Speculation – Page 16 – The Aleph Blog

Book Review: Backstage Wall Street

Posted on 21 March 2012 by David Merkel

I have long wanted to see a book that would teach ordinary investors how to avoid being cheated by those that create/sell financial products.? If this book isn’t it, the one that surpasses it will be astounding.? If Wall Street is a show, this book gives you a peek behind the curtain.

This book is really four mini-books in one:

1) How the author became a broker, and the ethical difficulties that were forced on him in the process.

2) The difficulties faced by do-it-yourself? investors, and the benefits of exchange-traded funds [ETFs].

3) On Brokerages, and all their conflicts of interest, culminating in the straight line pitch.

4) Investments to avoid, and advice from the wise.

That it is four in one is not a weakness but a strength.? Wall Street has many ways to skin investors, and each section provides insights that different people will benefit from.? It is a more comprehensive book in its short 240 pages as a result.

On Brokers

The first part of the book describes Wall Street as it was and is, with all of the players and their motives.? Josh spares no one; the tone of the book is cynical, but not unduly so, noting all of the problems with a profane sense of humor.? Some of the funniest bits of the book are recollections of conversations with greedy parties seeing an edge.

There is a certain level of despair for young brokers as they “cold call,” knowing that if they don’t succeed, they will be let go, but driven by the possibility of riches should they succeed.? Those who are successful gain money, prestige, bragging rights, and some level of freedom from tight control.

I have my own experience with this. though mostly on the institutional side where I told such brokers “Why would my client want that?!”? It’s astounding what level of deception those who sell investments will engage in, until they realize you can’t be conned, and then they use your ideas to con others.? (The institutional brokers only make money on transactions; if they know you are smart, they facilitate your ideas at the expense of those less talented.? Ugly, I know, but I didn’t invent this.)

On Do-it-Yourselfers

Now, if you are a total “do-it-yourselfer” like I was in the ’90s, where I researched and bought my own stocks for myself, with some success, this is not for you.? This is for those who research and use mutual funds and ETFs.? It goes into the history and development of asset management fund structures, explaining why they are how they are.

He also describes how the modern era came into existence with discount brokerages in the ’70s, and how during the bull of the ’90 it morphed into anyone can make tons of money, just buy stock!? One thing Josh does not talk a lot about, but was significant, was how when fixed commisions ended, the real reason for maintaining research staffs died.? And, when tick sizes moved from a eighth to a sixteenth to a penny, the reasons for having market makers and specialists dried up.? But you can’t cover everything.

One particularly funny part is page 110, with its real-life definitions of fund types.? Josh is at his best in the section where goes after leveraged and inverse ETFs, where a lot of investors lose money because they are meant to track daily performance of indexes, and generally lose money for those that hold them long-term.? He is similarly good when he criticizes the proliferation of ETFs that are too unique, and will never get a broad following.

On Brokerages

Brokers position themselves as experts, when they are really order-takers.? They hire analysts that are not that good on average, and issue more buy than sell opinions, which facilitate the investment banking and trading businesses.? It talks about the stories that brokerages tell in order to captivate people and make them invest.

And then, Josh discloses the “Straight-Line Pitch,” which has been used on many investors to make them invest with the brokerage.? I have to admit, given some of the initial publicity on this point, and my own experience with brokers, I was dubious about this part of the book, and, Josh leaves it to the end — this is the climax!

I was pleasantly surprised, and I would recommend that all investors read chapter 20.? Why?? To immunize yourself from the clever talk that boxes you in as they offer slick answers to your objections.? That is a major reason why I read books on marketing: I can’t be tricked!? (But it does force me to do my own research.)? If you don’t want to be tricked by clever brokers, read chapter 20.? It isn’t necessarily the best chapter of the the book, that will depend on your own needs, but chapter 20 is unique.

Oh, and why have I not experienced this? Being a total do-it-yourselfer, I told brokers that I knew better than they did; it led to some weird conversations as they found I knew more about it than their talking points.

Investments to Avoid — Advice from the Wise

Most bad investments are either volatile or illiquid.? Why do brokers sell illiquid investments?? Because they get high commissions.? Same for insurance agents.

Then there are investments that sneak between the regulatory cracks, like Chinese reverse mergers, Special Purpose Acquisition Corporations, and anything with secondary guarantees, or the sale of options to enhance income.

Ask the broker this: who can I sell this to if I don’t like it someday?? Who makes an active market in this?? Any pause on this, and don’t buy.? No pause, but an answer — write it down, and check it out.

In one sense, part of the answer to the problems this book brings up is to realize there is no urgency.? If it is a good idea today, it will be good a week from now, let me talk with smart friends and figure out if the idea makes sense.

As for advice from the wise, he invites about eight of his friends to opine on a variety of topics.? Most of them are well-known, but at least a few of them are obscure, unless you are in the business.? I found the counsel to be sound, aside from an obscure former actuary who writes on investments.

Quibbles

On page 118, he talks about how Vanguard would have been a natural for the ETF business, and how Bogle delayed them from getting in.? This is true, but Bogle resigned in 1999; I was at a dinner for his retirement in 1998 in Philadelphia, and met him and Brennan, his successor.? The first Vanguard ETF was created in 2001, VTI is the ticker.? Vanguard did not play a large role in ETFs until 2005, but to say they weren’t in the business is not correct.

Also, ETFs are not as good as they seem, because average investors in them trade them wrong, buying high and selling low.? ETFs do not correct for bad investor timing, even if they are lower-cost.

Who would benefit from this book: If you aren’t a total Do-it-Yourselfer in investments, you can benefit from this book, because it will teach you about the motivations of those who try to sell investments to you, and those who manage money for you.? If you want to, you can buy it here: Backstage Wall Street: An Insider?s Guide to Knowing Who to Trust, Who to Run From, and How to Maximize Your Investments.

Full disclosure: The author is a friend of mine, so I asked for the book.? He said ?yes? and he sent it to me.

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

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

Sorted Weekly Tweets

Posted on 17 March 2012 by David Merkel

Central Banking

Norway Faces Housing Bubble as Krone Steals Policy Agenda http://t.co/15hzb0So By cheapening the currency Norway gets an asset bubble $$ Mar 17, 2012
Unintended Consequences http://t.co/eLrKtCJc Sprott suggests that the financial system has a chemical dependency on the Central Banks. $$ Mar 17, 2012
Is the bond market tightening for the Fed? http://t.co/iRSerA8X The bond market is larger than the Fed; they can’t control the curve $$ Mar 17, 2012
Germany Turns Up Pressure on ECB http://t.co/w2yyfvU1 Difficult to see how the liquidity drains out of the ECB ~3 years from now $$ Mar 13, 2012
China central bank news conference on policy, yuan http://t.co/w8cy5K1Z & http://t.co/XcIFAbvb Japan buys Yuan, don’t think it means much Mar 13, 2012
Bond market certainly did not like the FOMC statement. “Don’t worry about energy prices, we got it all under control.” $$ #fuelinginfltion Mar 13, 2012

Investment Banking

Why banks will continue to rip off clients http://t.co/oTT9fd2i Conflicts on Wall Street, especially at $GS. Big guys know that. So what? Mar 17, 2012
Goldman Sachs?s long history of duping its clients http://t.co/2sXmKl0D Tells the story of how $GS foxed its way out of Penn Central CP $$ Mar 17, 2012
The CMBS maturity wall is here http://t.co/GrcEm1KO I remember buying CMBS deals 11-12 years ago. Bullet loans weak if can’t refinance $$ Mar 17, 2012
Goldman Roiled by Op-Ed Loses $2.2B for Shareholders http://t.co/yz0f0oLy A passing matter; of course IBs have conflicts of interest #duh Mar 17, 2012

China

Bo?s Ides of March http://t.co/mnKFU8Zx Not so much a move to the right as a statement against being flashy and self-promoting $$ Mar 17, 2012
Chinese Economy Already in ?Hard Landing,? JPMorgan?s Mowat Says http://t.co/kwFW2Ty6 Cyclical industries will produce less in China 2012. Mar 17, 2012
China’s official admission of slowing commerce activities http://t.co/br7H4D2o When a long trend changes, often moves further than expected Mar 17, 2012
China’s fixed asset investment growth moderating http://t.co/CEl5mZTc “Growth in real estate and manufacturing projects remains steady.” $$ Mar 13, 2012
GMO: Something’s Fishy in China http://t.co/DO8v4w8p Goes through the 10 signs of a bubble; finds that Chinese economy has most of them $$ Mar 13, 2012
US and Europe Move on China Minerals http://t.co/xyGsdkDq WTO ruled against China in January, pressing similar case 17 rare-earth metals Mar 13, 2012
Another call for an end to China driven industrial commodities “super-cycle” http://t.co/VAd5gR0D Investment is way too high & unproductive Mar 13, 2012

Rest of the World

Sarkozy?s Yield Drop at Risk With Hollande Victory http://t.co/ti25ozdq Surprise, if Hollande cares for poor in France, E-Zone suffers $$ Mar 17, 2012
Saudi Arabia Lifts Curtain on Diplomacy as Syria Killings Spur King to Act http://t.co/H8g8D5nG Favors 85% Sunnis over ruling 15% Alawites Mar 13, 2012
How about those Japanese net-net’s? http://t.co/SAZEcofy Making money in very ill-known small companies in Japan $$ Mar 13, 2012
The Islamic World’s Quiet Revolution http://t.co/ChNksuFm They’re having fewer children, which I already noted here: http://t.co/KnOGFeOA $$ Mar 13, 2012
Portugal Yield at 13% Says Greek Deal Not Unique http://t.co/bPBconfk After Greece, the next places to watch are Portugal & Spain. $$ Mar 13, 2012
Iran-Israel History Suggests a Different Future http://t.co/M1IzxuuB I never knew that Israel sold weapons to Iran in the ’80s. $$ Mar 13, 2012

Financial Sector

MetLife CEO’s Stress Test http://t.co/YaVV4GMp $MET doesn’t deserve to be treated as a systemically risky firm. Long liabilities protect Mar 17, 2012
Assurant Falls as California Seeks Rate Cuts http://t.co/d0OcDS09 FD: long $AIZ; this is overrated; ability of the commissioner limited $$ Mar 17, 2012
Felix Salmon At Columbia Journalism School: Don’t Blame Journalists For Failing To Prevent Financial Crisis http://t.co/0LrCwisB true, but Mar 13, 2012
Journalists, even if they understood what was going on in the finl mkts would face a tough time writing warnings in the midst of boom $$ Mar 13, 2012
US Government Agencies Comparing Notes On Algo Feeds http://t.co/15oAxpn9 Little speed advantages w/econ data can lead to big profits #SEC Mar 13, 2012
Marketview:Point of Reference http://t.co/Xlp5jczH “4 the 1st time this yr I can feel the true bullish sentiment among the investing public” Mar 13, 2012
Banks foreclosing on churches in record numbers http://t.co/fR3Ro9CJ Frankly, I am surprised that banks lend to some churches. $$ Mar 13, 2012
Banks Buy Treasuries at Seven Times Pace in 2011 http://t.co/SDKsJIUB What else to do with all the excess liquidity & weak borrowing $$ Mar 13, 2012

US Government-Related

Pension Benefit Costs Cut by Record 43 States, Study Says http://t.co/B8ZRg4gZ State take actions to reduce benefits to active employees Mar 17, 2012
Best Treasury Forecaster Says 10-Year Yield to Drop From Highs http://t.co/ma8YoN4u Don’t be too sure about Treasury rates rising $$ Mar 17, 2012
International Demand for U.S. Assets Rises http://t.co/FwdXqrWH As the E-Zone gets worse, demand for US debt improves. $$ Mar 17, 2012

Investing

Temporary Hedges eventually force Deleveraging http://t.co/0jVSWRzw On Energy Future Holdings, & why predicting the future is tough $$ Mar 17, 2012
Cyclicals persistent underperformance http://t.co/KkJ2q05p Cyclicals started underperforming in August. Relatively they never recovered. $$ Mar 17, 2012
Magnetic Fields http://t.co/S6VYIe5Y Good post. This graph is worth a look: http://t.co/EBhPh6ZN May help explain recent lost decade $$ Mar 13, 2012
Stock Compensation, Tax Law, Financial Reporting and Facebook’s IPO http://t.co/ULyVLNkr Future dilution may pressure $FB shares $$ Mar 13, 2012
A Value Investor’s Take on Shorting http://t.co/cZYueqGH Tactical discipline, not structural, b/c market can go nuts. Can help hedge $$ Mar 13, 2012

Miscellaneous

Considering Bankruptcy? Head to the Mall http://t.co/UvgEArMj Legal services offered for simple situations in mall locations. $$ Mar 13, 2012

Book Review: Pandora’s Risk

Posted on 16 March 201216 March 2012 by David Merkel

This is two books in one, and very well done.? The main part of the book explains risk and uncertainty in general terms, such that most people can understand it.? But for those that can deal with complex math, the latter part of the book offers a lot of additional firepower.

Risk is a tough subject because history only vaguely informs you as to how bad things can get.? Past is not prologue.? There are two possibilities, the past contains and event that was so horrible that it can never happen again, or, the past does not tell you how bad things can be.

Market observers took the first view, that the Great Depression could not repeat.? As a result, few prepared for a situation where there was too much debt, and insufficient ability to service it.

The subtitle of the book is rightly “Uncertainty at the Core of Finance.” Not risk, but uncertainty.? The distinct is important, because risks are things that we know some things about the possible economic outcomes, and can control them to a degree.? Uncertainty is where we don’t really understand the dimensions of the outcomes, and have little if any control.

There is fundamental uncertainty to the simplest aspect of finance, money.? Money seems stable enough in the short-run, but every now and then it fails due to hyperinflation, or the slow steady failure in the store of value sense of moderate inflation over long periods.

Wealth itself is uncertain.? Even if you own it free and clear, there’s no way to tell what it will be exchangeable for next year, much less further out.? There are a lot of people who thought they knew what their homes were worth 5-7 years ago that are decidedly disappointed.

Government debt is uncertain, as governments think they can always roll it over, but political and other obstacles can lead to a refusal to pay when debt service becomes high relative to tax revenues.

Banking is uncertain, mainly because of borrowing short to lend long.? If banks limited themselves to facilitating transactions, a lot of the uncertainty would go away.? Banks would be a lot smaller, less profitable, and there would be fewer of them, and the economy would be more stable.? (Entities with longer liability structures, like pension plans, endowments, and life insurers would become the new source of lending. More would be financed through equity.)

Credit is uncertain.? During boom times, corporate bonds behave independently, and diversification evens out results.? As a result, corporate credit seems safer than it really is, and marginal ideas get to borrow.? During bust times, far more corporate debt defaults than would be expected — there’s almost no such thing as an average year.? It’s either feast or famine.

There are things that can be done to try to mitigate uncertainty: credit ratings, or any scoring system for assets, lending at a more senior level, and Value-at-Risk.? Also using more robust assumptions on possible outcomes, which would lead to smaller position sizes, less leverage, or more cash.

The book has a real strength in showing how the the assumption of normally-distributed risks fails dramatically in many cases, and offers alternatives that would work better.? Trouble is, once you realize how volatile the world really is, a lot of strategies either don’t work, or need to be scaled back.

The book praises actuaries as risk managers, with their ethic codes and stress tests, as opposed to quants with Value-at-Risk and no ethics code.? Banks and Wall Street would be better off in the long run hiring actuaries, who think about risk more holistically, and getting rid of the quants in their risk control departments.? Same for the regulators who evaluate banks.

There are other controversial ideas here: is it possible that the strong economic growth of the past is an anomaly?? Is it possible that growth for nations, and the world as a whole follows S-curves, like products and companies?

This is an ambitious book, and I like it a lot because it is willing to cross boundaries and apply the principles in one? area to another that seemingly should not receive it.? I liked it a lot, and would recommend it to many.

Quibbles

On page 17, he thinks of currency as a put option, but I think of it as 0% overnight commercial paper.? On page 37, he confuses Moses and Joseph, having Moses predict the 7 good followed by 7 bad years, when it was Joseph who did that.

Who would benefit from this book: Every financial regulator should have this book.? Every academic burdened by the lies of Modern Portfolio Theory should get this book.? Anyone who fancies himself to be a risk manager should have this book.? Finally, if you want to understand why financial markets are inherently uncertain, this book will teach you well.? If you want to, you can buy it here: Pandora’s Risk: Uncertainty at the Core of Finance (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

Against Risk Parity

Posted on 4 February 20125 February 2012 by David Merkel

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

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

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

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

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

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

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

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

We Eat Dollar Weighted Returns — III

Posted on 2 February 2012 by David Merkel

Somebody notify the Bogleheads, they will like this one, or at least Jack will.? Yo, Jack, I met you over 15 years ago at a Philadelphia Financial Analysts Society meeting.

How bad are individual investors? at investing?? Bad, very bad.? But what if we limit it to a passive vehicle like the Grandaddy of all ETFs, the S&P 500 Spider [SPY]?? Should be better, right?

I remember a study done by Morningstar, where the difference between Time and Dollar-weighted returns was 3%/year on the S&P 500 open end fund for Vanguard, 1996-2006.

But here’s the result for the S&P 500 Spider, January 1993- September 2011.? Time-weighted return: 7.09%/year.? Dollar-weighted: 0.01%/yr.? Gap: 7%/yr+

Why so much worse than the open-end fund?? Easy.? Unlike the professional managers at Vanguard, and the relatively long term investors they attract, the retail short term traders of SPY trade badly; they arrive late, and leave late on average.

There is far more analysis to be done here, but to me, this confirms that Jack Bogle was right, and ETFs would be a net harm to retail investors.? The freedom to trade harms average investors, and maybe a lot of professionals as well.? It may also indicate that short-term trading as practiced by technicians may underperform in aggregate.? Not sure about that, but the conclusion is tempting.

One thing I will say: I am certain that profitable trading is not easy.? If you are tempted to trade for a living, the answer is probably don’t.

Anyway, here’s my spreadsheet on the topic:

Full disclosure: I have a few clients short SPY, hedged against my long positions.

The Rules, Part XXX (30)

Posted on 22 January 2012 by David Merkel

In the recent run-up, there was talk of the infallibility of equities.? This led to a higher level of variable compensation in the economy through option and share issuance and low pressure to raise fixed wages.? This was yet another form of hidden leverage, which hid the unprofitability of enterprises through share dilution.

That was written in 2001, after the flop of the Nasdaq.? I have sometimes said that bubbles are financing phenomena.? That’s true, but we can phrase it more generally: bubbles occur because of an asset-liability mismatch.? People go long a long-duration asset with short-duration funding.? The short duration funding can be borrowing, or vendor finance, or it can be a labor commitment in order to get equity or option awards.

People chase the long-term asset that seems so valuable, and give up time and interest (money’s version of time) to get it.? They give up more than they imagine for something of uncertain value.? In other words, a mania.? Give up something relatively certain in the short run for something with uncertain long run potential.

The attitude could be summed up with a conversation I heard in early 1998 between my boss and his best salesman, where the salesman said, “It’s a no-brainer, have the market pay your employees.”? His idea was that a constantly rising stock market would provide compensation to employees through stock awards, options, 401(k)s, etc., even as the market was straining at valuation limits.? It is probably a sign that the market is overheated, when market-based rewards become common.

Startups by their nature require that employees be flexible, and give up a lot of fixed guarantees.? What payments they receive at the beginning are small, and less than their work might deserve in most established contexts.? But there is the possibility of the big payoff, and the possibility of total loss.? The asset in question has a lot of variability, but the liability, the work that must be put in, is big, and may not vary much for success or failure.

In the tech bubble, many parties extended vendor credit because there were big profits to be made in the future.? Alas, but they lent to those with very uncertain prospects, and in March of 2000, the chain of leverage started to collapse, both for vendors, and for those that worked in the industries.? Just as hedge funds have a hard time holding onto good employees when performance goes bad, so it is for tech companies when financing dries up, and the stock price craters.? Rats desert the sinking ship.

“Free money” brings out the worst in people.? Do something small in the present and reap a huge future.? Sadly, it rarely works that way, except at the very beginning of a boom.? At the end of the boom, it is a maelstrom, with many people demanding to throw their money away in search of riches that will never be.

From a dated piece:

Crowd-following is common to humanity.? It takes a lot to stand apart from highly correlated behavior.? I?ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.? I said to her, ?They don?t know anything about investing!?? My mom replied, ?Oh, David.? You?re such a fuddy-duddy.? I just bought some Inktomi!?

Now, to set the record straight, that was just 1% (or less) of my mom?s assets, so an occasional flyer is acceptable.? Call it ?Mad Money.?? ? For my cousins, it was most of their investable assets.? My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I am close to concluding that it is impossible to teach the average person how to do well in investing.? They don’t have the patience or the willingness to learn. (Few want to be called “fuddy-duddy” by their mothers.) 😉

Getting rich quick is very rare, but it entrances some people several times in their lives, and rarely does it end well.? It is far better for most people to work hard in areas of the economy that are being rewarded, and invest excess cash in a mix of? stocks, long-dated investment grade bonds, money markets, and a little gold.

After all, it’s not what you make, it’s what you keep.

The Rules, Part XXVII, and, Seeming Cheapness vs Margin of Safety

Posted on 29 December 201129 December 2011 by David Merkel

The market takes action against firms that carry positions bigger than their funding base can handle.? Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.? After that happens, valuation-motivated sellers appear to offer more at those prices.? The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.? As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”? The short-term proclivities of investors usually have no effect on the long run value of companies.? Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.? One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.? And often, they invested in financials that looked cheap, but took too much credit risk.? Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.? Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.? Every time I read something by him or see a video with him, I think, “Bright guy.”? But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.? Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.? From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.? And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.? Are the assets and liabilities properly stated?? Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

Company size (the ability of management to make sure values are accurate or conservative declines with size)
Rapidity of the company’s growth
Length of the asset or liability
Uncertainty over when the asset will pay out, or when the liability will require cash
Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”? It is also a question of whether the company will have adequate financing to hold those assets in all environments.? For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”? All financial asset values are relative to the financing environment that they are in.? Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.? Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.? Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.? (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.? Do they try to grow rapidly?? That’s a danger sign.? There is always the tradeoff between quality, quantity, and price.? In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.? Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?? How much do they explain away one-time events?? Are they raising leverage to boost ROE, or are they trying to improve operations?? Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?? Even with good financial companies there are disappointments.? With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.? They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.? What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.? Even the others of his top 10 have not done well, and the fund as? a whole has suffered.? Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.? And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

A 9.9% return from inception to 5/31/2011 is hot stuff, and,
A 6.0% dollar-weighted return is very good as well.? Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”? Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.? The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.? It can be a negative self-reinforcing cycle for some time.? My one bit of advice would be: focus on margin of safety.? If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

Risk-Based Liquidity

Posted on 22 December 2011 by David Merkel

When there is financial failure, it comes as a result of illiquidity.? Now, truly, these parties are insolvent, because they took the risk of not being able to pay cash when it was due.? Illiquidity and insolvency are really the same thing, though many obfuscate.

If you can’t pay cash, it doesn’t matter what your assets are worth in “normal” times.? Banks should have planned in advance to make sure liquidity was always adequate, rather than doing the usual borrow short, lend long, that they usually do.

But after reading through the Fed ‘s proposal on bank solvency, I conclude that they may not get the picture.? They spend time on liquidity and other issues.? With liquidity, it is uncertain how they will view repo markets.? To me, those should be view as short-term finance of long dated assets.

During times of crisis, repo markets seize up, with rising repo haircuts.? Maybe I’ve read the Fed’s proposal wrong, but it seems that it neglects repo funding, which had a large effect on the recent crisis.

If banks had to be able to size their activity to survive a rise in repo haircuts equal to half of the highest that we have seen, it would probably be enough to make the issue go away, because the haircuts would be less likely to rise as a result of that restraint.

Now, I appreciate the perspective of this article from Dealbreaker on the topic.? All of the assets of the bank support all of the liabilities. In one sense, there are no assets that are tagged “equity” and others tagged “liability.”

P&C Insurance works a little different.? In that, premium reserves are invested in high quality short-term debt.? Claim reserves are invested in high quality debt similar to the period that claims are expected to be paid out over.? The remainder (the equity) can be invested in risk assets in order to earn a decent return for shareholders.? The idea is this: match liabilities with high quality assets of the same length, and take risk with the remainder of assets, realizing that they might might needed for liquidity in the worst case scenarios.

But really, banks should not be viewed differently.? They should invest like P&C or life insurers.? Invest in high quality assets equal to the terms of their liabilities — deposits (estimate stickiness), savings accounts (same), CDs (the term is known).? After that, take risks with the remaining assets in ways that reflect their comparative advantage, realizing that they might might needed for liquidity in the worst case scenarios.? Illiquid investments (e.g. private equity)? should not be allowed for a majority of of those investments.

If banks don’t engage in asset/liability mismatches aka maturity transformation, most of the risks of bank runs will go away.? And that is what I propose.? Note that if that happens, average people will have to pay some fee each year to have a checking account.? Banks would be liquidity utilities.

This fits under my rubric that the insurance industry is much better regulated than the banking industry.? Were it in my power to do so, I would turn banking regulation over to the states, and leave to the Fed control of monetary policy only.? You would soon see intolerant banking regulation, much like we see in insurance, and defaults would decline.

What could be better?

Get a Piece of the Schlock

Posted on 2 December 2011 by David Merkel

There is a benefit to reading books on marketing for those that will never be marketers: it will immunize you to sales pitches.? Think of it as studying the strategies of the enemy.? When you talk to salesmen, you can flip their words back at them, or tell them “no,” to the questions that have a guaranteed “yes” attached to them.? Better, if you want, you can tell them, “Stop. I know your tactics.? Cease the sales language and answer these questions I have…” Maybe they will cease.? If not, leave.? There are many places to buy, and some people that will listen to you elsewhere.

Some weeks ago, I was traveling, and heard an ad for a “financial seminar.”? This one sounded better than most, and featured the teachings of a well-known writer.? For fun, I signed up for the free seminar, just to see what would happen.

In reading what little I had before the seminar, I concluded that the only way of doing what they claimed was private ownership of high cash flow properties or businesses.? When I went to the seminar, I was not disappointed — that was the main idea.? Secondarily, they said you could get non-recourse financing easily, or equity limited partnerships to finance you.? (Money grows on trees…)

The first problem is this: mispriced properties are few and far between, and there is competition to buy them, generally.? Second, financing for property investment is scarce, especially for anything where the lender has no recourse to the borrower.

Passive Income

Passive income is an idol in these shows.? It seems like free money, but in practice it is difficult for investors to buy properties cheaply, finance them, and get rents that are far higher.

If it were that easy, they would create a REIT and do it themselves.? I asked the presenter at the end of the presentation: “If there are that many high cash flow properties available, why doesn’t a REIT buy them?? After all, they can finance more cheaply than you.”? Response: “What’s a REIT?”

That’s more than the wrong answer; it means you don’t know what you are doing.

Tactics

There was a lot of framing going on.? The package was worth $5000, but we have a special offer for $600.? Today for you?? $200.? After some people leave — “Yes, $200, but your spouse can some too.”? Oh and if you buy today, we’ll throw in these extras…

I suspect there were shills in the audience, who went back to buy.? I looked back several times, and estimated that 50-60 out of 200 went back to buy.? At the end, only 30 remained to hear the ending advice.

Regardless, the gross revenue of the day was around $6000, which supposedly covered only the cost of the presenter and the hotel room.? I have my doubts.

Other? Notes

Twice the presenter mentioned that the company that the author worked with was publicly traded.? Well, sort of, it deregistered in Spring 2011, and the company is worth less than $10 million today as it trades on the pinks.? What can you say for a company with a negative net worth, normally negative income, and very low trading volume?? (Leave aside the lawsuits…)

The presenter appealed to Buffett on not diversifying, but Buffett tells average investor that they are best invested in mutual funds.? Being undiversified carries with it the idea hat one is incredibly smart, and able to do far better then the averages.

The reason that they put forth a private market strategy is that it can’t be falsified.? That is the great thing about selling people on investing in real estate.? There is no way to put forth an audited track record.? You can tell anecdotes, and people buy your educational materials.

Summary

Be skeptical.? Nothing good is easy.? Anything advertised in investing can’t be that good.? I knew this, and my experience proved it as I reviewed the charlatans.

Book Review: Manias, Panics, and Crashes (Sixth Edition)

Posted on 12 November 201113 November 2011 by David Merkel

This is the first book that I have reviewed twice.? I reviewed the third edition of the book previously, but I am reviewing the sixth edition now.

Kindleberger places the manias, panics, and crashes on a common grid, to see their similarities,? In it he draws on a number of common factors:

Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies with those that borrowed to finance the assets
A lender of last resort appears to end the cycle

The advantage over the third edition is that you get to hear about the Asian crisis LTCM, the tech bubble, Madoff, and the present crisis (banking & housing, soon to be sovereigns).

The main point for readers is to beware when monetary policy is easy, banking regulation is lax, and many seem to favor buying the asset du jour, often with leverage.? What is self-reinforcing on the way up will be self-reinforcing on the way down, but with greater speed and ferocity, as bad debts have to be liquidated.

Quibbles

Hindsight is 20-20.? If the US Government had rescued Lehman, something else might have proven to be “too big to rescue,” that the government might allow to fail, but miss the connectedness of the institution.? I do think the US Government should have been a DIP lender to troubled firms, but not a buyer of equity.

Who would benefit from this book: Most investors would benefit from this book.? It will make you more skeptical of assets that seems to be doing unnaturally well; it will also make you more skeptical about catching falling knives in the market.? If you want to, you can buy it here: Manias, Panics and Crashes: A History of Financial Crises.

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.