Category: The Rules

The Rules, Part LXIX

Posted on by David Merkel

Photo Credit: EveryCarListed P || The world is tough, and you must prepare yourself to avoid licit con men

“Don’t buy what someone else wants to sell you. Buy what you have researched that you want to buy.”

David Merkel at Aleph Blog, many times

Poverty is not just a lack of money. It is a lack of knowledge, a lack of intelligent friends who can guide a person through tough decisions. Or, it is pride, thinking you can figure it out on your own when you are truly not capable. Stop it with the positive self-esteem jive. Most people should not have positive self-esteem — they need help, or, they need to spend more time figuring out the right answers to hard questions rather than using the time for leisure pursuits. They need to work harder to be smarter, or at least cultivate smart friends to help them.

The rule above has been mentioned at this blog 16 or so times in different ways. Many of the articles were dealing with penny stocks and other sorts of investment cons. Almost no one is out to do you a favor. The rules that the government puts in place to prevent fraud on a statutory basis will only catch the dumb crooks. Smart crooks can work around them, and convince you that they are your friend. Modern crooks are dressed nicely, speak nicely, and are friendly until the deal completes.

This is why you have to be your own best defender, or have intelligent friends to help you. Can you figure out:

  1. Am I getting a good deal on this house my realtor is trying to sell me?
  2. Am I getting a good deal on this car that this salesman is trying to sell me?
  3. Is the financing that they are offering me to buy the house or car a good deal?
  4. Can I reasonably negotiate with an employer for better compensation?
  5. Should I buy this life insurance or annuity policy that the salesman is showing me?
  6. Am I paying too much for investment services? Does my advisor have talent?
  7. Should I buy this complex investment that my broker says can’t lose?
  8. Can I ask for a discount on this big ticket item?

The answers to 4, 6a, and 8 are usually yes, and the rest are usually no. But I will tell you that this is the era of the internet. More information is available to the common man than at any time in the past, and better yet, some of that information is even correct. Be skeptical, but not cynical. Weigh arguments. Compare what different parties say, and try to understand who has the better argument. Learn how to negotiate — life is not fair, you don’t get what you deserve, you get what you negotiate.

Beware convenience. The first three letters of convenience are “con.” Spend a little more time analyzing price/quality tradeoffs before you decide to buy something. In the era of Yelp and Google, look at the ratings of those that you might buy from. In the era of Amazon and Google Shopping, use the internet to find the low price.

If you are not willing to put in the work, then don’t complain when you get a bad deal. It is easier now than ever to get information on price and quality. A subscription to Consumer Reports is cheap and worth it. So much pricing data and customer reviews are freely available over the internet.

So do your homework and buy– you will be better off than if you listen to a salesman who is compensated to sell you something that is not what you need.

The Rules, Part LXVI

Posted on by David Merkel

Photo Credit: Heather R || Round and round it goes, where it stops, nobody knows

Don’t bet the firm.

Attributed to the best boss I ever had, Mike Cioffi. I learned so much from him.

I was surprised to see how many times I mentioned at this blog how I considered and dropped the idea of writing floating rate Guaranteed Investment Contracts [GICs]. A lot of effort went into that decision, and unlike most decisions like that, the failures of competitors with a different view happened quite rapidly.

Also, this blog highlighted those that wrote terminable floating rate GICs later, and insurers that wrote contracts that had clauses allowing for termination upon ratings downgrades.

But that’s my own story. What of others?

The best recent example that I can give is oil producers both in 2015-6 and today. When oil prices plunged, many smaller marginal oil producers went broke. Why didn’t they take a more cautious view of their industry, and run with stronger balance sheets that could endure low crude oil prices for two years?

If you are managing for the price of your stock, maximizing the return on equity is a basic goal for many. That means shrinking your equity capital base, and living with the risk that your company could go broke with many others if the price of crude oil drops significantly. Of course, you could try to hedge your production, but at the risk of capping your returns.

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The main idea here is to have a strategy where you stay in the game. This means running with a thicker balance sheet, and hedging material risks. What stands in the way of doing that?

Having a thicker balance sheet might give a firm a lower valuation, and attract activists that will attempt to buy up the firm, partially using the excess capital that aided safety. The antidote to this is to actively sell shareholders on the idea that the firm is doing this to preserve the firm from the risk of failure, much as Berkshire Hathaway keeps excess assets around for reasons of avoiding risk and allowing for the possibility of gaining significant returns in a crisis.

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If you work for a single firm, most would say, “Of course! Don’t bet the firm! What, are you nuts!?”

But incentives matter. Where there are bonuses based on sales growth, sales will happen, regardless of the quality of them. Where there are bonuses based off of asset returns over a short period, you will have managers swinging for the fences. Where there are annual profit goals, there may be aggressive accounting and aggressive sales practices. But who cares about next year, much less the distant future? Who cares for the long-term interests of all who are affected by the firm?

Corporate culture matters. Excellent corporate cultures balance the short- and long-runs. They strive for excellent results while protecting against the worst scenarios. If the firm is able to survive, it can potentially do great things. Not so for the firm that dies.

To that end, incentives should be balanced. Those that play offense, like salesmen, should have a realized profitability component to their bonus. Investment departments should be judged on safety as well as returns. Conversely, defensive areas need to have some of their bonuses based on profits, and profit growth. It’s good to get all of a firm onto the same page nd be moderate, prudent risk-takers.

In closing, the main point here is that there is no reward so large that it is worth risking the future of the firm. Take moderate and prudent risks, but don’t take any risk where you and all of your colleagues may end up searching for new work. It’s not worth it.

Beyond that, to those that structure bonus pay, be balanced in the incentives that you give. Let them benefit from their individual efforts, but also benefit from the long-run safety and profitability of the firm as a whole. That will result in the greatest benefit for all.

The Rules, Part LXV

Posted on by David Merkel

Photo Credit: vldd || Relative to a complete bridge, what’s the value of a bridge that will never be completed?

Here’s number 65 in this irregular series:

The second-best plan that you can execute is better than the best plan that you can’t execute.

Rule LXV

It takes more than the right ideas to be an investor. It also takes the courage to make the hard decisions at the time when it hurts to do so.

Will you make more money if you allocate at least 80% of your assets to stocks and other risk assets? Yes. How will you hold on during a gut-wrenching bear market that gives you the feeling that you are losing everything?

You could just refuse to look at your statements, or listen to financial media. But most people will bump into that randomly during a bear market, because the level of chatter goes up so much. It may be better to take a second-best solution and reduce the portion of risky assets to 50-60%, and simply sleep better at night. Reduce until you won’t be nervous, and preferably, make this adjustment during the bull market.

Do you have a nifty trading strategy that you are tempted to overrule because it generates trades that you think don’t make sense, or come at times that seem too painful? Perhaps you need to abandon the strategy, or lower the size of the trades done. Maybe do half of what the strategy would tell you to do.

If you use the Kelly Criterion to size your trades, and the volatility drives you nuts, maybe size your trades to “half Kelly.”

Am I offering an opiate for underachievement? Well, no… maybe… yes… Look, personalities are not fixed, much as some say that they cannot change. If you have sufficient motivation, you can come up with ways to change your personality to be able to deal with more risk, or, conclude that you will do better if you take less risk.

Writing out a set of rules can useful, as is testing them to make sure they actually work. In general fewer rules are better.

An example of this in my life was when I was a corporate bond manager, I made an effort to forget prior prices of a bond, thus forcing me to be forward-looking in my management. When I was younger, I told myself that there would be losses, and they were a price of getting the gains on average.

But if you can’t make your personality change, then you have to adapt your investment strategy to let you be happy while still achieving most of your goals. As an example, if you like to sell stocks short, it would be wise to have some sort of limit as to how much you are willing to lose before closing out a trade — this applies more to shorting, as losses are unlimited as prices rise, but gains are capped.

Ordinarily, if a person or institution is close to even-keeled with respect to risk, the time horizon and uncertainty of the cash flows from the assets should be the main criteria for asset allocation. But when a person is overly timid or bold, that will become the dominant criterion for their asset allocation.

It is important not to be of two minds here. Admit your weaknesses, and either fix them, or live with them. The trouble comes when you think you are strong, but then give in when a bad event happens that was beyond your capacity to handle.

It’s also important to understand that the market can be more vicious than at any prior point in history. Yes, there are historical highs and lows for every variable — but both can be exceeded… the speed of the current bear market is an excellent reminder of that. Try to understand that there will be as Donald Rumsfeld once said “unknown unknowns.” Have you left enough slack in your strategy for some really bad scenarios? Have you considered that it’s not impossible to have a second Great Depression event, despite the best efforts of politicians, regulators and economists? Have you considered that it is possible to eclipse the valuation highs achieved in 2000?

And consider the phrase from my disclaimer “The market always has a new way to make a fool out of you.” Have you considered what scenario would be poison for what you currently do? Unlikely as it may be, can you live with that scenario? If not, scale down your strategy until you can live with it. Or, figure out what your coping strategy would be.

The first life insurer that I worked for had the strategy that if things went wrong with their investing, they would sell policies more aggressively and invest the proceeds to grow their way out of the problem. They ended up being the largest life insurance insolvency of the 1980s, as their worst case scenario arrived, and their capital was depleted. They would have done better to grow more slowly, and more soundly. The same would apply to Enron and other companies that try to grow too fast. This is another case where the second best is achievable, but the “best” is not.

So, know yourself, and know the markets well. Leave some slack in your strategy… don’t play it to or past the absolute maximum that you can handle. Have some humility, and live in reality. For most investors, that will pay off in a big way.

The Rules, Part LXIV

The Rules, Part LXIV

Posted on by David Merkel

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

  • Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
  • Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
  • Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
  • Students and middle-to-lower classes borrowing too much (autos, credit cards)
  • Interest rates and goods and services price inflation stay low in the face of this.
  • Low volatility (until now)
  • Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
  • Low credit spreads

No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:

  • Preservation of capital
  • Dry powder
  • Not finding opportunities
  • Momentum gives way to negative arbitrages.
  • Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?

There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

The Rules, Part LXIII

The Rules, Part LXIII

Posted on by David Merkel

Photo Credit: Pete Edgeler
Photo Credit: Pete Edgeler

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Onto the next rule:

“We pay disclosed compensation. ?We pay undisclosed compensation. ?We don’t pay both?disclosed compensation?and undisclosed compensation.”

I didn’t originate this rule, and I am not sure who did. ?I learned it at Provident Mutual from the Senior Executives of Pension Division when I worked there in the mid-’90s. ?There is a broader rule behind it that I will get to in a moment, but first I want to explain this.

There are many efforts in business, particularly in sales, where some?want to hide what they are truly making, so that they can make an above average income off of the unsuspecting. ?At the Pension Division of Provident Mutual, the sales chain worked like this: our representatives would try to sell our investment products to pension plans, both municipal and corporate. ?We preferred going direct if we could, but often there would be some fellow who had ingratiated himself with the plan sponsor, perhaps by providing other services to the pension plan, and he would become a gateway to the pension plan. ?His recommendation would play a large role in whether we made the sale or not.

Naturally, he wanted a commission. ?That’s where the rule came in, and from what I?remember at the time, many companies similar to us did not play by the rule. ?When the sale was made, the client would see a breakdown of what he was going to be charged. ?If we were paying disclosed compensation to the “gatekeeper,” we would point it out and mention that that was *all* the gatekeeper was making. ?If the compensation was not disclosed, the client would see the bottom line total charge, and he would have to evaluate if that was good or bad deal for plan participants.

Our logic was this: the plan sponsor would have to analyze the total cost anyway for a bundled service against other possible bundled and unbundled services. ?We would bundle or unbundle, depending on what the gatekeeper and client wanted. ?If either wanted everything spelled out we would do it. If neither wanted it spelled out, we would only provide the bottom line.

What we would never do is provide a breakdown that was incomplete, hiding the amount that the gatekeeper was truly earning, such that client would see the disclosed compensation, and think that it was the entire compensation of the gatekeeper.

We were the smallest player in the industry as far as life insurers went, but we were more profitable than our peers, and growing faster also. ?Our business retention was better because compensation surprises did not rise up to bite us, among other reasons.

Here’s the broader rule:

“Don’t be a Pig.”

Some of us?had a saying in the Pension Division, “We’re the good guys. ?We are trying to save the world for a gross margin of 0.25%/year on assets, plus postage and handling.” ?Given that what we did had almost no capital requirements, that was pretty good.

Most scandals over pricing involve some type of hiding. ?Consider the pricing of pharmaceuticals. ?Given the opaqueness is difficult to tell who is making what. ?Here is another?article on the same topic?from the past week.

In situations like this, it is better to take the high road, and make make your pricing more transparent than your competitors, if not totally transparent. ?In this world where so much data is shared, it is only a matter of time before someone connects the dots on what is hidden. ?Or, one farsighted competitor (usually the low cost provider) decides to lay it bare, and begins winning business, cutting into your margins.

I’ll give you an example from my own industry. ?My fees may not be the lowest, but they are totally transparent. ?The only money I make comes from a simple assets under management fee. ?I don’t take soft dollars. ?I make money off of asset management that is?aligned with what I myself own. ?(50%+ of my total assets and 80%+ of my liquid assets are invested exactly the same as my clients.)

Why should I muck that up to make a pittance more? ?It’s a nice model; one that is easy to defend to the regulators, and explain to clients.

We probably would not have the fuss over the fiduciary rule if total and prominent disclosure of fees were done. ?That said, how would the brokers have lived under total transparency? ?How would life insurance salesmen live? ?They would still live, but there would be fewer of them, and they would probably provide more services to justify their compensation.

Even as a bond trader, I learned not to overpress my edge. ?I did not want to do “one amazing trade,” leaving the other side wounded. ?I wanted a stream of “pretty good” trades. ?An occasional tip to a broker that did not know what he was doing would make a “friend for life,” which on Wall Street could last at least a month!

You only get one reputation. ?As Buffett said to the Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives back in 1991 regarding Salomon Brothers:

I want the right words and I want the full range of internal controls. But I also have asked every Salomon employee to be his or her own compliance officer. After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends, with the reporting done by an informed and critical reporter. If they follow this test, they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.

This is a smell test much like the Golden Rule. ?As Jesus said, “Therefore, whatever you want men to do to you, do also to them, for this is the Law and the Prophets.” (Matthew 7:12)

That said, Buffett’s rule has more immediate teeth (if the CEO means it, and Buffett did), and will probably get more people to comply than God who only threatens the Last Judgment, which seems so far away. ?But I digress.

Many industries today are having their pricing increasingly disclosed by everything that is revealed on the Internet. ?In many cases, clients are asking for a greater justification of what is charged, or, are looking to do price and quality comparison where they could not do so previously, because they did not have the data.

Whether in financial product prices, healthcare prices, or other places where pricing has been bundled and secretive, the ability to hide is diminishing. ?For those who do hide their pricing, I will offer you one final selfish argument as to why you should change: given present trends, in the long-run, you are fighting a losing battle. ?Better to earn less per sale with happier clients, than to rip off clients now, and lose then forever, together with your reputation.

 

The Rules, Part LXII

The Rules, Part LXII

Posted on by David Merkel

Ben Graham, who else?

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Well, I didn’t think I would do any more “Rules” posts, but here one is:

In markets, “what is true” works in the long run. “What people are growing to believe is true” works in the short run.

This is a more general variant of Ben Graham’s dictum:

?In the short run, the market is a voting machine but in the long run, it is a weighing machine.?

Not that I will ever surpass the elegance of Ben Graham, but I think there are aspects of my saying that work better. ?Ben Graham lived in a time where capital was mostly physical, and he invested that way. ?He found undervalued net assets and bought them, sometimes fighting to realize value, and sometimes waiting to realize value, while all of the while enjoying the arts as a bon vivant. ?In one sense, Graham kept the peas and carrots of life on separate sides of the plate. ?There is the tangible (a cheap set of assets, easily measured), and the intangible — artistic expression, whether in painting, music, acting, etc. (where values are not only relative, but contradictory — except perhaps for Keynes’ beauty contest).

Voting and weighing are discrete actions. ?Neither has a lot of complexity on one level, though deciding who to vote for can have its challenges. (That said, that may be true in the US for 10% of the electorate. ?Most of us act like we are party hacks. πŸ˜‰ )

What drives asset?prices? ?New information? ?Often, but new information is only part of it. It stems from changes in expectations. ?Expectations change when:

  • Earnings get announced (or pre-announced)
  • Economic data gets released.
  • Important people like the President, Cabinet members, Fed governors, etc., give speeches.
  • Acts of God occur — earthquakes, hurricanes, wars, terrorist attacks, etc.
  • A pundit releases a report, whether that person is a short, a long-only manager, hedge fund manager, financial journalist, sell-side analyst, etc. ?(I’ve even budged the market occasionally on some illiquid stocks…)
  • Asset prices move and some people mimic to intensify the move because they feel they are missing out.
  • Holdings reports get released.
  • New scientific discoveries are announced
  • Mergers or acquisitions or new issues are announced.
  • The solvency of a firm is questioned, or a firm of questionable solvency has an event.
  • And more… nowadays even a “tweet” can move the market

In the short run, it doesn’t matter whether the news is true. ?What matters is that people believe it enough to act on it. ?Their expectation change. ?Now, that may not be enough to create a permanent move in the price — kind of like people buying stocks that Cramer says he likes on TV, and the Street shorts those stocks from the inflated levels. ?(Street 1, Retail 0)

But if the news seems to have permanent validity, the price will adjust to a higher or lower level. ?It will then take new data to move the price of the asset, and the dance of information and prices goes on and on. ?Asset prices are always in an unstable equilibrium that takes account of the many views of what the world will be like over various time horizons. ?They are more volatile than most theories would predict because people are not rational in the sense that economists posit — they do not think as much as imitate and extrapolate.

Read the news, whether on paper or the web — “XXX is dead,” “YYY is the future.” ?Horrible overstatements most of the time — sure, certain products or industries may shrink or grow due to changes in technology or preferences, but with a few exceptions, a new temporary unstable equilibrium is reached which is larger or smaller than before. ?(How many times has radio died?)

“Stocks rallied because the Fed cut interest rates.”

“Stocks rallied because the Fed tightened interest rates, showing a strong economy.”

“Stocks rallied just because this market wants to go up.”

“Stocks rallied and I can’t tell you why even though you are interviewing me live.”

Okay, the last one is fake — we have to give reasons after the fact of a market move, even anthropomorphizing the market, or we would feel uncomfortable.

We like our answers big and definite. ?Often, those big, definite answers that seem right at 5PM will look ridiculous in hindsight — especially when considering what was said near turning points. ?The tremendous growth that everyone expected to last forever is a farce. ?The world did not end; every firm did not go bankrupt.

So, expectations matter a lot, and changes in expectations matter even more in the short-run, but who can lift up their head and look into the distance and say, “This is crazy.” ?Even more, who can do that precisely at the turning points?

No one.

There are few if any people who can both look at the short-term information and the long-term information and use them both well. ?Value investors are almost always early. ?If they do it neglecting the margin of safety, they may not survive to make it to the long-run, where they would have been right. ?Shorts predicting the end often develop a mindset that keeps them from seeing that things have stopped getting worse, and they stubbornly die in their bearishness. ?Vice-versa, for bullish Pollyannas.

Financially, only two things matter — cash flows, the cost of financing cash flows, and how they change with time. ?Amid the noise and news, we often forget that there are businesses going on, quietly meeting human needs in exchange for a profit. ?The businessmen are frequently more rational than the markets, and attentive to the underlying business processes producing products and services that people value.

As with most things I write about, the basic ideas are easy, but they work out in hard ways. ?We may not live long enough to see what was true or false in our market judgments. ?There comes a time for everyone to hang up their spurs if they don’t die in the saddle. ?Some of the most notable businessmen and market savants, who in their time were indispensable people, will eventually leave the playing field, leaving others to play the game, while they go to the grave. ?Keynes, the great value investor that he was, said, “In the long run we are all dead.” ?The truth remains — omnipresent and elusive, inscrutable and unchangeable like a giant cube of gold in a baseball infield.

As it was, Ben Graham left the game, but never left the theory of value investing. ?Changes in expectations drive prices, and unless you are clever enough to divine the future, perhaps the best you can do is search for places where those expectations are too low, and tuck some of those assets away for a better day. ?That better day may be slow in coming, but diversification and the margin of safety embedded in those assets there will help compensate for the lack of clairvoyance.

After all, in the end, the truth measures us.

The Rules, Part LXI (The End… of the Past)

The Rules, Part LXI (The End… of the Past)

Posted on by David Merkel

Rule: every rule has exceptions, including this one

In the long-run, and with hindsight, most actions of the market make sense. ?Sadly, we live in the short run, and our lives may only see one to 1.5 full macro-cycles of the market in our lives. ?We live in a haze, and wonder what useful economic and financial rules are persistently valid?

We live in a tension between imitation and thought, between momentum and valuation, between crowds and lonely reasoning, between short-term thinking and long-term thinking.

It would be nice to be like Buffett, who has no constraint on his time horizon, managing to the infinite horizon, because he has so much that setbacks would mean little to him. ?But most of us have retirements to fund, college expenses, a mortgage, and many other things that make us far more subject to risk.

Does valuation matter? ?You bet it does. ?When will it matter next? ?Uh, we can’t answer that. ?When we come up with a good measure of that, people begin using it, and the system changes.

My personal asset allocation for most of my life has been 75% risk assets/25% cash. ?Especially now, when bond yields are so low, I don’t see a lot of reason to extend the maturities of my bond portfolio, aside from a small position in ultra-long Treasuries, which is a hedge against deflation.

Investment reasoning is a struggle between the short-term and the long-term. ?The short-term gets the news day-by-day. ?The long term silently gains value.

If you invest long enough, you will have more than your share of situations where you say, “I don’t get this.” ?It can happen on the bull or bear sides of the market, and you may eventually be proved right, but how did you do while you were waiting?

Thus, uncertainty.

Is there a permanent return premium to investing in equities? ?I think so, but it is smaller than most imagine, particularly if compared against BBB/Baa bonds.

I’m not saying there are no rules. ?Far from it, why did I write this series?! ?What I am saying is that we have to have a firm understanding of the time horizon over which the “rules” will work, and an understanding of market valuations, sensing when valuations are high amid a surging market, and when valuations are low amid a plunging market. ?There are times to resist the trends, and times to embrace the trends.

The rules that I embrace and write about are useful. ?They reduce risk and enhance return. ?I once said to Jim Cramer before I started writing at RealMoney that the rules work 65% of the time, they don’t work 30% of the time, and 5% of the time, the opposite of the rules works. ?This is important to grasp, because any set of tools used to analyze the market will be limited — there is no perfect set of rules that can anticipate everything. ?You should expect disappointment, and even embarrassment with some degree of frequency. ?That’s the way of the market even for the best of us.

Hey, Buffett bought investment banks, textiles, shoes and airlines at the wrong times. ?But we remember the baseball players who had seasons that were better than .400, and Buffett is an example of that. ?In general, he made errors, but he rarely compounded them. ?His successes he compounded, and then some.

The rule I stated above is meant to be a paradox. ?In general, I am a long-term oriented, valuation-driven investor who seeks to maximize total return over the long haul, with significant efforts to avoid risk. ?Do I always succeed? ?No. ?Do I make significant mistakes? ?Yes. ?Have my winners more than paid for my losers over the 20+ years I have been an active investor? Yes, yes, and then some.

But this isn’t about me. ?Every investor will have days where they will have their head in their hands, like I did managing the huge corporate bond portfolio in September 2002, where I said to the high yield manager one evening as we were leaving work, “This can’t keep going on like like this, right? ?We’re close to this burning out, no?

He was a great aid to my learning, an optimist who embraced risk when it paid to do so. ?At the time, he agreed with me, but told me that you can never tell how bad it could get.

As it was, that was near the bottom, and the pains that we felt were those of the market shaking out the crud to reveal what had long lasting value. ?Or at least, value for a time, because?the modus operandi of the Fed became inflating a financial/housing bubble. ?That would not work in the long run, but it would work for a time. ?After that, I worked at a place that assumed that it would fail very soon, and was shocked at how far the financial excesses would eventually run. ?I was the one reluctant semi-bull in a bear shop that would eventually be right, but we had to survive through 4+ years of increasing leverage, waiting for the moment when the leverage had gone too far, and then some.

Being a moderate risk-taker who respects risk is a good way to approach the markets. ?I have learned from such men, and that is what I aim for in my investing. ?That means I lag when things are crazy, and that is fine with me. ?I don’t play for the last nickel — that nickel may cost many bucks. ?Respect the markets, and realize that they aren’t here to serve you; they exist to allocate capital to the wise over the long run. ?In the process, some will try to profit via imitation — it’s a simple strategy, and time honored, but when too many people imitate, rather than think, bad things happen.

The End, for Now

This post is the end of a long series, and I thank those who have read me through the series. ?I think there is a lot of wisdom here, but markets play havoc ?with wisdom in the short run, even if it wins in the long run. ?If I find something particularly profound, I will add to this series, but aside from one or two posts, all of the “rules” were generated prior to 2003. ?Thus, this is the end of the series.

The Rules, Part LX

The Rules, Part LX

Posted on by David Merkel

Rapid upward moves in volatility almost always presage a bounce rally.

Again, I am scraping the bottom of the barrel, but this is a common aspect of markets. ?When things get tough, scaredy-cats buy put options. ?That pushes up option implied volatilities. ?The same doesn’t happen when prices are rising, because that happens slower. ?Prices fall twice as fast as they rise in the stock market.

Emotions play a big role with options, and many do not use them rationally. ?Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.

As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up. ?As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged. ?Their pseudo-selling is over, and a bounce rally will happen.

Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise. ?People buy equities as fears dissipate.

Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility). ?Use this knowledge to guide your portfolio positioning. ?At present, it is more reliable then many other measures of the market.

Next time, I end this series. ?Till then.

The Rules, Part LIX

The Rules, Part LIX

Posted on by David Merkel

Productivity increases are only so when they result in an increase of desired consumer goods purchasable at prior prices.

As I commented in my last piece, I’m scraping the bottom of the barrel as I come to the end of this series. ?I’ll keep this short. ?The concept of hedonics has some value as it tries to adjust price indexes for quality improvements. ?Where it goes wrong is equating technical improvement with usefulness. ?With products where technology is improving rapidly, often hedonic improvements cannot be measured, because the prior product is no longer being sold. ?If it were being sold, it would provide significant information about how much people value product improvements. ?As it is, sometimes economists try to estimate improvement in value off of technical improvements.

A computer that is twice as fast, with twice the RAM and twice the storage, is not twice as valuable. ?To the degree that hedonics takes shortcuts ?to estimate value, it overestimates how much value is added by technological improvement.

The Rules, Part LVIII

The Rules, Part LVIII

Posted on by David Merkel

Can contingent claims theory for bond defaults be done on a cash flow/liquidity basis?? KMV-type models seem to fail on severely distressed bonds that have time to breathe and repair.

We’re getting close to the end of this series, and I am scraping the bottom of the barrel. ?As with most aspects of life, the best things get done first. ?After that diminishing marginal returns kick in.

Here’s the issue. ?It’s possible to model credit risk as a put option that the bondholders have sold to the stockholders. ?As such, equity implied volatility helps inform us as to how likely default will be. ?But implied volatilities are only available for at most two years out, because they don’t commonly trade options longer than that.

Here’s the scenario that I posit: there is a company in lousy shape that looks like a certain bankruptcy candidate, except that there are no significant events requiring liquidity for 3-5 years. ?In a case like this, the exercise date of the option to default is so far out, that the company can probably find ways to avoid bankruptcy, but the math may make it look unavoidable. ?Remember, the equity has the option to default, but they also control the company until they do default. ?Being the equity is valuable, because you control the assets.

Bankruptcy means choking on cash flows out that can’t be made. ?Ordinarily, that happens because of interest payments that can’t be made, rather than repayment of principal. ?If interest payments can be made, typically principal payments can be refinanced, unless credit gets tight.

The raw math of the contingent claims models do not take account of the clever distressed company manager who finds a way to avoid bankruptcy, driving deals to avoid it. ?The more time he has, the more clever he can be.

This is a reason why I distrust simple mathematical models in investing. ?The world is more complex than the math will admit. ?So be careful applying math to markets. ?Think through what the assumptions and models mean, because they may not reflect how people actually work.

 

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