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Book Review: Financial Tales

Posted on 24 October 201525 October 2015 by David Merkel

This financial book is different from the 250+ other financial books that I have reviewed, and the hundreds of others I have read. ?It tells real life stories that the author has personally experienced, and the financial ramifications that happened as a result. ?Each?of the 60+ stories illustrates a significant topic in financial planning for individuals and families. ?Some end happy, some end sad. ?There are examples from each of the possible outcomes?that can result from people interacting with financial advice (in my rough large to small probability order):

Followed bad advice, or ignored good advice, and lost.
Followed good advice, and won.
A mixed outcome from mixed behavior
Followed bad advice, or ignored good advice, and won anyway.
Followed good advice, and lost anyway.

The thing is, there is a “luck” component to finance. ?People don’t know the future behavior of markets, and may accidentally get it right or wrong. ?With good advice, the odds can be tipped in their favor, at least to the point where they aren’t as badly hurt when markets get volatile.

The stories in the book mostly stem from the author’s experience as a financial advisor/planner in Maryland. ?The stories are 3-6 pages long, and can be read one at a time with little loss of flow. ?The stories don’t depend on each other. ?It is a book you can pick up and put down, and the value will be the same as for the person who reads it straight through.

In general, I thought the author advocated good advice for his clients, family and friends. ?Most people could benefit from reading this book. ?It’s pretty basic, and maybe, _maybe_, one of your friends who isn’t so good with financial matters could benefit from it as a gift if you don’t need it yourself. ?The reason I say this is that some people will learn reading about the failures of others rather than being advised by well-meaning family, friends, and professionals. ?They may admit to themselves that they?have been wrong when they be unwilling to do it with others.

I recommend this book for readers who need motivation and knowledge to guide themselves in their financial dealings, including how to find a good advisor, and how to avoid bad advisors.

Quibbles

The book lacks generality because of its?focus on telling stories. ?It would have been a much better book if it had one final chapter or appendix where the author would take all of the lessons, and weave them into a coherent whole. ?If nothing else, such a chapter would be an excellent review of the lessons of the book, and could even footnote back to the stories in the book for where people could read more on a given point.

I know this is a bias of mine regarding books with a lot of unrelated stories, but I think it is incumbent on the one telling the stories to flesh out the common themes, because many will miss those themes otherwise. ?In all writing, specifics support generalities, and generalities support specifics. ?They are always stronger together.

An Aside

I benefited from the book in one unusual way: it gave me a lot of article ideas, which you will be reading about at Aleph Blog in the near term. ?I’ve never gotten so many from a single book — that is a strength of reading the ideas in story form. ?It can catch your imagination.

Summary / Who Would Benefit from this Book

You don’t need this book if you are an expert or professional in finance. ?You could benefit from this book?if you want to improve what you do financially, improve your dealings with your financial advisor, or get a good financial advisor. ?if you want to buy it, you can buy it here: Financial Tales.

Full disclosure:?The author sent a free copy?to me directly. ?Though we must live somewhat near to one another, and we both hold CFA charters, I do not know him.

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.

Too Many Vultures, Too Little Carrion, Redux

Posted on 22 October 2015 by David Merkel

Photo Credit: TexasEagle || A: Do you see any prey? B: No, I don't. Do *you* see any prey? — Photo Credit: TexasEagle || A: Do you see any prey? B: No, I don’t. Do *you* see any prey?

I was surprised to find that I wrote another piece with the same title — 8.5 years ago, before the housing bubble crashed. ?It was a short piece (with dead links). ?Here it is:

I had a cc post over at RealMoney called Too Many Vultures, Too Little Carrion . The idea was that there?s too much money ready to rescue dud assets at present. Yesterday, Cramer had his own blog entry suggesting that the absorption of subprime assets at relatively high prices implied that the depositary financial sector is a sound place to invest. I disagree. In the early phases of any secular change, there are market players who snap up distressed assets, and later they find out that they could have gotten a better bargain had they waited.

The good sale prices for subprime portfolios is not a sign of strength, but a sign that there is a lot of vulture capital looking for deals. The true problems will surface when the vulture capital gets burned through or scared away.

That last paragraph is the “money shot.” ?When there is too much vulture capital waiting to invest in distressed securities, marginal business concepts don’t get destroyed, clearing the way for a reduction in capacity, and healthy firms pick up the pieces. ?At such a time, you have to wait until the distressed players get hosed, or get smart.

Today’s topic is the debt and equity of companies producing energy, or providing services to them, all of which get hurt by a lower oil price. ?In the recent past, you have had marginal energy companies able to get financing amid decreasing opportunities for decent profits. ?Thus the article at the Wall Street Journal talking about hedge funds losing money on recently placed bets on energy.

Aiding the financing of marginal companies can pay off if the companies will be profitable within a reasonable window of time, or, if you are trying to buy assets cheap for a reorganization. ?But if there is too much capacity, and thus low prices for products, the profits after financing may never emerge, and the value of the assets may sag.

Let me talk about another group of oil companies on the global scene. ?They are relatively high cost players with large-ish balance sheets that are presently pushing to recover market share. ?Yes, I am talking about OPEC countries. ?Not the national oil companies of those countries, but the countries themselves.

Think of the countries as the companies, because the companies themselves fund the government of these countries. ?Consider this quotation from the Bloomberg article to which I linked, regarding one of the stronger OPEC countries, Saudi Arabia:

Saudi Arabia, the main architect of OPEC?s new strategy, will have a budget deficit of 20 percent of gross domestic product this year,?the International Monetary Fund estimates. While the kingdom has been able to tap foreign currency reserves and curb spending to cope with the slump, financial assets may run out within five years if the government maintains current policies and prices stay low, the IMF said Wednesday.

Less wealthy OPEC members have even fewer options. The threat of political unrest is mounting in the ?Fragile Five? of Algeria, Iraq, Libya, Nigeria and Venezuela, according to RBC Capital Markets LLC.

Think of the budget deficits that the OPEC countries have to fund in the same way you think about the debt service of a US E&P company. ?The deposits of oil being produced may be low cost in and of themselves, but any profits go to cover debt service of the greater enterprise, and whatever is not covered, more will be borrowed, should the markets allow it.

What’s the longest that this game could be played? ?Never say never, but I would be shocked if this could continue ?to 2020. ?That said, there are a lot of OPEC countries that won’t make it that far, and a lot of E&P and services businesses that won’t make it that far either. ?Now, the countries could face severe political turbulence, but eventually, they will have to reduce what they borrow and spend. ?That doesn’t mean the oil stops flowing, though a new government could decide to cut spending further, and save the patrimony (crude oil) for a better day.

The free market oil producers are another matter… they can go under, and production would likely stop. ?The question is what side of the solvency line you end up on when enough production capacity is eliminated. ?If you are still solvent, you will reap some reward for your fiscal rectitude as prices rise again, and the Saudis breathe a sigh of relief, congratulating themselves for winning a very expensive game of “chicken,” or, a Pyrrhic economic war.

As such, be careful playing in heavily indebted companies that benefit from higher energy prices. ?That they are limping along should be no comfort, because those that they presently rely on for financing will eventually have to give up, much as those snatching up bargains in subprime?had to give up when the financial crisis hit.

And for those watching the price of crude oil, this is yet another reason why Brent crude should remain near $50/bbl, for a few years. ?It is the uneasy equilibrium where producers are both entering the market and giving up. ?The Saudis don’t want it much lower — there are limits to the pain that they want to take, as well as impose on the rest of OPEC.

Return to the PEG Ratio

Posted on 21 October 2015 by David Merkel

Photo Credit: Tony & Wayne || Do we PEG the growth of pretty flowers?

I was looking through an article to see if it had any decent stock ideas, and noted that most of the companies featured were growth stocks. ?As such, my first pass for analysis is the PEG ratio, which is the ratio of the Price-Earnings ratio divided by the growth rate expressed as a percentage (e.g. 8% => 8 for this calculation.).

I’ve written about the PEG ratio a long time ago, and it is a classic article of mine. ?The PEG ratio is a valid concept for “growth at a reasonable” price investors. ?It does not work well for value investors or aggressive growth investors. ?My rule for implementation comes to this: if the current P/E ratio is 12 or higher?and the PEG ratio is lower than 1.5, that stock might be worth a look. ?Better to find the PEG ratio below one, though.

I went through the article and concluded that maybe Becton Dickinson and Hanesbrands might be worth a look. ?But then I thought, “What if I applied the formula to propose overvalued stocks?”

I set my screener for a 2016 PE higher than 12 and a PEG higher than 2.0x, with failing momentum, where the stock was down more than 20% in the nine months prior to the current month. ?Here were the 50 stocks that resulted:

What I find fascinating here is the mix of hot companies, basic materials and energy names, and limited partnerships.

This is only a start for analysis, so don’t run out and short these. ?Not that I am big on shorting, but high earnings valuations, and failing price momentum could be a good place to start. ?I have no positions in any of these companies, and I rarely if ever short. ?I just thought this would be an interesting exercise.

Why Companies SHOULD Offer Earnings Guidance

Posted on 21 October 2015 by David Merkel

Picture Credit: Insider Monkey || Isn’t Jamie Dimon handsome?

Recently Jamie Dimon was interviewed by Bloomberg, and commented that companies should stop giving earnings guidance. This is out of character for me, but I will explain why companies should offer earnings guidance. (Why is it out of character? Previously I have said that I don’t personally care whether firms that I own give earnings guidance or not… that still remains true.)

From the interview:

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said corporate leaders shouldn?t give earnings guidance because they can?t predict the future and should focus instead on long-term performance.

Some CEOs ?start making promises they shouldn?t make,? Dimon, 59, said Monday in a Bloomberg Television interview with Stephanie Ruhle. ?Don?t make earnings forecasts. You don?t know what?s going to happen every quarter. I don?t even care about quarterly earnings.?

<snip>

While many JPMorgan shareholders ?completely appreciate? long-term investing, other market participants overreact to short-term results, Dimon said. The New York-based firm last week reported third-quarter profit that missed analysts? estimates as a slump in trading and mortgage banking drove revenue lower from a year earlier.

Dimon is mostly right, as far as he goes, particularly when you think about a complex bank, where the accounting for profits over a short period is less than an exact science.

I’ve written at least two articles on earnings estimates:

In general, I think you have to have something like [adjusted non-GAAP (ANG)] earnings estimates in order for shareholders to have some measure of how corporations are tracking in their goals of building value. ?That doesn’t mean that corporations have to facilitate that, because the sell side?will do it themselves if the company is big enough, the shares trade enough, or?it raises capital often enough.

Dimon and other CEOs can sit back and let the earnings estimates be their own little sideshow. ?Still, there is a reason to give forward guidance. ?It lowers your cost of capital on average.

Forward guidance gives investors (and sell side analysts comfort that there is a business model there that is predictable in building value. ?I’m not talking about GAAP earnings, but ANG?earnings because in principle they should reflect the true increase in the per share value of the firm after eliminating accounting entries that distort that effort.

Now don’t get me wrong. ?Not all companies craft their?ANG earnings so honestly — they may even adjust differently period to period to make things look good. ?As with all things in the market, buyer beware.

But if companies can show that they have adequate control over their financial results such that they forecast future earnings and they honestly come to pass, investors will think the place is better managed than most, and reward it with a higher P/E multiple.

That is my simple argument.

A Bigger Brick in the Wall of Worries

Posted on 17 October 201518 October 2015 by David Merkel

I have my list of concerns for the economy and the markets:

Unexpected Global Macroeconomic Surprises, including more from China
Student Loans, Agricultural Loans, Auto Loans — too much
Exchange Traded Products — the tail is wagging the dog in some places, and ETPs are very liquid, but at a cost of reducing liquidity to the rest of the market
Low risk margins — valuations for equity and debt are high-ish
Demographics — mostly negative as populations across the globe age
Wages in the “developed world” are getting pushed to the levels of the “developing world,” largely due to the influence of information technology. ?Also, technology is temporarily displacing people from current careers.

But now I have one more:

7) ?Nonfinancial corporations, once the best part of the debt markets, are beginning to get overlevered.

This is worth watching. ?It seems like there isn’t that much advantage to corporate borrowing now — the arbitrage of borrowing to buy back stock seems thin, as does borrowing to buy up competitors. ?That doesn’t mean it is not being done –?people imitate the recent past as a useful shortcut to avoid thinking. ?Momentum carries markets beyond equilibrium as a result.

If the Federal Reserve stimulates by ~~duping~~ getting economic actors to accelerate current growth by taking on more debt, it has worked here. ?Now where is leverage low? ?Across the board, debt levels aren’t far from where they were in 2008:

As such, I’m not sure where we go from here, but I would suggest the following:

Start lightening up on bonds and stocks that would concern you if it were difficult to get financing. ?How well would they do if they had to self-finance for three years?
With so much debt, monetary policy should remain ineffective. ?Don’t expect them to move soon or aggressively.
Fiscal policy will remain riven by disagreements, and hamstrung by rising entitlement spending.
Long Treasuries don’t look bad with inflation so low.
Leave a little liquidity on the side in case of a negative surprise. ?When everyone else has high debt levels, it is time to reduce leverage.

Better safe than sorry. ?This isn’t saying that the equity markets can’t go higher from here, that corporate issuance can’t grow, or that corporate spreads can’t tighten. ?This is saying that in 2004-2006, a lot of the troubles that were going to come were already baked into the cake. ?Consider your current positions carefully, and develop your plan for your future portfolio defense.

Book Review: 100 to 1 in the Stock Market

Posted on 15 October 2015 by David Merkel

How can a book be largely true, but not be a good book? ?By offering people a way to make a lot of money that is hard to do, but portraying it as easy. ?It can be done, and a tiny number succeed at it, but most of the rest lose money or don’t make much in the process. ?This is such a book.

Let me illustrate my point with an example. ?Toward the end of every real estate bull market, books come out on how easy it is to make money flipping homes. ?The books must sell to some degree or the publishers wouldn’t publish them. ?Few actually succeed at it because:

It’s a lot of work
It’s competitive
It only works well when you have a bunch of people who are uneducated about the value of their homes and are willing to sell them to you cheap, and/or offer you cheap financing while you reposition it.
Transaction costs are significant, and improvements don’t always pay back what you put in.

You could make a lot of money at it, but it is unlikely. ?Now with this book, “100 to 1 in the Stock Market,” the value proposition is a little different:

Find one company that will experience stunning compound growth over 20-30+ years.
Invest heavily in it, and don’t diversify into a lot of other stocks, because that will dilute your returns.
Hold onto it, and don’t sell any ever, ever, ever! ?(Forget Lord Rothschild, who said the secret to his wealth was that he always sold too soon.)
Learn to mention the company name idly in passing, and happily live off of the dividends, should there be any. 😉

Here are the problems. ?First, identifying the stock will be tough. ?Less than 1% of all stocks do that. ?Are you feeling lucky? ?How lucky? ?That lucky? ?Wow.

Second, most people will pick a dog of a stock, and lose a lot of money. ?If you aren’t aware, more than half of all stocks lose money if held for a long time. ?Most of the rest perform meh. ?Even if you pick a stock you think has a lot of growth potential, there is often a lot of competition. ?Will this be the one to survive? ?Will some new technology obsolete this? ?Will financing be adequate to let the plan get to fruition without a lot of dilution of value to stockholders.

Third, most people can’t buy and hold a single stock, even if it is doing really well. ?Most succumb to the temptation to take profits, especially when the company hits a rough patch, and all companies hit rough patches, non excepted.

Fourth, when you do tell friends about how smart you are, they will try to dissuade you from your position. ?So will the financial media, even me sometimes. ?As Cramer says, “the bear case always sounds more intelligent.” ?Beyond that, never underestimate envy. 🙁

But suppose even after reading this, you still want to be a home run hitter, and will settle for nothing less. ?Is this the book for you? ?Yes. ?it will tell you what sorts of stocks appreciate by 100 times or more, even if finding them will still be rough.

This book was written in 1972, so it did not have the benefit of Charlie Munger’s insights into the “Lollapalooza” effect. ?What does it take for a stock to compound so much?

It needs a sustainable competitive advantage. ?The company has to have something critical that would be almost impossible for another firm to replicate or obsolete.
It needs a very competent management team that is honest, and shareholder oriented, not self-oriented.
They have to have a balance sheet capable of funding growth, and avoiding crashing in downturns, while rarely issuing additional shares.
It has to earn a high return on capital deployed.
It has to be able to reinvest earnings such that they earn a high return in the business over a long period of time.
That means the opportunity has to be big, and can spread like wildfire.
Finally, it implies that not a lot of cash flow needs to be used to maintain the investments that the company makes, leaving more money to invest in new assets.

You would need most if not all of these in order to compound capital 100 times. ?That’s hard. ?Very hard.

Now if you want a lighter version of this, a reasonable alternative, look at some of the books that Peter Lynch wrote, where he looked to compound investments 10 times or more. ?Ten-baggers, he called them. ?Same principles apply, but he did it in the context of a diversified portfolio. ?That is still very tough to do, but something that mere mortals could try, and even if you don’t succeed, you won’t lose a ton in the process.

Quibbles

Already given.

Summary / Who Would Benefit from this Book

You can buy this book to enjoy the good writing, and learn about past investments that did incredibly well. ?You can buy it to try to hit a home run against a major league pitcher, and you only get one trip to the plate. ?(Good luck, you will need it.)

But otherwise don’t buy the book, it is not realistic for the average person to apply in investing. ?if you still want to buy it, you can buy it here: 100 to 1 in the Stock Market.

Full disclosure:?I bought it with my own money. ?May all my losses be so small.

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.

Learning from the Past, Part 6 [Hopefully Final, But It Won’t Be…]

Posted on 8 October 20158 October 2015 by David Merkel

Photo Credit: Tony Webster || Bridges can collapse -- so can leverage... — Photo Credit: Tony Webster || Bridges can collapse — so can leverage…

This is the last article in this series… for now. ?The advantages of the modern era… I went back through my taxes over the last eleven years through a series of PDF files and pulled out all of the remaining companies where I lost more than half of the value of what I invested, 2004-2014. ?Here’s the list:

Avon Products [AVP]
Avnet [AVT]
Charlotte Russe [Formerly CHIC — Bought out by Advent International]
Cimarex Energy [XEC]
Devon Energy [DVN]
Deerfield Triarc?[formerly DFR, now merged with?Commercial Industrial Finance Corp]
Jones Apparel Group [formerly JNY — Bought out by Sycamore Partners]
Valero Enery [VLO]
Vishay Intertechnology [VSH]
YRC Worldwide [YRCW]

The Collapse of Leverage

Take a look of the last nine of those companies. ?My?losses?all happened during the financial crisis. ?Here I was, writing for RealMoney.com, starting this blog, focused on risk control, and talking often?about rising financial leverage and overvalued housing. ?Well, goes to show you that I needed to take more of my own medicine. ?Doctor David, heal yourself?

Sigh. ?My portfolios typically hold 30-40 stocks. ?You think you’ve screened out every weak balance sheet or too much operating leverage, but a few slip through… I mean, over the last 15 years running this strategy, I’ve owned over 200 stocks.

The really bad collapses happen when there is too much debt and operations fall apart — Deerfield Triarc?was the worst of the bunch. ?Too much debt and assets with poor quality and/or repayment terms that could be adjusted in a negative way. ?YRC Worldwide — collapsing freight rates into a slowing economy with too much debt. ?(An investment is not safe if it has already fallen 80%.)

Energy prices fell at the same time as the economy slowed, and as debt came under pressure — thus the problems with Cimarex, Devon, and to a lesser extent Valero. ?Apparel concepts are fickle for women. ?Charlotte Russe and Jones Apparel executed badly in a bad stock market environment. ?That leaves Avnet and Vishay — too much debt, and falling business prospect along with the rest of the tech sector. ?Double trouble.

Really messed up badly on each one of them, not realizing that a weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. ?As such, if you are worried about a crushing market environment in the future, you will need to stress-test to a much higher degree than looking at financial leverage only. ?Look for companies where the pricing of the product or service can reprice down — commodity prices, things that people really don’t need in the short run, intermediate goods where purchases?can be delayed for a while, and anyplace where high fixed investment needs strong volumes to keep costs per unit low.

One final note — Avon calling! ?Ding-dong. ?This was a 2015 issue. ?Really felt that management would see the writing on the wall, and change its overall strategy. ?What seemed to have stopped falling had only caught its breath for the next dive. ?Again,?an investment is not safe if it has already fallen 80%.

There is something to remembering rule number 1 — Don’t Lose Money. ?And rule 2 reminds us — Don’t forget rule number 1. ?That said, I have some things to say on the positive side of all of this.

The Bright Side

A) I did have a diversified portfolio — I still do, and I had companies that did not do badly as well as the minority of big losers. ?I also had a decent amount of cash, no debt, and other investments that were not doing so badly.

B) I used the tax losses to allow a greater degree of flexibility in investing. ?I don’t pay too much attention to tax consequences, but all concerns over?taking gains went away until 2011.

C) I reinvested in better companies, and made the losses back in reasonably short order, once again getting to pay some taxes in the process by 2011. ?Important to note: losses did not make me give up. ?I came back with vigor.

D) I learned valuable lessons in the process, which you now get to absorb for free. ?We call it market tuition, but it is a lot cheaper to learn from the mistakes of others.

Thus in closing — don’t give up. ?There will be losses. ?You will make mistakes, and you might kick yourself. ?Kick yourself a little, but only a little — it drives the lessons home, and then get up and try again, doing better.

Full disclosure: long VLO — made those losses back and then some.

Notes on the SEC’s Proposal on Mutual Fund Liquidity

Posted on 7 October 2015 by David Merkel

I’m still working through the SEC’s proposal on Mutual Fund Liquidity, which I mentioned at the end of?this article:

Q: <snip> Are you going to write anything regarding the SEC?s proposal on open end mutual funds and ETFs regarding liquidity?

A: <snip> …my main question to myself is whether I have enough time to do it justice. ?There?s their white paper on liquidity and mutual funds. ?The proposed rule is a monster at 415 pages, and I may have better things to do. ? If I do anything with it, you?ll see it here first.

These are just notes on the proposal so far. ?Here goes:

1) It’s a solution in search of a problem.

After the financial crisis, regulators got one message strongly — focus on liquidity. ?Good point with respect to banks and other depositary financials, useless with respect to everything else. ?Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty. ?Even money market funds weren’t that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.

The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough. ?In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.

The proposal allows for “swing pricing.” ?From the SEC release:

The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use ?swing pricing.??

Swing pricing is the process of reflecting in a fund?s NAV the costs associated with shareholders? trading activity in order to pass those costs on to the purchasing and redeeming shareholders.? It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.? Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.

A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund?s NAV known as the swing threshold.? The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold.? The fund?s board, including the independent directors, would be required to approve the fund?s swing pricing policies and procedures.

But there are simpler ways to do this. ?In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly. ?This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on.

Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies. ?Those are frequently used for funds where the underlying assets are less liquid. ?Those would more than compensate for any losses.

2) This disproportionately affects fixed income funds. ?One size does not fit all here. ?Fixed income funds already use matrix pricing extensively — the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask.

In order to get a decent yield, you have to accept some amount of lesser liquidity. ?Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss? ?Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds.

Liquidity risk in bonds is important, but it is not the only risk that managers face. ?it should not be made a high priority relative to credit or interest rate risks.

3) One could argue that every order affects market pricing — nothing is truly liquid. ?The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk.

4)?Liquidity is not as constant as you might imagine. ?Raising your bid to buy, or lowering your ask to sell are normal activities. ?Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do. ?It is very easy to underestimate the amount of potential liquidity in a given asset. ?As with any asset, it comes at a cost.

I spent a lot of time trading illiquid bonds. ?If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of. ?What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry. ?Just be diffident, say you want to pick up or pose one or two?million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation. ?I actually found it to be a lot of fun, and it made good money for my insurance client.

5) It affects good things about mutual funds. ?Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm. ?Illiquid assets, properly chosen, can add significant value. ?As Jason Zweig of the Wall Street Journal said:

The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are ? and a rare few into bigger risk-takers than ever.

You want to kill off active managers, or make them even more index-like? ?This proposal will help do that.

6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc?

Summary

You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic. ?It would be better if the SEC just withdrew these proposed rules. ?My guess is that the costs outweigh the benefits, and by a wide margin.

Book Review: The Art of Execution

Posted on 1 October 2015 by David Merkel

Some books are better in concept than they are in execution. ?Ironically, that is true of “The Art of Execution.”

The core idea of the book is that most great investors get more stocks wrong than they get right, but they make money because they let their winners run, and either cut their losses short or reinvest in their losers at much lower prices than their initial purchase?price. ?From that, the author gets the idea that the buy and sell disciplines of the investors are the main key to their success.

I know this is a book review, and book reviews are not supposed to be about me. ?I include the next two paragraphs to explain why I think the author is wrong, at least in the eyes of most investment managers that I know.

From my practical experience as an investment manager, I can tell you that your strategy for buying and selling?is a part of the investment process, but it is not the main one. ?Like the author, I also have hired managers to run a billion-plus dollars of money for a series of multiple manager funds. ?I did it for the pension division of mutual life insurer that no longer exists back in the 1990s. ?It was an interesting time in my career, and I never got the opportunity again. ?In the process, I interviewed a large number of the top long-only money managers in the US. ?Idea generation was the core concept for almost all of the managers. ?Many talked about their buy disciplines at length, but not as a concept separate from the hardest part of being a manager — finding the right assets to buy.

Sell disciplines received far less emphasis, and for most managers, were kind of an afterthought. ?If you have good ideas, selling assets is an easy thing — if your ideas aren’t good, it’s hard. ?But then you wouldn’t be getting a lot of assets to manage, so it wouldn’t matter much.

Much of the analysis of the author stems from the way he had managers run money for him — he asked them to invest on in their ten best ideas. ?That’s a concentrated portfolio indeed, and makes sense if you?are almost certain in your analysis of the stocks that you invest in. ?As such, the book spends a lot of time on how the managers traded single ideas as separate from the management of the portfolio as a whole. ?As such, a number of examples that he brought out as bad management by one set of managers sound really?bad, until you realize one thing: they were all part of a broader portfolio. ?As managers, they might not have made significant adjustments to a losing position because they were occupied with other more consequential positions that were doing better. ?After all, losses on a stock are capped at 100%, while gains are theoretically infinite. ?As a stock falls in price, if you don’t add to the position, the risk to the portfolio as a whole gets less and less.

Thus, as you read through the book, you get a collection of anecdotes to illustrate good and bad position and money management. ?Any one of these might sound bright or dumb, but they don’t mean a lot if the rest of the portfolio is doing something different.

This is a short book. ?The pages are small, and white space is liberally interspersed. ?If this had been a regular-sized book, with white space reduced, it might have taken up 80-90 pages. ?There’s not a lot here, and given the anecdotal nature of what was written, it is?not much more than the author’s opinions. ?(There are three pages citing an academic paper, but they exist as an afterthought in a chapter on one class of investors. It has the unsurprising result that positions that managers weight heavily do better than those with lower weights.) ? As such, I don’t recommend the book, and I can’t think of a subset of people that could benefit from it, aside from managers that want to be employed by this guy, in order to butter him up.

Quibbles

The end of the book mentions liquidity as a positive factor in asset selection, but most research on the topic gives a premium return to illiquid stocks. ?Also, if the manager has concentrated positions in the stocks that he owns, his positions will prove to be less liquid than less concentrated positions in stocks with similar tradable float.

Summary / Who Would Benefit from this Book

Don’t buy this book. ?To reinforce this point, I am not leaving a link to the book at Amazon, which I ordinarily do.

Full disclosure:?I?received a?copy from a PR flack.

Book Review: DIY Financial Advisor

Posted on 26 September 2015 by David Merkel

I am generally not a fan of formulaic books on investing, and this is particularly true of books that take unusual approaches to investing. This book is an exception because it does nothing unusual, and follows what all good quantitative investors know have worked in the past. ?The past is not a guarantee of the future, but?if the theories derived from past data make sense from what we know about human nature, that’s about as good as we can get.

The book begins with a critique of the abilities of financial advisors — their fees, asset allocation, and security selection. ?It then shows how models of financial markets outperform most financial advisors.

Then, to live up to its title , the book gives simple versions of models that can be applied by individuals that would have outperformed the markets in the past. ?You can beat the markets, lower risk, and “Do It Yourself [DIY].” ?It provides models for asset allocation, stock selection, and risk control, simple enough that a motivated person with math skills equal to the first half of Algebra 1 could apply them in a moderate amount of time per month. ?It also provides a simpler version of the full model that omits the security selection for stocks.

The book closes by offering three reasons why people won’t follow the book and do it themselves: fear of failure, inertia, and not wanting to give up an advisor who is a friend. ?It also offers three risks for the DIY investor — overconfidence, the desire to be a hero (seems to overlap with overconfidence), and that the theories may be insufficient for future market behavior.

This is where I have the greatest disagreement with the book. ?I interact with a lot of people. ?Most of them have no interest in learning the slightest bit about investing. ?Some have some inclination to learn about investing, but even the simple models of the book would make their heads spin, or they just wouldn’t want to take the time to do it. ?Some of it is similar to seeing a Youtube video on draining and refilling your automatic transmission fluid. ?You might watch it, and say “I think I get it,” but the costs of making a mistake are sufficiently severe that you might not want to do it without an expert by your side. ?Most will take it to the repair garage and pay up.

I put a knife to my own throat as I write this, as I am an investment advisor, but there is more specialized knowledge in the hands of an auto mechanic than in an investment advisor, and the risk of loss is lower to manage your own money than to fix your own brakes. ?That said, enough people after reading the book will say to themselves, “This is just one author, and I barely understand the performance tables in the book — if right, am I capable of doing this? ?Or, could it be wrong? ?I can’t verify it myself.”

The book isn’t wrong. ?If you are willing to put in the time to follow the instructions of the authors, I think you will do better than most. ?My sense is that the grand majority?people are not willing to do that. ?They don’t have the time or inclination.

Quibbles

The book could have been clearer on the ROBUST method for risk control. ?It took me a bit of effort to figure out that the two submodels share half of the weight, so that when submodels A & B flash green — 100% weight, one green and one red — 50% weight, both red — 0% weight.

Also, the book is enhanced by the security selection model for stocks, but how many people would have the assets to assemble and maintain a portfolio with sufficient diversification? ?The book might have been cleaner and simpler to leave that out. ?The last models of the book don’t use it anyway.

Summary / Who Would Benefit from this Book

I liked this book, and I recommend it for those who are willing to put in the time to implement its ideas. ?This is not a book for beginners, and you have to be comfortable with the small amount of math and the tables of financial statistics, unless you are willing to trust them blindly. ?(Or trust me when I say that they are likely accurate.)

But with the caveats listed above, it is a good book for people who are motivated to do better with their investments. ?If you want to buy it, you can buy it here:?DIY Financial Advisor.

Full disclosure:?I?received a?copy from one of the authors, a guy for whom I have respect.

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.)