Stocks – Page 10 – The Aleph Blog

When I was a Boy…

Posted on 29 November 2016 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Takeaways

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

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

The Soviet Union will bury us.

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

China will bury us.

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

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

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

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

It’s never different.

It’s always different.

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

Ending Thoughts

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

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

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

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

Posted on 26 November 201627 November 2016 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Summary

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

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

The Band Travels Up

Posted on 26 November 2016 by David Merkel

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

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

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

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

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

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

“Do Half” Applied

Posted on 22 November 2016 by David Merkel

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

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

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

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

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

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

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

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

On Long-Term Corporate Investments

Posted on 19 November 201620 November 2016 by David Merkel

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There is a statement commonly made that firms in the US aren’t doing as well as they can in the long-run because the calculation of quarterly earnings inhibits long-term investment. ?I’m not sure that such statements are true or false, but I will try to explain the problem or lack thereof in this post.

Common reasons for alleging the problem

The division between management and ownership means that managements often act in their own interests rather than those of shareholders.
Management incentives are calculated over too short of a period of time.
Quarterly earnings distract from long-term planning.
Accounting methods do not allow for capitalizing certain types of investments, and so they don’t get done to the degree necessary.
Investing for the long-run will create greater returns.
It is easier to simply buy back stock or pay dividends in the short run. ?Investing more?will create greater returns.

I’d like to get rid of a few of these arguments quickly. ?First, there is no evidence that investing more produces greater returns, and there is evidence that stocks that do buybacks and pay dividends tend to outperform. ?There is evidence in specific cases that buying back stock at high prices destroys value, but what?high prices are is often only know in hindsight. ?That said, I encourage corporate boards and managements to have their own conservative estimate of the private market value of their firm, and only to buy back stock when the price is below that estimate.

Second, there is no evidence that long-term investing produces greater returns on average. ?Here’s why: longer investments are less certain than shorter ones, and require longer-term capital to finance them, which is more expensive.

I remember the Japanese making their long-term investments in the 1980s — they were regarded as very farsighted. ?They invested a lot at what seemed like low ROEs, but their stock market kept going up, and they were hailed as geniuses that would bury the barbaric capitalism of the US. ?As it was, the ROEs were low, and in many cases negative.

I liken it to trying to hit a home run in baseball. ?It’s a high-risk, high-return strategy, but tends to lead to worse results than just trying to get on base. ?Many good returning projects for firms are small, and short-term in nature. ?Incremental improvement can go a long way.

Reasons 1-4 have a little more punch in my opinion, but they are all solvable by setting up an alternative accounting basis that facilitates long-term projects, using that as the definition for pro-forma earnings to present to Wall Street, and using it for management performance measurement and compensation.

There is a trick here, though. ?Management and the board have to be intelligent enough to have both:

A long-term investment that they know with high probability will be a success, and
A means of measuring the progress toward the goal over a long period of time.

Both of those are tough. ?Long-term projects can go wrong for a lot of reasons — cultural change, technological change, economic change, competitive change, change in the ability to keep the company as a whole financed, and more.

And, it’s not as if I don’t see project timelines in presentations that managements give to investors and analysts. ?Long-term investing does get done, even if the GAAP or tax accounting treatments don’t favor it in the short run.

As I have mentioned before, corporate valuation depends on free cash flow, and GAAP accounting does not affect that. ?As such, quarterly GAAP earnings should not affect the willingness of companies to take on long-term projects that they think will be winners.

That leaves management incentives, which are always a problem. ?Most good incentive plans are a mix of short and long-run items. ?The mix will depend on the maturity of the industry, and the relative opportunities faced by the firm.

Conclusion

If there is a problem here, boards and managements have adequate tools at their disposal to try to solve the problem, with the added risk that the cure could prove worse than the disease. ?As an example, consider trying to get sleepy pipelines and utilities to innovate on long-term projects that are hard to manage and measure. ?Well, that was Enron, Dynegy and a variety of companies that learned that there aren’t a lot of ways to dramatically improve performance in a mature business.

But there may be no problem here at all. ?The US has been one of the better performing markets in the developed world, and in general, industries that invest a lot do not outperform industries that do less investing. ?We may not need to adjust our methods at all.

Also, we might not need as many tax incentives from the government to promote investing either. ?In my opinion, the good investments will get done. ?Investments that require tax incentives just encourage management teams to do tax farming.

Management teams are less short-term focused than most imagine. ?If they don’t invest a lot for the long-term, it may just be that there aren’t many attractive long-term investments capable of providing returns greater than the cost of longer term capital needed to finance the investments.

Weird Begets Weird

Posted on 9 November 2016 by David Merkel

Photo Credit: Steve Rotman || What could be weirder than President Trump?!

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I have a saying “Weird begets weird.” Usually I use it during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

Well, we can say the same for many aspects of world affairs, including the US election. ?Many people?benefit from free trade, more than get hurt. ?Those who get hurt vote with greater probability. ?Though immigrants are actually a net help to the US economy, because many people think they hurt the economy, they vote accordingly.

After Brexit, there are related effects. ?People are less willing to surrender local advantages for matters that would be larger broad advantages. ?Who knows? ?Maybe the EU will break up next. ?Nah. ?Nothing good happens to continental Europe.

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Tomorrow, I will be a buyer. ?I don’t expect anything good out of Trump, but there is nothing worse from him than Clinton. ?I have 15% cash on hand for clients and me, and I will buy as the market falls.

The Sun Will Rise Tomorrow, DV

Posted on 8 November 2016 by David Merkel

Photo Credit: MDV?|| May you live to see many beautiful sunrises!

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Regardless of your political point of view, life will go on after the election. ?Truth, given the two leading candidates, I get why many feel bad — they are both personally flawed to the degree that we shouldn’t want to entrust them with power. ?We all are sinners, myself included. ?That said, those who lead scandalous lives are unfit to lead society.

But under most conditions, cultures, economies, and governments survive bad leaders. ?This is true globally. ?This has been true in the US historically.

And guess what? ?The markets really don’t care that much about current politics. ?Markets in aggregate react to changes in the long-term view of economic activity. ?The only things that interfere with economic activity to that degree are:

Sudden

Wars (think of the World Wars, or the Thirty or Hundred Years Wars)
Plague (think of the Black Death, severe as it was the influenza epidemic of 1918 was just a speed bump in comparison)
Famine (usually associated with severe Socialism… think of the Ukraine in 1932-33, the Great Leap Forward 1958-61, Pol Pot in Cambodia, present-day North Korea or Venezuela…?and there is more)

Gradual

Changes in human fertility
Technological change
Gradual increasing willingness for people to be trusting in economic relationships, leading to investment, lending and trade on a wider scale, leading to lower costs of capital. (That included ending the teaching of Aristotle that money is sterile, which happened among Christians at the Reformation, and among Muslims in the late 20th century in some convoluted workarounds)
Cultural changes such as the willingness to not engage in subsistence agriculture, and trust the division of labor. ?Willingness to educate children (including women) rather than use them for immediate productive purposes.
Desire of the governing powers to wall off resources for their private use or non-use ?(think of governments owning huge amounts of land, and denying use of the land to most. ?Same for technologies?and resources.)

I’m sure there are things I left out, which could make for a lively conversation in the comments. ?But note this: in general, though the sudden events may have severe effects on economies and markets, they tend to be the most transitory. ?It’s the gradual changes that have the most effect in the long-run.

Also note that most of these do not get affected much by normal politics. ?Yes, the “one child policy” affected human fertility, but look at efforts by governments to get husbands and wives to have children and the effects are tiny at best. ?And even the “one child policy” is partially reversed, and I expect that it will be dropped in entire. ?(And then the Christians and Muslims can stop hiding their children…)

Governments can intervene in economies lightly or moderately, and people adjust. ?Overall productivity doesn’t change much. ?At severe levels of intervention, it ?changes a lot. ?Intelligent people look for the exits, even at the cost of being exiles.

Governments can go to war, and if it is small relative to a country that is involved, the effects are light. ?Big wars are different, and can destroy productivity for a generation, or permanently, if the culture doesn’t survive.

The Great Depression, bad it was, and loaded with policy failures of Hoover and FDR, ended in less than a generation. ?The markets recovered as if it had never happened, and then some.

Are our government policies, including those of the central bank, lousy? ?Yes. ?WIll they get worse under Trump or Clinton? ?Sure.

Things won’t likely be bad enough to derail the economy and the markets for more than a generation, so invest for the future. ?The Sun will rise tomorrow, Lord willing.

But,?the Son of God will reign forever.

Afterthought

The collapse of debt fueled bubbles can only affect less than a generation. ?Why? ?They don’t affect productive capital assets, they only affect who owns them, and receives benefits from them. ?That is why depressions have far less effect than major wars on your home soil or major plagues. ?Eventually a new group of people pick up the pieces at reduced prices, and use the capital to new and better ends.

Book Review: Inside the Investments of Warren Buffett

Posted on 27 October 201627 October 2016 by David Merkel

Writing books about Warren Buffett is a bit of a cottage industry, and one that is getting scarce for new ideas. ?This book takes a new approach because the author takes 20 companies that Buffett bought, and analyzes them himself using principles?derived from things Buffett has written.

That brings me to my first critique of the book. ?You are getting the author’s point of view for analysis, which is?somewhat similar to Buffett’s, but is usually not Buffett’s view. ?In a minority of?cases he references something Buffett wrote at the time. ?He did not interview Buffett for this book, which is normal for most books about Buffett.

Buffett didn’t typically do simple analyses, though by the end, he could simplify them to make it understandable to average people. ?I’m not saying Buffett’s math wasn’t simple; I am saying that he took great account of qualitative aspects of a business — honest & competent management, owner earnings (free cash flow), moats (sustainable competitive advantages), ability to reinvest excess earnings profitably, etc. ?The author takes account of many of these things much?of the time, but my view is that Buffett did more still. ?Also, Buffett spent more time on margin of safety issues than the author did.

My second critique is that the book is a lot?shorter than it looks. ?Many of the pages are filled with the financials of the companies being analyzed, and only a tiny portion of the data there is referenced by any analysis in the book. ?The book of 260 pages is more like 200 in total length. ?For some readers that will be a plus, for others a minus.

The book does well in picking a range of investments by Buffett in terms of success. ?Some of his less successful?decisions are here — Berkshire Hathaway itself, US Air, Salomon Brothers, Gen Re, and IBM. ?It also looks at investments where Buffett bought it all, and where Buffett bought part of a company. ?Additionally, it covers investments initiated over a long time, ranging from the partnership years to the present.

My third critique is that in addition to the financial data, there is occasionally more padding in the book than needed — an interview of?Buffett by?Matt Rose of BNSF stands out, though many of the descriptions of the businesses involved could have been tighter.

On the whole, it is a good book, giving the opinions of another value investor on twenty asset purchase decisions by Buffett. ?Those familiar with Buffett will probably want to pass by the book; better to read Buffett himself. ?Never investors could benefit from the author’s viewpoint, as it gives a consistent way to build a value investing philosophy in a single book.

Quibbles

Already mentioned.

Summary / Who Would Benefit from this Book

Those more experienced with Buffett’s own writings could ignore this book. ?Those who are newer to value investing could benefit. ?If you want to buy it, you can buy it here: Inside the Investments of Warren Buffett: Twenty Cases.

Full disclosure:?The publisher asked me if I wanted a free copy and I assented.

If you enter Amazon through my site, and you buy anything, including books, 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.

Fuller disclosure: long BRK/B for myself and clients

The Plumbing of Investing

Posted on 25 October 2016 by David Merkel

Photo Credit: Rex Babiera ||Ours is an old house, and its guts reflect that. — Photo Credit: Rex Babiera || Ours is an old house, and its guts reflect that.

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A question?from a reader on my recent post Me Too!:

I recently ran across Ed Thorp?s ?Beat the Market.? I find reasonable his idea that you can take on risks that (almost / essentially) cancel each other out. Find assets that are negatively correlated to buy one long and the other short (he did it with stock warrants in the 60?s but when I started looking into that, well, I?m late to that party, so nevermind).

I?m uncomfortable with shorting anyway, so what about going long in everything and rebalancing when the assets get out of whack? Aren?t a lot of the price movements of various assets (cash, bonds, stocks, real estate, precious metals) the result of money flowing towards or away from that asset? If people are, on net, selling their stocks, to what type of asset are they sending the proceeds? I can?t predict where people will stash their money next, but if I own a little of everything, I?m both hedged against prolonged depression of one asset class and aware of what?s gotten ?expensive? and what?s ?cheap? now.

Along these same ?indexing? lines, what do you think of using ALL the sector ETFs (Vanguard has 11) to index each sector and then rebalance among them as they change in value? How would that application of your portfolio rule 7 differ than when applied to individual stocks? Also, do you think it would be subject to the same / similar danger as everyone else ?indexing? as you wrote about above?

My, but there is a lot here. ?Let me try to unpack this.

Paragraph 1: All of the easy arbitrages are gone or occupied to the level where the risks are fairly priced. ?Specialists ply those trades now, and for the most part, they earn returns roughly equal to short-term risky debt. ?They tend to get hurt during financial crises, because at those points in time, fundamental relationships get disturbed because of illiquidity and defaults amid demands for liquidity and safety.

Paragraph 2:?First, rebalancing is almost always a good idea, but it presumes the asset classes/subclasses in question is high quality enough that it will mean-revert, and that your time horizon is long enough to benefit from the mean reversion when it happens. ?Also, it presumes that you aren’t headed for an utter disaster like pre-WWII Germany with hyperinflation. ?Or confiscation of assets in a variety of ways, etc.

Then again, in really horrible times, no strategy works well, so that is not a criticism of rebalancing — just that it is useful most but not all of the time.

Aren?t a lot of the price movements of various assets [snip] the result of money flowing towards or away from that asset?

Back to the basics. ?Money does not flow into or out of assets. ?When a stock trade happens, shares flow?from one account to another, and money flows the opposite direction, with the brokers raking off a tiny amount of cash in the process. ?Prices of assets change based on the relative desire of buyers and sellers to buy or sell shares near the existing prior price level. ?In a nutshell, that is how secondary markets work.

Then, there is the primary market for assets, which is when they were originally sold to the public. ?In this case, corporations offer stocks, bonds, etc. to individuals and institutions in what are called initial public offerings [IPOs]. ?The securities flow from the companies to the accounts of the buyers, and the money flows from the accounts of the buyers to the companies. ?The selling prices of the assets are typically set by syndicates of investment bankers, who rake off a decent-sized chunk of the money going to the companies. ?In this case, yes, the amount of money that people are willing to pay for the assets will dictate the initial price, unless the deal is received so poorly that it does not take place. ?After that, secondary trading starts. ?(Note: this covers 95%+ of all of the ways that assets get to public markets; there are other ways, but I don’t have time for that now. ?The same is true for how securities get extinguished, as in the next paragraph.)

The same thing happens in reverse when companies are bought in entire, either fully and partially for cash, and in the process, cease to be publicly traded. ?The primary and secondary markets complement each other. ?Corporations and syndicates take pricing cues from the levels securities trade at in the secondary markets in order to price new securities, and buy out existing securities. ?Value investors often look at primary markets to estimate what the assets of whole companies are worth, and apply those judgments to where they buy and sell in the secondary markets.

Trying to guess where market players?will raise their bids for assets in secondary trading is difficult. ?There are a few hints:

Valuation: are asset cheap or rich relative to where normalized valuation levels would be for this class of assets?
Changes in net supply of assets: i.e., the primary markets. ?Streaks in M&A tend to persist.
Price momentum: in the short-run (3-12 months), things that rise continue to rise, and vice versa for assets with?falling prices.
Mean-reversion: in the intermediate term (3-5 years), things that currently rise will fall, and vice-versa. ?This effect is weaker than the momentum effect.
Changes in operating performance: if you have insight into companies or industries such that you see earnings trends ahead of others, you will have insights into the likely future performance of prices.

All of these effects vary in intensity and reliability, both against each other, and over time. ?If you own a little of everything, many of these effects become like that of the market, but noisier.

Paragraph 3:?If you want to apply rule 7 to a portfolio of sectors, you can do it, but I would probably decrease the trading band from 20% to 10%. ?Ditto for a portfolio of country index ETFs, but size your trading band relative to volatility, and limit your assets to developed and the largest emerging?market countries. ?With a portfolio of 35 stocks, the 20% band has me trade about 4-5 times a month. ?With 11 sectors your band should be sized to trade 1-2 times a month. ?20 countries, around 3x/month. ?If it is a taxable account set the taxation method to be sell highest tax cost lots first.

Remember that portfolio rule 7 is meant to be used over longer periods of time — 3 years minimum. ?There are other rules out there that adjust for volatility and momentum effect that have done better in the past, but those two effects are being more heavily traded on now relative to the past, which may invalidate the analogy from history to the future.

Using portfolio rule 7 overweights smaller companies, industries, sectors, or countries vs larger ones. ?It will not be as index-like, but it is still a diversified strategy, so it will still be somewhat like an indexed portfolio.

Finally, even if we get to the point where active management outperforms indexing regularly, remember that indexing is still likely to be a decent strategy — the low cost advantage is significant.

That’s all for now, and as always, comments and questions are welcome.

Me Too!

Posted on 22 October 201623 October 2016 by David Merkel

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I have sometimes said that it is common for many people to imitate the behavior of others, rather than think for themselves. ?There are several reasons for that:

It”s simple.
It’s fast.
And so long as you don’t run into a resource constraint it works well.

People generally have a decent idea who their smartest friends are, and who seems to give good advice on simple issues. ?If your neighbor says that the new Chinese food place is excellent, and you know he knows his food, there is a very good chance that when you go there that you will get excellent Chinese food as well.

You might even tell your friends about it; after all, you want to look bright as well, and its neighborly to share good information. ?That works quite well until the day that Yogi Berra’s dictum kicks in:

Nobody goes there anymore. It?s too crowded.

The information indeed was free, but space inside the restaurant was not, even if patrons weren’t paying to get in. ?And even if they have carryout, the line could go around the block… a hardship for many even if?you are getting the famous Ocean Broccoli Beef. ?(Warning: Hot in every way.)

Readers of my blog know that the same thing happens in markets. ?Imitation was a large part of the dot-com bubble and the housing bubble. ?When a less knowledgeable friend is making what is seemingly free money, it is very difficult for many people to resist the temptation to imitate, because if it works for him, it ought to work better for the more knowledgeable.

As such, prices can get overbid, and the overshoot above the intrinsic value of the assets can be considerable. ?It all ends when the cost of capital to finance?the asset is considerably higher than the cash flow that the asset throws off. ?And as with all bubbles, the end is pretty ugly and rapid.

But what if you had a really big and liquid strategy, one that threw off decent cash flow. ?Could that ever be a bubble? ?The odds are low but the answer is yes. ?It is possible for any strategy to distort?relative prices such that the assets inside a strategy get significantly above intrinsic value — to the point where they discount negative future returns over a 5-10 year horizon. ?(As an aside, negative interest rates are by definition a bubble, and the instruments traded there are in big liquid markets. ?The severity of that bubble collapsing is likely to be limited, though, unless there is some sort of payments crisis. ?The relative amount of overvaluation is small, and has to be small.)

Indexing as Imitation

Today, indexing is a form of imitation in two ways. ?The first way is not new — it is a way of saying “I want the average result, and very low fees.” ?It’s a powerful idea and generally a good idea. ?If used for long-term investment, and not short-term speculation, it allows capital to compound over long periods of time, and keeps people from making subpar investment decisions through panic and greed.

Then there is the second way of imitation: indexing because it is now the received wisdom — all your friends are doing it. ?This is a momentum effect, and at some point even indexing through a large index like the S&P 500 or Wilshire 5000 could become overdone. ?The effects could vary, though.

You could see more larger private corporations go public because the advantage of cheap capital overwhelms the informational and other advantages of remaining private.
You could see corporations reverse financial engineering, and issue more cheap stock to retire expensive debt. ?On the other hand, it would be more likely that credit spreads would tighten significantly, leaving debt and equity balanced.
You would see pressure on corporations with odd capital structures like?multiple share classes to simplify, so that all of the equity would trade at high multiples.
Corporations could dilute their stock to pay for resources — labor, land, intellectual capital and physical capital. ?Or, buy up competitors. ?If you think that is farfetched, I remember the late ’90s where it was cool for executives to say, “Let the stock market pay your employees.”
People could borrow against their homes to buy more stock, or just margin up.

If you see what I am doing — I’m trying to show what a distorted price for publicly traded stocks in an big index could do — and I haven’t even suggested the obvious — that an unsustainable price will correct eventually, and maybe, in a dramatic way.

I’m not saying that indexing is a bubble presently. ?I’m only saying it could be one day. ?Like the imitation illustrations given above, when a lot of people want to do the same thing without bringing additional information to the process, shortages develop, and in some cases prices rise as a result.

One final note: active management would get more punch at some point, because informationless index investing would lead to some degree of mispricing that active managers would take advantage of. ?At the rate money is currently exiting active management and going into indexing, that could be five years from now (just a guess).

As with all things in investing, the proof will be seen only in hindsight, so take this with a saltshaker of salt. ?As for me, I will continue to pick stocks. ?It has worked well for me.