when those ideas would have failed off of historical returns.? As I often say, “The markets always have a new way to make a fool out of you.”? This is another example.

One final note, perhaps more scholarly: the idea of levering up requires buying and holding, and that bad markets happen randomly, with no streaks.? Unfortunately, the equity market returns less than a buy-and-hold investor receives, because people buy and sell at the wrong times.? Buy-and-hold investors are daring people; they confront the natural tendencies toward greed and panic, and they do better than average in the long run.? One buying and holding on leverage would have to have a steel gut, which is not characteristic of younger investors.

So, don’t lever up.? I say this to investors young and old, experienced and inexperienced.? Getting an equity-like return is difficult enough in the long run.? Don’t make your life more difficult by levering up.

Book Review: When Genius Failed

Posted on 4 June 200822 June 2017 by David Merkel

One review of a good Roger Lowenstein book deserves another? Perhaps good things come in pairs. 😉

I decided to review “When Genius Failed,” because reading “While America Aged” reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.

I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)

When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.

The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.

Um, oh yeah, book review.? LTCM suffered from a number of troubles:

They were systemically short liquidity.
They did not consider the effect of others mimicking their trades.
They were internally disorganized; leadership was weak.
They intensified their leverage at the wrong time.

The liquidity aspect is significant.? Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also.? LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities.? This set the stage for the run-on-the-fund.? Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.

In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.

The lack of discipline inside LTCM, was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book.? Financial businesses that last require tight controls on risk taking.

Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends.? They levered up at the wrong time.? The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.

Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed.? It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking.? The assets are illiquid, the liabilities are more liquid.? Their balance sheets are opaque.? Many of them are in the same risk posture.? Many of them are more leveraged than they would like to be.? Bear has already fallen, will Lehman fall next?

Just because investors are smart does not mean that they are infallible.? Any investor playing at a high enough level of leverage can be ruined.? This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors.? Not losing money is a big help in making money, and skepticism in investing is usually a plus.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission, and your costs don’t increase. This is my version of the ?tip jar.? Thanks to all who support me.

A Good Month — A Good Year, so far

Posted on 31 May 2008 by David Merkel

Of the 35 stocks in my portfolio, only 4 lost money for me in May: Magna International, Group 1 Automotive, Reinsurance Group of America, and Hartford Insurance.? My largest gainer, OfficeMax, paid for all of the losses and then some.

I am only market-weight in energy, so that was not what drove my month.? Almost everything worked in May: company selection, industry selection, etc.? My other big gainers were: Charlotte Russe, Helmerich & Payne, Japan Smaller Capitalization Fund, and Ensco International.? I have often said that I am a singles hitter in investing — this month is a perfect example of that.

Now, looking at the year to date, I am not in double digits yet, but I am getting close — I am only 3.6% below my peak unit value on 7/19/07.? My win/loss ratio is messier: 15 losses against 32 wins.? It takes the top 5 wins to wipe out all of the losses.? The top 5: National Atlantic, Cimarex, Helmerich & Payne, Arkansas Best, and Ensco International.? Energy, Trucking, and a lousy insurance company that undershot late in 2007.

The main losers: Deerfield Triarc (ouch), Valero, Royal Bank of Scotland, Avnet, and Deutsche Bank.

I much prefer talking about my portfolio than individual stock ideas, because I think people are easily misled if you offer a lot of single stock ideas.? I have usually refused to do that here; I am not in the business of touting stocks.? I do like my management methods, though, and I like writing about those ideas.? If I can make my readers to be erudite thinkers about investing; I have done my job.

So, with that, onto the rest of 2007.? I don’t believe in sitting on a lead — I am always trying to do better, so let’s see how I fail or succeed at that in the remainder of 2007.

PS — When I have audited figures, I will be more precise.? You can see my portfolio, for now, at Stockpickr.com.

Full disclosure: long VLO AVT NAHC XEC HP ESV MGA GPI RGA HIG OMX CHIC JOF

Industry Ranks

Posted on 31 May 2008 by David Merkel

Time for another dose of my industry ranks.? Here’s the list, complete with the ideas that are most attractive for me to investigate:

Remember, this uses the Value Line Industries, and it can be used in Value mode (green industries), or Momo mode (Red industries)? I look to buy from the green list, but I have a tendency to let companies that I own that are on the red list hang around.? Momentum tends to persist in the short run, and I have usually trimmed exposure due to my rebalancing discipline.

My next reshaping is not until early July, but I expect that it will be a doozy, because I will redeploy proceeds from National Atlantic, as well as a new slug of cash that I have received.? I’m running at 12% cash now, but if you count in National Atlantic, it is more like 18%.? That has to come down, so in a month or so, I will have to deploy cash.? I’m looking for a downdraft to do it in, but those don’t always come on schedule.

Full disclosure: long NAHC

Concluding the Current Portfolio Management Series

Posted on 18 May 2008 by David Merkel

To start, let me gather together my conclusions from the prior articles, and add one more:

Get the right industry.
Get a bright management team.
Don?t panic over small setbacks. Buy more.
Rebalance your portfolio regularly to fixed weights.
Dividends matter.
Buy cheap.
Trade away for better opportunities when you find them.
Don?t play with companies that have moderate credit quality during times of economic stress.
Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
Spend more time trying to see whether management teams are competent or not.
Cut losses when your estimate of future profitability drops to levels that no longer justify holding the asset.
Diversify, diversify, diversify!

Okay, take another look at the graph above, and see that my gains are bigger and more frequent then my losses. Nonetheless, I took some significant losses. How could I bear those losses? Diversification. No position has ever been more than 7% of my portfolio, and the normal position is 2.9% in my 35 stock portfolio. I can take some whacks on individual positions if my overall investing is working.

My key question in deciding whether to sell a stock is whether I think its future returns are likely to be less than alternative investments. That is the only good reason to sell a stock, but few investors follow that rule. I may get my estimates of future value wrong, but if I do it consistently, my results should be good.

You can review my eight rules here. From my prior articles, you can see how my rebalancing trades have added value overall, even though on my losing trades, they added to the losses. Value works, Momentum works, and industry rotation works if it is done right.

My focus on accounting integrity, similar to to the work done by Piotorski, helps value investing work by avoiding value traps. I don’t miss every trap, but if I miss enough of them, I end up doing well.

Finally, our minds are not geared to make decisions where the dimensions of the decision are large. My methods compress the dimensions of the decision, and turn the decision into a swap transaction, where you trade something worse for something better.

That’s what I do in investing, and perhaps in the near term, I will gain my first sizable external clients. In closing, here is a list of all of my trades over the past 7.7 years:

Full disclosure: long the portfolio listed at Stockpickr.com.

Book Review: Beating the Market, 3 Months at a Time

Posted on 26 April 200826 April 2008 by David Merkel

A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.

Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…

I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.

If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.

Enough about my review process; on with the review:

When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.

The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.

Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.

I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.

Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?

Commend

Momentum effects do tend to persist across equity styles.
Momentum effects do tend to persist across international regional equity returns.
Momentum effects do tend to persist on high yield returns in the short run.
The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
Keeps investment expenses low.
Gives you some more advanced strategies as well as simple ones.
The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)

Discredit

The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.

The Verdict

I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:

There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
Interest rates are low today, and equity valuations are not low.

Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.

Full disclosure: If you buy anything from Amazon after entering through one of my links, I get a small commission.