Category: Stocks

Now We’re Talking Volatility

Now We’re Talking Volatility

Posted on by David Merkel

If the gyrations of the equity market today were not enough, we are in a historically unusual situation where 3 of the last five business days have had moves on the S&P 500 of over 4% in absolute terms.? Since 1928, how many times has that happened?? 69 times.? Dig this:

So, on average, you make money investing during volatile times, but the possibility of moderate-to-severe loss is significant.? Those losses came in the Great Depression era (as did the huge gains), but for those that have read me a long time, you know that I believe that a second Great Depression is not impossible.? I don’t care how much policymakers say that they have learned, the system has an odd way of mutating to create the same result through a new process.? The market always has a new way to make a fool out of you.

Aside from the crash in 1987, only the depression era has had similar volatility, and they had it for a long time.? Even 1973-74 did not rate under that measure (though it resembled the Chinese water torture).

Take this with a grain of salt.? A salt shaker even.? Eddy Elfenbein and Bespoke often do analyses like these, and they have a certain wisdom most of the time.? But data-mining is always dangerous.? The question that must be asked is whether there is a mechanism to explain the results.? In this case, there is.? Volatile markets scare investors away, and drive prices down, in general.? This causes stock to move from weaker to stronger hands, i.e., from the weakly capitalized to the strongly capitalized (now I get to send my electricity check to Mr. Buffett).

So, ask yourself this: are we heading into a depression?? If not, buy some stock.? Personally, I’m not certain about whether we aren’t heading into a depression.? I view it as a 25% chance now.? Perhaps my next article will help explain.? As for me, I am continuing my normal policy of having 70% of my net worth in risk assets.

AIG: America’s Insurance Giant

AIG: America’s Insurance Giant

Posted on by David Merkel

How Much Can the US Government Guarantee? For now, whatever they want, or so it seems.? Perhaps the new question should be what dodgy assets can the Federal Reserve cram into the monetary base?

I’m talking about AIG, and this is one place where only the Fed could have acted, aside from the State of New York (too small).? The Fed can act because in a crisis, they can lend to anyone on a collateralized basis.? Essentially, they took most of the company as collateral for the loan with 80% ownership if things go right.? If things go wrong it will only increase our monetary inflation.? (Note: regulators typically take over financial companies, and though AIG is a holding company with many insurers domiciled in NY, most of the company is not regulated by the State of New York.? The Treasury could not act, and the State of New York did its best, but it was not enough.)

Consider some of the good articles posted on the deal:

(Naked Capitalism live-blogs, almost)

(WSJ)

(Big Picture)

(NYT)

(Bloomberg)

I find it amusing that the former CEO of Allstate, Ed Liddy, is the new CEO.? Allstate, for all its complexity, is a matchbox car compared to AIG’s non-functional Maserati.? That said, I like the pick.? He will simplify, simplify, simplify.? He will also have the time to do it.? (And, if he found getting Allstate’s stock price up to be a challenge, so he said to me once, oh my, here is the challenge of a lifetime.)? I also find it amusing because AIG often did not think much of Allstate.

Now, the senior secured bank loan effectively subordinates all other holding company debt.? That said, that debt will probably rally as a result of the rescue.? I’m not so sure about the stock, though, this is a lot of dilution to swallow.? Even though the preferred may not get dividends for two years, that might rally on the rescue.

But could this have been avoided?? Yes.? It comes down to one simple concept: Risk Based Liquidity.? Never finance illiquid assets with liquid liabilities.? Doing so invites a run on the bank.? Now in the modern context, one has to consider contingent liquidity: do you have ratings triggers in your bonds, insurance agreements, or derivative agreements?? That sets up a slippery slope where a cliff used to be.? AIG got killed primarily because they allowed for short-term calls on cash as credit ratings declined.? If the troubles from Life Insurers regarding GICs is not enough, nor utilities or reinsurers with ratings downgrade clauses, certainly this should show the folly of allowing ratings triggers in insurance/financial agreements.? I’m not saying that insureds are stupid to ask for them; I am saying that they should be illegal.

AIG left itself in a position where a very bad credit environment could destroy the company.? That resulted from writing insurance on seemingly unlikely credit events that are now more likely than one could have expected.? Also, there are the years of accounting misstatements because of the culture of fear that pervaded the company.

What can I say?? The financial companies that have failed had liquid liabilities and illiquid assets.? The first job of risk control is to assure sufficient liquidity under 99.5% of all scenarios.? This was not true of Fannie, Freddie, Merrill, Bear, Lehman, AIG, Countrywide, etc.? LIquidity costs money, which is why short-sighted managements intent on current earnings scrimp on liquidity.? But liquidity is the lifeblood of business, far more so than earnings.

Remember this when you invest, and look for companies that provide for significant adverse deviation.? And, all this said, I worry for our republic.? Our liberties are slowly disappearing before us, in a haze of government rescues.

AIG Borrows from Itself

AIG Borrows from Itself

Posted on by David Merkel

The Governor of New York, possibly thinking about his tax base, and perhaps 30,000 jobs, has allowed AIG to borrow $20 billion from its subsidiaries.? Details are scant, but this can be one of three things:

  • AIG has surplus assets in its NY-domiciled subsidiaries in excess of their risk-based capital requirements.? If true, borrowing against these would be a no-brainer that should have been pursued long ago.? Favoring this view is the NY Governor, who says AIG is “extraordinarily solvent.”
  • AIG has surplus assets in its NY-domiciled subsidiaries, but not in excess of their risk-based capital requirements.? Borrowing against these would be a risky gamble, because it lowers the amount of risk margin available to absorb adverse deviations.
  • Some combination of both — say that AIG has only $15 billion in surplus assets in its NY-domiciled subsidiaries… $5 billion would reduce risk margins.

The risk here is that you end up with insolvencies of some of AIG’s subsidiaries.? Though poential losses to policyholders would be unlikely to be large, assessments would be made to other insurer though the state guaranty funds in order to keep policyholders whole, but potentially at a cost to the other insurers.

This has the potential to look really bright or really stupid, and in a short amount of time, too.? Final note: It’s not impossible, but I would be surprised if the Federal Government or the Federal Reserve intervenes on AIG when it would not with Lehman.

Investing in Financial Stocks is Tough

Investing in Financial Stocks is Tough

Posted on by David Merkel

At RealMoney, I wrote an article in 2005 called, Buyers Beware: Financials are Different.? In addition to many other things I mentioned there, I gave six ways that financials were different:

  • Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. Demand is the ultimate limiting factor, but this affects financial, industrial and services businesses alike. But with a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps”), but more often, capital limits growth.
  • The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed with the business remaining as functional as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
  • Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint. This is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims-paying-ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
  • Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk or systemic risk; guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.); and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification. In a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence cannot be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
  • Rapid growth is typically a negative. Financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
  • Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company. The regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.

In general, accruals are weaker than cash entries in accounting.? Not all accruals are created equal either.? Some are less certain to be collected/paid, and some are further out in the future than others.

Financial stocks are generally bags of accrual entries in an accounting sense, with some more certain than others.? E.g., a short-tail personal lines P&C insurer’s accounting is a lot more certain than that of an investment bank.

This is why management quality matters so much with financial stocks.? The managements of financial companies must be competent and conservative, and all the more so to the degree that the accruals that they post are less certain.? Companies that grow too rapidly, or lack obvious risk control are to be avoided.

Looking at the Present Concerns

I own a bunch of insurance companies, but no banks or other financials.? Why?? Insurers are profitable and cheap, and are not under threat from credit risk to the degree that other financials are.? Consider the threats to AIG, Citi, Lehman, Merrill, GM, Ford, Wamu, etc.? The companies that got into trouble grew too fast, levered up too much, neglected risk control disciplines, and more.

Now their valuations have been crunched, and their financing options are limited.? Fortunately there are the options of last resort:

  • Have you maxed out trust preferred obligations? Other subordinated debt?
  • Have you maxed out preferred stock?
  • Have you issued convertible debt to monetize volatility?
  • Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
  • Have you sounded out investors in your corporate bonds about debt-for equity swaps?
  • And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

Given that Bear got a guarantee, perhaps others could too, though I think the US Government is far less willing now.? I could also add another point: have you sold your most valuable liquid assets?

With the crises being faced by financial companies, there is a rule that separates the survivors from the losers: Losers sell their best assets, and play for time.? Survivors/winners sell their worst assets and hunker down — they have enough financial slack that they don’t have to engage in panic behavior.

In an environment like this, where there is a lot of uncertainty, avoiding suspect financials is prudent.? This applies to those who take on the risks from such institutions when the decisions have to be made quickly on whether to buy them or not.? Thus I would be careful on the equities of any buyers in this environment, and would be a seller of any company that is a rapid buyer during this time of financial stress.

Full disclosure: no positions in companies mentioned.? I own SAFT LNC AIZ MET RGA HIG UAM among insurers, and might buy some more….

Another Look At Fannie and Freddie

Another Look At Fannie and Freddie

Posted on by David Merkel

For what it is worth, I am the proud owner of a “Fannie Fraud Patrol” T-shirt.? The fraud patrol was a loose mix of investors who felt that Fannie Mae’s finances were misstated back in 2003.? My small contribution to the effort was showing that the fair value balance sheet was not compatible with the standard balance sheet.? That was a pretty basic finding for an actuary used to doing cash flow testing.

I did not post much on Fannie and Freddie after the partial takeover by the US Government, because there wasn’t all that much that I could add.? I had gotten my calls right, most notably:

If you followed those calls, you made good money, particularly the first one.

But with all of the fuss over the actions of the Treasury, I must note several items:

  • Congress has the power to reverse or modify what the Treasury has done.? (Not that I ever expect much out of Congress…)
  • Even if the Treasury succeeds in lowering mortgage rates, that does not mean much when borrowers aren’t capable of scraping together the proper downpayment.??? Lower interest rates do not stimulate economic sectors under stress, but do stimulate healthy sectors, as housing did in 2001-3, while industry suffered.
  • I don’t like being a wet blanket, but aside from preventing systemic risk from letting senior debt and agency MBS suffer credit risk (these are big things), there isn’t a lot to boast about in the takeover.? At best, this leads to the wind-off of two entities that never should have been created.? Housing should not be subsidized by US taxpayers.

To the free market purists, who I sympathize with, I say let the hybrids die.? Our government has meddled too much in lending markets, but it is egregious when they do so where there is a private profit motive.? This bailout delivered real pain to those that were equity holders, while protecting against systemic risk.? The moral hazard issue to equity and preferred holders is dead.? They can lose it all, or close to it.? This is real improvement.

To liberals I say the public interest has been protected.? Systemic risk is avoided.? It is better that those without the wherewithal to own homes rent, than that they strain to own.

To all of Congress I say, if the Administration comes to you asking for a rise in the debt ceiling, ask them to sell their mortgage-backed securities first.? Why should those with mortgages be favored over renters and freeholders?

Avoiding Doomed Sectors, Redux

Avoiding Doomed Sectors, Redux

Posted on by David Merkel

Those that have followed me for a while know that I rotate industries.? The idea is to buy:

  • Strongly capitalized companies that are at their cyclical trough, or
  • Moderate-to-strongly capitalized companies where pricing trends are under-discounted.? Often these companies have positive price momentum.

Also, the idea is to avoid:

  • Sectors where valuation metrics are cheap, but the indutries are in terminal decline.
  • Weakly capitalized companies and industries where product pricing is weak.

The sectors to avoid are what I term “doomed sectors” though it applies better to the first example of the two.? My favorite example of a doomed sector is newspapers.? I don’t care how cheap they get, I am not buying.? They are obsolete.? As for the second example, think about depositary financial companies, or companies that take a lot of credit risk.? Eventually they will bounce back, but it will take a while.

Here’s my current industry ranks:

IndustryRanks-9-12-08
IndustryRanks-9-12-08

So, why don’t I dig through Hotels/Gaming, Air Transport, and Homebuilding?? Hotels are overbuilt.? Air Transport is a losers’ game; there are always romantic male entrepreneurs willing to invest at subpar prospective returns, because they like to see the planes fly.? Homebuilding?? There is a glut of homes.

If you can avoid bad sectors, your performance will be pretty good.? That has helped me over the past eight years.

I like investing in the green zone, in industries that I think have a future.? Good picks there can last for years.? There is another way to play my industry model, though.? Put money in the top ten industries, and keep it there as the berst industries change.? The trouble is, it is a high turnover strategy, though it beats the index by about 6%/year.? I’m not sure what trading friction would do to the return advantage.

That’s my view on industry rotation.? I prefer playing for longer periods and slower trading, but the system can be used in a momentum mode.

Too Bad for Preferred Stock

Too Bad for Preferred Stock

Posted on by David Merkel

From an old CC post:


 David Merkel
Why I Don’t Like Preferred Stock
6/9/2006 9:19 AM EDT

If I take risk, I want a decent probability of getting paid for taking the risk, and paid well. If I don’t want to take risk, I want a high degree of certainty that I’m not going to lose money, and if I do lose money, it won’t be much.

Having been a corporate bond manager in my last job (2001-03), I learned that I had all of the downside of stocks, with little of the upside of stocks. (One exception: buying MBNA floating-rate trust preferreds in late 2002 for $68 — they were at par ($100) in less than a year, matching the performance of MBNA stock, but that is rare, outside of distress situations. Another exception: fixed-income risk arbitrage was, in many cases, wider than that of equity arbitrage … examples from that era: Golden State, Household International and Allfirst, but I digress…

The situation is worse with preferred stocks. At least with corporate bonds you have a priority call on the assets of the firm in insolvency. Preferred stock typically gets 10 cents on the dollar in insolvency vs. 40 cents or so on senior unsecured corporates and 80 cents on bank debt.

Preferred stocks are called preferred because the dividend on the preferred must be paid for the common stock to receive a dividend. But with speculative ventures where the common doesn’t pay a dividend anyway, that is a small safeguard. Another small safeguard is the ability of the preferred holders to elect a few directors if the dividend is not paid. Nice, but it usually doesn’t tip the balance of corporate governance.

The recent troubles with Fannie and Freddie preferreds, where they lost 80%+ of their value, has hurt the preferred stock market.? Well, good.? Preferred stock is a vehicle that hates volatility.? The preferred holder just wants to clip his dividend payments and receive his principal back eventually.? He doesn’t benefit if the common rises (I leave aside convertible preferreds), and he is not protected during times of default.

This applies to all hybrid debt, trust preferreds, etc.? They may act like fixed income securities in good times, but in situations of economic stress, they behave more like equity than debt.

Be wary of those that promise high income relative to safer strategies.? It is rare that they succeed.

Avoiding Doomed Sectors

Avoiding Doomed Sectors

Posted on by David Merkel

It’s a tough market out there.? You can’t eat relative performance, and I am off a percent or two year-to-date.? I have made a number of moves in the portfolio recently:

  • Rebalancing sale of Jones Apparel
  • Rebalancing sale of Shoe Carnival
  • Rebalancing sale of Lincoln National
  • Rebalancing buy of ConocoPhillips
  • Sale of Gehl in entirety

In a bear market, I consider it unusual that I have gotten off so many rebalancing sales, but part of that is being willing to embrace an out-of-favor sector — retail.? That said, my cash position has risen to around 6%.

In this situation, being willing to embrace out-of-favor sectors, but not “doomed” sectors can pay off.? In my opinion, depositary and credit-sensitive financials are a doomed sector until the backlog of questionable names begins to diminish.? Fannie and Freddie are off the table, and didn’t S&P do us a favor by kicking them out of their indexes?? Surely they will add them to the Small Cap 600, right?? Sorry, no.? The cow is out in the pasture; closing the barn door won’t help.

Part of the trouble here is ripple, or, second-order effects.? Ordinarily, second-order effect diminish and get swallowed up by larger factors effecting the economy/markets.? But with financials, because of all of the layers of debt, the failure of a large institution can lead to a cascade of failures.? Much as I don’t like government bailouts, the reason why the Treasury stood behind the senior obligations of Fannie and Freddie was to avoid a cascade of failures, because their senior debt and guaranteed MBS are so widely held by financial institutions.

Until the institutions that can produce ripple effects either fail or conclusively survive, the bear market continues.? Bear markets are most often financing-driven; so long as financial firms are under stress, firms that rely on them for financing will be under stress as well.

Bailout Conditions for Lehman Brothers

On an unrelated note, what should be the terms for bailing out Lehman Brothers?

  • The government should only care about systemic risk, not specific risk, so they should only guarantee the derivatives counterparty of Lehman, with significant skin in the game from Lehman.
  • The equity, preferred equity, and subordinated debt of Lehman should be wiped out before the Treasury shells out one dollar.
  • Senior debtholders should take a haircut — they will get paid in new Lehman stock.

Lehman reports tomorrow, ahead of schedule.? Fears have led to a fall in the stock price.? It is quite possible that Lehman will report a good quarter to dispel doubts; it is also possible that they will announce a government takeover of some sort.? I can’t tell.? I do know that for the market to normalize, the big problem have to be resolved.? Lehman Brothers is one of those problems and it is not resolved yet.

Full disclosure: long LNC SCVL JNY COP

When Good Things Happen to Bad Stocks

When Good Things Happen to Bad Stocks

Posted on by David Merkel

I’ll write something more about Fannie and Freddie at a later time.? Things have worked out there largely as I expected.

What I did not expect is that the market would be up a lot on a day like today.? I did expect that Treasuries would be down.? After all, there are more claims on the Treasury now than before.

Why should the market be up?

  • The possibility of lower mortgage rates, which will help those that can put money down on a new home, and those that can refinance within conforming limits.
  • Risk is shifted off the balance sheets of lending institutions that held the senior debt of the GSEs.
  • A big uncertainty is resolved.? (And the next uncertainty has not arrived… yet.)

Now, as for me, I am probably having my best relative outperformance day ever, and it is due to one stock in my portfolio: Gehl.? As the AP says, “Construction and farm equipment maker Gehl Corp. said Monday it is being purchased by its largest shareholder Manitou BF SA for $450 million, or $30 per share.”? 120% premium to the Friday close.? I can live with that. 🙂

I don’t play for takeovers, particularly not in this environment where financing is scarce.? But in value investing, if you have reasonable financed assets trading at a discount to their value, takeovers will sometimes come, though rarely at premiums like this deal.? Wow.

There’s one more thing I would like to point out here.? I sometimes get a little criticism for not having an automatic sell rule.? My first purchase of GEHL was around $20.? I averaged down twice.? Each time I reviewed the position, and concluded financing was adequate, though short-term earnings did not look promising.? I concluded that over a 2-3 year timeframe, I would probably be rewarded, or not lose much.? If I had used a mechanical sell rule, I would not have gotten the good side of Gehl.? (And, for those that keep score, this gain almost pays for the loss in Deerfield.)

That’s how it goes.? I could not predict this incident, and I have enough bad things that happen that I also can’t predict.? But in a well-diversified portfolio of cheap, well-financed stocks, there can be room for good surprises.? I just happened to get a big one today.? (And, it puts me in the plus column for YTD performance.? What a tough year for the market.)

Full disclosure: Flat GEHL — my limit orders got lifted as I wrote this…

Another Look at My Investment Screening Methods

Another Look at My Investment Screening Methods

Posted on by David Merkel

Recently I received an e-mail from one of my readers on my investing methods.? I thought it might be useful for all of my readers, so I am going to answer it here.

I liked your post of your 8 investing rules and also your 4/16/08 post where you list your metrics for ranking potential stocks.? I too believe that a disciplined investing style that adheres to certain rules and metrics is very important in controlling the emotions that lead to subpar returns, and have been trying to develop a set of metrics for my own quantitative investing methodology. I noticed that some of your metrics are different that the common ratios I’ve usually come across while developing my methodology.??I was wondering?if you could answer a few questions regarding?them.

Note: the links are to posts that I think he meant.? If not, my apology.

P/E:??You use?three different P/E criteria, which makes P/E very important in your strategy.??Why do you?use P/E as opposed to P/Cash flow, which many believe is more telling than P/E???Do you have any concern in using forward P/E ratios, considering that analysts are notorious for being wrong with their earnings predictions (David Dreman?discusses this in his books)?

Ideally, we want an accurate forward estimate of free cash flow.? No one knows that, so I have to compromise.? P/E did have three spots in my April post, but that gave it a weight of 3/13ths.? Why not cash flow?? I’m open to the concept, and I have used it in the past.? In tough markets where M&A is not happening, CFO and EBITDA measures tend not to work as well.? I give forward P/Es higher weights when we are in the beginning of a recovery, with corporate bond spreads starting their rally.? Once the rally is established, and spreads have tightened, that is when M&A heats up, that is when EV/EBITDA, and P/CFO metrics have more punch.? During bear phases, I give more weight to P/B and P/Sales.

I’ve talked with a lot of different investment managers, and some like trailing P/Es and others, forward P/Es.? In general, the sell side is optimistic, but there is an advantage to using their estimates.? They provide a control mechanism.? Their estimates drive stock performance in the short run and they provide a gauge to how results are tracking against expectations.? I think that their estimates reflect the view of the market as a whole usually.? I try to balance optimistic and pessimistic indicators in my valuations, so as not to overplay either side.

Net Operating Accruals:? Do you use this metric based on the research done by Sloan and used in Piotroski’s Z_score?

No, I got this through Hirshleifer and a number of other financial economists.? That doesn’t mean that it might not be the same thing researched by Sloan and Piotroski.? Piotroski’s Z-score has a lot to commend it; the only trouble is that very few companies get those high scores.

Volatility, RSI, Neglect:? These are metrics that I have seen few people discuss. ?What is?your basis for using them? I believe I read an abstract to a?study that found that low volatility stocks outperform high volatility stocks- is this what you are trying to take advantage of???What is the measurement for neglect anyway???Sorry for my lack of knowledge on this subject.? When I read this post I was suprised that, as a contrarian fundamental investor,?you used so many technical metrics.? Do you try to use metrics that have?very little following because?methodologies lose their?effectiveness when?they becomes popular (like the small cap effect)?

What is a technical indicator?? I don’t read charts.? I do try to look for stocks that are off the beaten path, and there are some non-price measures that indicate that.? As for volatility, I would point you to this article at the excellent CXO Advisory blog.? Yes, low volatility tends to outperform.

It’s not that I am looking at technicals, but anomalies.? I believe in the Adaptive Markets Hypothesis, which says that inefficiencies exist in the markets, but only for a while because when they are big enough, investors take advantage of them, and compete them away.? The markets are only mostly efficient, and I try to take advantage of what is “on sale” when I reshape my portfolio.

The neglect measure is what fraction of the company’s shares trade.? In general, companies with lower share turnover tend to do better.

As for RSI, that is one area where I have changed.? I used to use momentum as “buy what’s falling” metric.? There’s too much evidence for the contrary, and so I have flipped RSI so that weight is given to stocks with positive momentum.? Positive momentum tends to generate positive returns, because people are conservative in their estimates.? Buying momentum makes sense except when many are doing it.? After things have been running hot for a while, I would drop the metric.

What helps me go where others will not are my industry models.? One of my core beliefs is that industries are under-analyzed.? Also, Industry behavior is more basic to the market than size and value/growth distinctions.? If I analyze industries that are out of favor, and buy financially strong names in those industries, it is difficult to go wrong.

When I look at anomalies, I look for things where retail and professional investors tend to err.? Those are places where human nature tends to encourage people to make wrong decisions.? People like to play controversial stocks — they tend to be overvalued.? People like to play well-known stocks.? They are overvalued as well.? Momentum?? The market as a whole is slow to react to new data.

I don’t aim for metrics with small followings.? I aim for things that have worked over time.? Before the calculation of the metrics, my industry models toss in a number of out-of-favor names.? After the calculation of the metrics, I look at earnings quality, frequency of beating estimates, a more detailed look at the balance sheet, etc.

I view my non-fundamental variables as measures that complement the valuation side of the analysis.? (Valuation is most important, but it is not everything.)? They help in avoiding value traps (net operating accruals), and point at stocks that other investors are ignoring.? They aren’t perfect, and if they were perfect, I am sure that I don’t use them perfectly.? The object is to tilt the odds in my favor of having a successful investment.? That is what my screening methods (rule 8 ) intend to do, as well as the rest of my eight rules.

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