Photo Credit: Kailash Giri || I used to live near a crude oil refinery. Got soot on my car, but it provided a lot of jobs for people in the area.
Data from Value Line, Calculations by me
Remember when I used to do posts like these? The last full time was May 2014. I lost access to the data, and eventually I gave up.
Recently, I got access to the data back, and I rebuilt the model. I’ll do a post like this every now and then.
My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted?? Price momentum tends to persist, but look for areas where it might be even better in the near term.
If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.
My candidates from both categories are in the column labeled ?Dig through.?
You might notice that I have no industries from the red zone. That is because the market is so high. I only want to play in cold industries. They won?t get so badly hit in a decline, and they might have some positive surprises.
If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion. I generally play in the green zone because I hold stocks for 3 years on average.
Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.
Huh? Why change if things are working well? I?m not saying to change if things are working well. I?m saying don?t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don?t make much money.
Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.
I like some technology stocks here, some industrials, some retail stocks, particularly those that are strongly capitalized.
I?m looking for undervalued industries. I?m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.
At present, I am trying to be defensive. I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.
The Red Zone has tech, financials, communications, and areas geared to home building and improvement. I don’t own much in the way of financials, aside from a few beaten-up life insurers. Really, I don’t own much in the red zone at all.
In the green zone, I picked almost all of the industries. I don’t like retail much, and I am not a fan of E&P here. That still leaves me with a bunch of cyclicals in industries that have lagged the market, and a melange of other things.
The questions is: how well will the economy continue to do? This recovery is pretty long in the tooth. If it doesn’t do well, how much protection does a low valuation carry?
What would the model suggest? Ah, there I have something for you, and so long as Value Line does not object, I will provide that for you. I looked for companies in the industries listed, but in the top 4 of 9 balance sheet safety categories, and with returns estimated over 12%/year over the next 3-5 years. The latter category does the value/growth tradeoff automatically. I don?t care if returns come from mean reversion or growth.
Also, I wanted firms selling at a low-ish forward EV/EBITDA multiple (in relative terms to each industry), and having grown book value after dividends are reinvested over the past seven years.
But anyway, as a bonus here are the names that are candidates for purchase given this screen. Remember, this is a launching pad for due diligence, not hot names to buy.
Data is a mix from AAII Stock Investor, Value Line and Sentieo || Calculations are mine
Full Disclosure: Clients and I own shares in DLX, SLB, GPC & MGA
Photo Credit: Sitoo || No, you can’t eat money. But without money farmers would have a hard time buying what they need to grow crops, and we would have a hard time bartering to buy the crops
Data obtained from filings at SEC EDGAR
Tonight I am going to talk about one of the most underrated concepts in finance — the difference between dollar-weighted and time-weighted returns, and why it matters.
So far on this topic, I have done at least seven articles in this series, and you can find them here. The particular article that I am updating is number 3, which deals with the granddaddy of all ETFs, the SPDR S&P 500 ETF (SPY), which has been around now for almost 27 years. It is the largest ETF in the world, as far as I know.
From the end of January 1993 to the end of March 2019, SPY returned 9.42%/year on a time-weighted or total return basis. What that means is that if you had bought at the beginning and held until the end, you would have received an annualized return of 9.42%. Pretty good I say, and that is an advertisement for buy and hold investing. It is usually one of the top investing strategies, and anyone can do it if they can control their emotions.
Over the same period, SPY returned 7.29%/year on a dollar-weighted basis. What this means is if you took every dollar invested in the fund and calculated what it earned over the timespan being analyzed, they would have received an annualized return of 7.29%.
That’s an annualized difference of 2.13%/year over a 26+ year period. That is a serious difference. Why? Where does the difference come from? It comes partially from greed, but mostly from panic. More shares of SPY get created near market peaks when everyone is bullish, and fewer get created, or more get liquidated near market bottoms. Many investors buy high and sell low — that is where the difference comes from. This also is an advertisement for buy and hold investing, albeit a negative one — “Don’t Let This Happen To You.”
Comparison with the 2012 Article
Now, I know few people actually look at the old articles when I link to them. But for the sharp readers who do, they might ask, “Hey, wait a minute. In the old article, the difference was much larger. Time-weighted was 7.09%/year and dollar-weighted was 0.01%/year. Why did the difference shrink?” Good question.
The differences between time- and dollar-weighted returns stems mostly from behavior at turning points. As I have pointed out in prior articles, typically the size of the difference varies with the overall volatility of the fund. People get greedy and panic more with high-volatility investments, and not with low-volatility investments.
That said, most of the effects of the difference are created at the turning points. During the midst of a big move up or down, the amount of difference between dollar- and time-weight returns is relatively small. The big differences get created near the top (buying) and the bottom (selling).
So, since the article in 2012, the fund has grown from $80 billion to over $260 billion at the end of March 2019. There have been no major pullbacks in that time — it has been a continuous bull market. We will get to see greater divergence after the next bear market starts.
Be Careful what you Read about Dollar-Weighted Returns
I’m not naming names, but there are many out there, even among academics that are doing dollar-weighted returns wrong. They think that differences as cited in my articles are too large and wrong.
The idea behind dollar-weighted return is to run an Internal Rate of Return calculation. To do that you have to have a list of the inflows and outflows by date, together with the market value of the fund at the end as an outflow, and calculate the single rate that discounts the net present value of all the flows to zero. That rate is the dollar-weighted return, and you can use the XIRR function is Excel to help you calculate it. (Note that my calculations use a mid-period assumption for when the cash flows.)
The error I have seen is that they try to make the dollar-weighted calculation like that of the time-weighted, creating period by period values. Now, there is a way to do that, and you can see that in the appendix below. As far as I can tell, they are not doing what I will write in the Appendix. Instead, they treat each year like its own separate investing period and calculate the IRR of that year only, and then daisy-chain them like annual returns for a time-weighted calculation.
Now, the time-weighted calculation does not care at all about investor-driven cash flows, like purchases and sales of fund shares, aside from dividend payments and things like that. It does not care about the size of the fund. It just wants to calculate what return a buy and hold investor gets. [Just remember the rule that an NAV must be calculated any time there is a cash flow of any sort, otherwise some inequity takes place.]
The dollar-weighted calculation cares about all investor cash flows, and ultimately about the size of the fund at the end of the calculation. It doesn’t care about when the returns are earned, but only when the cash flows in and out of the investment.
The odd hybrid method is neither fish nor fowl. Time-weighted corresponds to buy and hold, and dollar-weighted to the returns generated by each dollar in the fund. The hybrid says something like this: “We will calculate the IRR each year, but then normalize the fund size each year to the same starting level so that the fund flows at tops and bottoms do not compound. Then we show them year-by-year so that the returns are comparable to the total returns for each year.
As H. L. Mencken said:
Explanations exist; they have existed for all time;?there is always a well-known solution to every human problem?neat, plausible, and wrong.
Source: Quote Investigator citing Mencken’s book “Prejudices: Second Series”
In an effort to make a simple annual comparison between the two, they eradicate most of the effects of selling low and buying high. More in the Appendix.
Summary
Be aware of the difference between dollar-weighted and time-weighted returns. If you have a strong control on your emotions, this is not as important. If you tend to panic, this is very important. It is more important if you buy highly volatile investments, and less so if you size your volatility to your ability to bear it.
To fund managers I would say this: if you are tired of all of the inflows and outflows, and are tired of getting whipsawed by your clients, maybe you should take a step back and lower the overall risks you are taking. This will benefit both you and your clients.
Appendix
Here’s how to run an annual calculation of dollar weighted returns that be correct. For purposes of simplicity, I will assume a simple annual calculation that has multiple cash flows inside it. (If we are working with a US-based mutual fund, there would be reporting of change in net assets every six months.)
Calculate the first year (dw1) the way the hybrid method does. No difference yet. Then for the second year, run the IRR calculation for the full two-year period (IRR2). Then the second year only dollar-weighted return (dw2) would be:
((1+ IRR2) ^2) / (1+dw1) -1 = dw2
and for each successive period it would be:
(1+IRR[n])^n(1+IRR[n-1])^(n-1) – 1 = dw[n]
That is more complex than what they do, but it would preserve the truths that each entail. It would make the values for the yearly dollar-weighted returns look odd, but hey, you can’t have everything, and the truth sometimes hurts.
Full disclosure: a few of my clients are short SPY as part of a hedged strategy.
Photo Credit: The Aspen Institute || His shadow still affects central banking today…
At Aleph Blog, I will argue for things that are against my short term interests. After all, the higher stock and bond prices go, the higher my income goes in the short-run. In the long-run, that’s not sustainable.
I am here this evening to criticize the philosophy of Alan Greenspan that had the FOMC doing the bidding of the stock, bond, and futures markets.
Don’t disappoint the markets.
Give the markets what they want, and everything will work out well.
Flag the markets to tell what your intentions are.
None of those are the province of the Fed. The Fed is supposed to care for:
Low inflation
Low labor unemployment
Moderate long-term interest rates
(and indirectly) A healthy banking system, because the levers of Fed policy depend on it.
All of these things are going well at present, AND the yield curve has normalized. So why loosen again? Well, Fed funds futures indicate a igh probability of a cut… so give the market what it wants, right?
Ah, bring back Volcker and Martin, who would follow their statutory mandate, and not just mention it to excuse policy errors.
I write this partly after reading this article at Marketwatch. The article is a mix of different opinions, but the ones that get me are the ones that say that the Fed has to listen to the markets.
Well, that’s what Greenspan, Bernanke, and Yellen did, and it led us into a low interest rate morass because they never let recessions do their work and eliminate entities with low marginal efficiencies of capital.
Recessions are not always bad, and lower interest rates are not always good. Just as fires are good for forests in the long run, so are recessions that clear away marginal economic ideas.
It may not come this week. It may not come in the next few years, but eventually the Fed will be willing to offend the markets again. When it does, the jolts will be considerable, but it may lead to a better economy in the long-term.
Picture Credit: Brian Solis || What is true for a political leader is not the same as for an investor, unless you are an activist or a short seller who publishes
Understanding the consensus in investing is important. During the middle of when an investment idea is succeeding or failing, typically the consensus is correct. At the turning points, the consensus is typically wrong. That is why it is important to try to understand what the consensus is.
Often we listen to or read the news to learn the what current opinion is. In the quotation in the picture above, King was a major molder of the consensus on race relations in America. He knew the situation, and took action to try to change people’s minds, and thus move the consensus to a better place — closer to a colorblind society. We haven’t arrived on that yet; maybe in the generation of my children we will get there. We owe a debt of gratitude to King politically. (Religion was a different matter for King. If you want to read about that, there is an appendix at the bottom.)
Picture credit: tara hunt || Active managers must avoid being consensus thinkers, lest they be expensive indexers
But for investors, reading or listening to the news will not give you the consensus. It will give you opinions, and sometimes the agreeing chatter of opinions may give you the illusion that you know the consensus.
In an election, the consensus is whoever manages to win a majority of votes, whether of people, or their electoral representatives. This is can take place in a simple district, or in the more messy situation of who prime minister will be in a parliamentary system, or even the election of a US President.
But in the markets consensus does not stem from what is said, but rather where money is invested. This is once again the concept of Ben Graham’s voting machine. Thus to understand the consensus, we don’t read the news. Rather, we look at prices, and then try to do some sort of analysis, usually fundamental, to see whether the consensus is right or wrong.
Indexing is the ultimate statement of an investor saying he will just go with the consensus. That’s not a bad idea for many people. Active investing is a statement that you think the consensus is wrong, and that over a reasonable period of time, the consensus will be proven wrong, and you will make good money in the process. But part of that question is whether your investors will hang around long enough for you to be proven right. The other part is that you could be wrong — non-consensus does not mean right. (In my time, I have known more than my share of cranks who held extreme minority positions for a long period, and would rarely admit they were wrong. When they would admit failure, typically, they would blame someone else.)
Now let me give you two large present examples of how the “consensus” in the investment news is not the market consensus:
One frequent thing that I run into both on the web and radio is the argument from many advisors as to how pessimistic investors are today. The correct way to understand this is that because the market is high, many investors are skittish about future commitments. So what is the consensus here? The big investors of the world have and are investing money in the stock market such that prices are high — they discount a low expected future return.
The second example is people who kvetch about low interest rates and say they have nowhere to go but up. I’ve been hearing this off and on since 1987, when my boss said, “Interest rates will never go below 10%.” These arguments are a little dented today, because of the shell-shock stemming from negative interest rates in much of the developed world, but I still read commentators on the web and on the radio saying that interest rates must rise.
But what does the behavior of market participants tell you? It tells you that investors at present are yield-hungry, and that there has been money looking for a home than entities willing to borrow. No promises about the future, but the consensus has been that yields have been attractive to lenders, and that may continue for a while.
Now a hybrid regarding investment consensus and activists and short sellers who publish their opinions to the market in an effort to profit. In the long run, the cash flows will dictate the market movements, but in the short run their words, purchases/sales, and expected purchases/sales implied by their writing will drive prices in the short run.
Articles
Now, I’ve written a series of articles dealing with this topic over the years:
On Contrarianism — ” With markets, it doesn?t matter what people say.? What matters is what they rely upon.” I give several examples for how to possibly generate a correct contrarian (or, non-consensus) opinion.
My 9/11 Experience — A brief telling of what happened to me on 9/11/2001, but focusing on the very non-consensus investment decisions we made immediately after that.
The Ecology of Investment Strategies — ‘ Any investment strategy can be overused.? Part of the job of a portfolio manager is to ask the question ?To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?? ‘ (I wish I had applied that to my deep value investing when the FOMC dropped rates to zero.)
Book Review: The Most Important Thing — Howard Marks as an investor is probably the best explainer of non-consensus investing, which he entitles “second level thinking.” I’m currently reading the book Non-Consensus Investing by Rupal Bhansali. This also seems to be a good book on the topic, and I will likely review it.
But then if you want to hear the same thing from someone who is out of favor right now it would be: Book Review: The Only Three Questions That Count by Ken Fisher. It’s his second question: ” What can you fathom that others find unfathomable?”
Summary
In general, talk is cheap. Money talks louder than human chattering when it comes to the markets. The consensus derives from the investment actions that market players make, not the words they utter.
Appendix (skip if you don’t want to read a brief critique of liberation theology)
Martin Luther King, Jr. was probably the most famous American example of a liberation theologian. Unlike many liberation theologians in Latin America, he was far more moderate in his goals — he sought the end of segregation, not a violent revolution.
Even the verse the liberation theologians so often cite, Jesus saying, “Think not that I have come to bring peace. I have not come to bring peace but a sword,” wasn’t talking about war. It meant that a division would be made between Christians and non-Christians, such that non-Christians would sometimes hate Christians, even if they were family members.
But King’s preaching nonetheless focused on ending a great evil in this life, rather than pointing people to repentance from sin, and faith in Jesus Christ, which would lead to eternal happiness in the life after death.
The Bible does not promise human happiness in this life to Christians, or anyone else for that matter. Christ said believers should not be surprised if they were persecuted, poor, and/or their own families might hate them. He said “I will never leave you nor forsake you.” He would bring comfort in the midst of sorrow.
As the BIble says, “What does it profit a man to gain the whole world, and lose his soul?” (This was my Bloomberg banner message for years.) The liberation theologian offers his hearer a poor deal. “Listen to me, overthrow the wicked government — God is behind you — He will support you in your goal.” Even if they succeed, and those who rebel rarely win, they might be happy for this life, but not eternally.
There are many verses in the Bible that discourage rebellion against the powers that be, but the overarching reason is that God sets rulers in place, even bad ones (see Romans 12). God says, “Vengeance is Mine, I will repay.” As such, it is not for us to take revenge against those who rule us. As it says in the Psalms many times, God will bring judgment on all bad rulers.
That’s my brief argument. I have a lot more to say, but the main thing is this: the Bible focuses on the eternal, not the temporal. It teaches that this short life of ours that ends in death is a test. Would you rather ignore God and enjoy life now, or deny present desires, and aim for heaven? God isn’t looking for perfection, but repentance and faith in Jesus Christ as Lord.
I know that I fail to always do what’s right, but I trust in Christ. Anyway, if you got this far, pray and consider it. Thanks.
Disclosure
If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.
Picture Credit: Olivier ROUX || Simplicity almost always beats complexity.
I’m not a fan of EIAs. I’m not a fan of variable annuities, unless they’re really simple with rock-bottom expenses and no surrender charges. I’m not a fan of ETNs. I hate structured notes. I’m also not a fan of ETFs that are filled with derivatives.
* Small compared to the pool that they fish in * Follow broad themes * Do not rely on irreplicable assets * Storable, they do not require a ?roll? or some replication strategy. * not affected by unexpected credit events. * Liquid in terms of what they represent, and liquid it what they hold.
The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.
But tonight I have another complex investment to avoid, and a simple one to embrace. First the avoid…
There was a piece at Bloomberg Businessweek called ETFs With Downside Protection? It?s Complicated. These are called defined outcome ETFs. Basically they are a bundle of equity options that cut your losses, while limiting your gains on a given equity index. (Also, you don’t get dividend income, and have to pay manager fees.) In-between the cap on gains, and where losses kick in, your returns should move 1:1 with the index. The same will be true with losses after the first N% get eaten — below N% losses, you begin taking losses.
Illustration of Defined Outcome ETF returns as compared to an index fund using the same index as the Defined Outcome ETF
I wanted to keep the illustration simple. This hypothetical defined outcome ETF caps gains at 10%, and absorbs the first 15% of losses. This example assumes no fees, which would likely be lower on the index fund. This example assumes no dividends, which would get paid to you in the index fund, but not on the defined outcome ETF.
Defined outcome ETFs purchase and sell tailored options that are backed by the central counterparty the Options Clearing Corporation — a very strong, stable institution. Credit risk still exists, but if the OCC goes down, many things will be in trouble. The options exist for one year, after which gains are paid to and losses absorbed by ETF shareholders. The ETF then resets to start another year following the same strategy with slightly different levels because the relative amounts of the cap and the loss buffering rely on where equity volatility is for a given index at the start of the year.
Unlike an index fund, your gains cannot grow tax-deferred, though if you have gains, you can roll them over into the next year.
I’ve read the offering documents, including the sections on risk. My main argument with the product is that you give up too much upside for the downside protection. The really big up years are the places where you make your money. There aren’t so many “average” years. The protection on the downside is something, but in big down years it could be cold comfort.
The second part is the loss of dividends and paying higher fees. Using the S&P 500 as a proxy, a 2% dividend lost and a 0.5% added fee adds up to quite a cost.
There are implementation risks and credit risks but these risks are small. I ran a medium-sized EIA options book for a little more than a year. This is not rocket science. The investor who is comfortable with options could create this on his own. They list more risks in the offering documents, but they are small as well. What gets me are the costs, and the upside/downside tradeoff.
Yes, interest rates are low. Yields on some stocks are higher than the yields on the Barclays’ Aggregate [bond] Index. But if you only bought those bonds, you would have a rather unbalanced portfolio from a sector standpoint — heavy on utilities and financials. The Barclays’ Aggregate still outyields the S&P 500, if not by much, like 0.8%/yr.
The real reason that you hold bonds and cash equivalents is not the income; it is risk reduction. I’m assuming no one is thinking of buying the TLT ( 20+ Year Treas Bond Ishares ETF), which is more of a speculator’s vehicle, but something more like AGG ( US Aggregate Bond Ishares Core ETF), which yields 0.3% more, but the overall volatility is a lot less.
With AGG, fixed income claims of high investment grade entities will make it through a deflationary crisis. In an inflationary situation like the 70s, the bonds are short enough that over a five year period, you should make money, just not in real terms.
It’s good to think long term, and have a mix of fixed and variable claims. The bonds (fixed claims) lower your volatility so that you don’t get scared out of your stocks (variable claims) in a serious downdraft.
The models I have run have returns max out in an 80/20 balanced fund, and the trade-off of risk for return is pretty good down to a 60/40 balanced fund. In my personal investing, I have always been between 80/20 and 60/40.
Thus the need for bonds. In a bad scenario, stocks will fall more than bonds, and the balanced fund will buy stocks using proceeds of the bonds that have fallen less to buy stocks more cheaply. And if the stock market rises further, the balanced fund will sell stocks and use the proceeds to bank the gains by buying bonds that will offer future risk reduction, and some income.
As such, consider the humble balanced fund as a long-term investment vehicle that is simple and enduring, even when rates are low. And avoid complexity in your investment dealings. It is almost never rewarded.
Picture Credit: OTA Photos || This is easier said than done!
The SEC is seeking ideas on how to make small cap stocks more tradable. Let me quote the closing of an article from the Wall Street Journal:
In soliciting the proposals, the SEC laid out a number of possible approaches, without endorsing any of them.
One such approach would limit trading in low-volume stocks to the exchange where they are listed. Nasdaq Inc. has promoted a similar plan, arguing that it would create deeper markets for small-cap stocks by concentrating the trading of their shares on one venue. But critics, including some rival exchanges,?have attacked Nasdaq?s plan?as anticompetitive, saying it would benefit big exchanges like Nasdaq.
In another approach floated by the SEC, trading in low-volume stocks would take place in periodic auctions, separated by discrete time intervals, instead of continuously throughout the trading day.
I’m not sure that any of these proposals will work. Longtime readers know that I think that liquidity is hard to permanently increase, or decrease for that matter.
By nature, small cap stocks have smaller floats. There’s less information about them Many accounts and managers have mandates that don’t allow them to purchase small cap stocks. Bid-ask sizes and spreads tend to be smaller and larger respectively than those of large caps. That’s largely a function of floating market cap and the underlying riskiness of the company in question. Market structure plays less of a role.
The composition of investors does matter. It typically doesn’t change that much; it is cyclical. Horizons shorten as volatility rises, and vice-versa.
The more buy-and-hold investors there are, the more liquidity decreases. The more traders with short time horizons there are, the more liquidity increases. Commissions declining will possibly make time horizons a little shorter for day-traders, but I can’t imagine that the effect will be that big.
As a smaller investor, I do like the concept of a central order book that would have a monopoly on trading a stock, because it would remove an informational edge that high-frequency traders [HFT] have. I don’t think it would increase liquidity much though. It would change where the trades happen, and perhaps who makes the trades. I think that some less technologically inclined investment advisors would be willing to put up larger bids and asks in such a context, but they would mostly replace lost volume from HFT.
I also think that having more auctions during the day would be a good idea, say like one every half hour. I don’t think it would increase liquidity, though. Trading would become more sparse away from the auctions.
I own four illiquid stocks for my stock strategy clients, and one less liquid closed-end fund for my bond clients. I can trade them if I need to. I just have to be more patient with those securities, and break trades up into bite-size pieces.
For me, trading is a way of implementing changes to the portfolio. If any of the proposed changes happened, my trading would not change much at all. I suspect that would be true for all but the investors with the shortest time horizons, but I think that could go either way. We have lower commissions on one hand, and disadvantages for HFT on the other. Could be a wash.
Enough rambling. I don’t see a lot of likely change here, and liquidity should not be the highest priority at the SEC. Rather than facilitating more secondary trading, it would be nice to see more private firms going public. SEC efforts on that would get my attention.
Photo Credit: Simon Cunningham || Not paying a dividend does not create an enforceable claim, as happens when an interest payment is not made.
Don’t get me wrong, I love dividends. I even have a money management strategy based off of them. But I know that dividends are more fickle than most of their fans admit. The infatuation that some money managers have with dividends is misplaced. To say that “Dividends don’t lie,” is an overstatement. Yes, the check will clear, and you get money, but that does not mean that the next dividend will get paid.
I have always said that reliable dividends flow from businesses with predictable free cash flow. As such, I don’t look for dividends, but free cash flow. As a check on that, I watch debt levels in the companies that I own. If the debt levels are persistently increasing as a fraction of assets, it is likely a sign that the company is borrowing to pay the dividend.
Borrowing to pay the dividend — an old phrase, dating back to the 1970s and prior. Companies know that a consistent and growing dividend attracts investors. They are reluctant to not grow the dividend, much less cut it, lest massive selling take place. But businesses have their limits, and paying a dividend beyond those limits leads to an eventual dividend cut.
No management team will admit to being uncomfortable with its dividend payout. The Fed may as well admit that they don’t know what they are doing. It’s not gonna happen. But prior to a surprise dividend cut, the company will borrow more, probably hoping that business will rebound, and that the increased dividend will be sustainable.
In the 1970s, there were many dividend cuts. At the end of the 70s there was no cachet to dividends. With interest rates so high, income was to be found in bonds, even if inflation was going to the sky.
I remember the 1970s even if I was a teenager then. I was gifted two bits of stock in the 1960s, and the companies paid their dividends until they failed. I remember taking my dividend checks to the bank to add to my savings account. I still knew that the two stocks I had been gifted, Magnavox and Litton Industries, were disappointments that had given me less than the value of when the stocks were purchased.
In a significant recession, many companies will cut their dividends in order to avoid bankruptcy. Dividends are subject to the boom/bust cycle as much as any other aspect of corporate behavior.
This is why I say be careful regarding dividends. We are in a bull market now, with prices near the recent peak. Financing is plentiful and cheap. As Buffett has said:
Only when the tide goes out do you discover who’s been swimming naked.
brainyquote.com/quotes/warren_buffett_383933
Summary
My main point to you is this: don’t assume that dividends are automatic. Test the companies whose stock you want to buy to see that they have adequate capacity to pay the dividends, and that they are not borrowing to pay them.
I like my dividend portfolios. They are roughly half as volatile as the market, and have had decent returns. But I don’t blindly trust the dividends that companies pay as if they are an obligation. Be wary and analyze the safety of the dividends that you are paid.
Photo credit: https://boardgamegeek.com || I probably played Jate 100+ times with my friends as a kid. Even at the time, I knew the market did not behave the way it did in Jate, or any other stock market game that I played.
All of the common board games that I have run into on the stock market are unrealistic. The stock market does not work the way the board games say that it works.
Nonetheless, I think that board games, and other games that involve money are useful for children. Why? Because they encourage kids to think in terms of budgets (money is limited), and in terms of using money to gain returns.
Business is a large part of life, and it is difficult to get children to appreciate what goes on there. Business games, though not realistic, promote curiosity regarding business and investing. Nothing is ever as easy in business or investing as in a game, but nonetheless the concepts of budgeting, compounding, and diversification (or lack thereof) appear.
I am not endorsing any particular game. My view is that game that involve money as a major aspect of the game are good for children, as it teaches them about goals, investing, and limits.
I am not in the crowd that thinks that indexing or ETFs will create a crisis. As I have said before, long-term performance of assets relies on the underlying productivity of the businesses issuing the assets. Short-term performance is also affected by the behavior of secondary market traders, but those effects get eventually washed out by the underlying productivity of the businesses issuing the assets.
And there you have it in slightly different garb: Ben Graham’s weighing machine versus the voting machine. The voting machine is transitory. The weighing machine is permanent. After all, think of a private business — it only has the weighing machine, and it does well enough producing cash flow for the owners, creditors, etc., without the sideshow of the price of its stock and bonds being publicly estimated each day.
In this case, the voting machine has people buying and selling bundles of stocks. But what does that replace? People owning equivalent amounts of individual stocks. People have varying propensities toward panic and greed. Those who would have sold their stocks in a panic or bought stocks in a bullish frenzy will do the same with the ETFs that they hold. It will be the same amount of selling pressure in aggregate.
Now, it is possible that some stocks are misrepresented in the ETFs in which they reside. My favorite example is refiners in the Energy Select Sector SPDR Fund (XLE) . The economics of most stocks in XLE are positively geared off of crude oil and natural gas prices. Refiners, unless they are gambling on their hedges, usually don’t hedge fully, and the economics are negatively geared to energy prices. Ever since XLE became popular, the refiners often trade in tandem in the short run with the rest of the Energy stock complex.
So what happens? Refiners then correct after a bull run of energy prices when their earnings don’t reflect the stock price. Vice-versa for positive earnings surprises in a bear phase for energy prices.
Summary
ETFs do present some anomalies for the markets, but they are localized to the sectors or strategies that are being pursued. For the market as a whole, they are simply pass-through vehicles that have little to no macro effects, aside from increasing short-run price correlation between stocks in the largest ETFs.
Here’s another article that I edited at The Balance:?Short Selling Stocks- Not for the Faint Hearted.? The original author started out conservative on the topic, and I took it up another notch.
For this article, I:
added the information about changes to the uptick rule (which did not reflect anything post-2006),
corrected a small math error,
made the example more realistic as to how margin works in this situation,
added almost all of the section on risks
totally rewrote the section on picking shorts (if you dare to do it), and,
added the famous comment by Daniel Drew.
I have shorted stock in my life at the hedge fund I worked at, hedging in arbitrage situations, and very rarely to speculate.? Shorting is a form of speculation shorts don’t create economic value.? They do us a service by pruning places that pretend to have value and don’t really have it.
In general, I don’t recommend shorting unless you have a fundamentally strong insight about a company that is not generally shared.? That happens with me occasionally in insurance where I have spoken negatively about:
Penn Treaty
Tower Group
The various companies of the Karfunkels
The mortgage and financial guaranty insurers
Oh, and the GSEs… though they weren’t regulated as insurers… not that it would have mattered.
But I rarely get those insights, and I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited.? It is really a hard area to get right.
Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long.? If you just hold stocks, bonds, and cash, no one can ever force you out of your trade.? The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment.? Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.
So be careful, and in general don’t short stock.? If you want more here, also read The Zero Short.? Fun!
