Category: The Rules

The Rules, Part XLVII

The Rules, Part XLVII

Posted on by David Merkel

Crashes are the result of a shift from a positive self-reinforcing cycle to a negative self-reinforcing cycle.

Cycles in business and investment tend to be self-reinforcing.? That is true because most men don’t think, they imitate.? Economics needs to revise its view of man as rational, because it hurts to think differently.? It is much easier to go with the flow of your relatively successful neighbors, and imitate them.? Thinking for yourself is needless effort to many.? Why bother with that when doing well is a simple thing?

The trouble is, early imitators are few, because the signal is not so big.? Late imitators are many; the signal is big, and wrong.? The dumb money arrives at the end of a boom.? At that time, asset prices are so high that the asset must make gains over the next ten years in order to cover the capital cost of the investment.? At peaks, it would pay better to hold fixed income, and not play in the hot asset.

At the peak, it only takes a few sellers to overcome the market, because all of the dumb money is exhausted.? They are fully invested.? Valuation-sensitive buyers are wary.? This is one reason why markets rise slower than they fall.? Credit expands to aid the boom, but when the bust comes, new credit is cut off rapidly.? Thus we have crashes, and the economy never moves as quickly as the market, but the economy moves with more persistence.

I want to attack this from a different angle.? In 1929, before the crash, there was an article by J. J. Raskob in Ladies Home Journal entitled, “Everybody Ought to Be Rich.”? Think about that title.? Stocks flew as a result of the easy money policy of the Fed in the ’20s.? Some had invested in the market and made a fortune up to 1929.? Was that sustainable? No.? Did many keep it? No, very few.

But now suppose that everyone had invested in the market in mid-1929, off of Mr. Raskob’s advice.? Stocks would have soared further, and crashed worse.? Why?? The pricing of stocks is not arbitrary — a high price must be justified by high earnings relative to where an investment grade bonds yield.? As it was, the highly indebted economy of 1929 was ripe for a fall, with earnings and bond yields falling dramatically.? At least the Great Depression solved their debt problem — the Great Recession isn’t doing it for us.

But can everyone be rich?? Gotta break it to you, the answer is no.? Part of it is relative — there will always be some differences wealth/income because of a number of factors: some work harder, some work faster, some invest better, some get a better starting position, etc.

But part of it is absolute.? Some jobs don’t make sense unless you have less-skilled workers to accept lower wages for picking fruit, daycare, delivering pizza, etc.? In a society where almost all people marry and have more than two kids naturally on average, that means many of those low level jobs will fall to the young.? In societies where the birth rate is low, a lot of those jobs go to immigrants from poorer nations.? Now if you accept the idea that there is a spread of abilities in people, you know that there are less-skilled people by the time they arrive at age 25.? Some of it is natural.? Some of it is laziness.? Some of it is bad planning.? Many of those that are less skilled will occupy the low-end jobs, and in a society with reasonable population growth, there won’t be much room for immigration.

Everyone ought to be rich?? Because they invest?? If everyone were a value investor of high degree, and we parted with our excess income regularly to invest, where would the opportunities be?? In a situation like that, brighter and more motivated people would try to start businesses where they levered their own abilities without trying to play on the secondary markets, assuming they could find people to work with them.

The idea that “everyone ought to be rich” is hooey.? There are rare times when an asset class gets on a roll and seems invincible:

  • Stocks in the 20s, 50s-60s, 80s-90s
  • Bonds in the 80s-00s
  • Commodities in the 70s, 00s
  • Cash in the 70s
  • Real estate in the 20s, 70s-80s, first half of 00s

But to profit in those eras, you would have to know the right place to be, have proper discretion make wise investments, AND have enough funds socked away in order to make the wise investments.? By the time someone writes a book/article “Everyone ought to be rich,” or “How you can be rich by flipping real estate,” etc., it is too late.? And please ignore the scam ads where penny stocks create millionaires — that applies to those few selling the penny stocks, not those buying.

Few people have achieved great wealth through investing.? The ordinary sorts are those who manage other people’s money in public markets, and a lot of it, and do a middling-to-good job, so that clients don’t leave.? Other do it through private equity, but there again, they are levering other people’s money.? Then there are those that use mostly their own money, like Buffett, Munger, etc., and find undervalued situations relative to prospects regularly.? Those are precious few.

Society has people that make money off of:

  • Work
  • Lending
  • Managing physical assets
  • Managing businesses
  • Managing financial assets

That last category gets too much attention.? Most people have better advantage upgrading their skills, or owning private businesses that they understand well.? That may not make them rich, but it might make them well-off.

Summary

There are booms and busts, and each period has self-reinforcing behavior.? It is difficult to time booms and busts.? Some get the booms; some get the busts; very few get both.? It is tough to make money off of the boom-bust cycle and keep it.? It is really tough to make your living entirely through investing, unless you inherit it.? Work to enhance your skills to your best advantage wherever you work.

But no, everyone can’t be rich, and we have to accept that reality, and reflect that in government policy.? Encourage free and fair competition; eschew crony capitalism.? Don’t give anyone, rich or poor, an unfair advantage.

Finally, recognize what the neoclassical economists won’t admit — you can’t get rid of the boom/bust cycle.? It is a fact of life, and all of the tinkering with policy will never eliminate it — it will only intensify it.

The Rules, Part XLVI

The Rules, Part XLVI

Posted on by David Merkel

Speculative companies should be evaluated on cash, burn rate, probability of success, size of potential market and margins at maturity.

I rarely buy speculative companies, but it is an interesting question as to how speculative companies like Amazon, Google, or a biotech firm should be valued.? Speculative companies are like options; they often end with no value, and occasionally end with a large value.

Here are my five points:

  • Cash
  • Burn rate
  • Probability of success
  • Size of potential market, and
  • Margins at maturity.

Cash and burn rate tell you how long the company has to play before it fails.? If a company is spending cash in an effort? to produce a profitable business, how long can it do so until it runs out of cash?

That plays into the probability of success — more time means a higher probability, mostly, but desperation can aid success.? Other aspects on probability of success include the competition, novelty/reliability of the science, etc.

If the strategy does succeed, how large could the market be that is served, and how big could the margins be as part of an oligopoly?

But after all that, discount for the probability of failure, and discount the future earnings stream at 20%/year, because this is so uncertain.

As I said to colleagues at one firm I worked for in 2004, “Imagine Google gets 20% of the profits of the global advertising business 10 years out, and holds onto it?? What would that be worth?”

It would be worth a lot, and Google has probably exceeded that profitability estimate, thus the high market valuation of Google.? Give credit to people with clever ideas at the right time.

Anyway, be careful investing in speculative companies — this is an area where you will get more strikeouts than home runs.? I tend to be a singles hitter in investing, but with a high average.? But in the few cases where I look at a speculative company, this is how I do it.

 

The Rules, Part XLV

The Rules, Part XLV

Posted on by David Merkel

Market rents are typically fixed in size.? When a strategy to exploit a particular market inefficiency gets too big, returns to the rent disappear, or even go negative prospectively, even if they appear exceedingly productive retrospectively.

If you have read me for any decent amount of time, you know I am big on economic and financial cycles, and how they can’t be eliminated.? There are two groups that think the cycles can be eliminated:

  • Politicians and Central Bankers who think they can create permanent prosperity, when all they really create is an increase in overall debt.
  • Efficient market theorists who think there are no strategies that beat the market.

It is the second group that I am dealing with this evening.? Market strategies trend.? If we have had outperformance from value investing this year,? the odds are good that we will have it next year, unless it has gone on for too many years (5+).

Ideas in investing tend to streak, get overinvested, then die.? This is one reason why I don’t believe articles about the death of various investment concepts.? We need to think about investment ecologically.? There are no permanently valid investment factors to beat the market.? There are many investment factors that beat the market over time, but not while many are pursuing them.? Imitation drives returns, and then over-imitation kills them.

That means we should be wary when a strategy has been working too well for too long.? It also means we should be skeptical when any strategy with a strong thesis behind it is declared “dead.”? That may be the very time to consider it, or maybe wait a year or two.? Many strategies are forgotten; after a time of failure it is time to remember them.

Part of this stems from the biases of institutional investors.? They think that their winnowing down of the investable universe through screening will always produce a good crop of candidates in which to invest.? But that’s not true.? Talented investors think more broadly, and are willing to consider investments that don’t fit within common screens.

The thing is: strategies go in cycles.? They are born at a time when no one loves them.? They gain currency from the good returns of those who adopt them, leading to a frenzy where many adopt the strategy, and returns are great, but now companies that fit the strategy are overvalued.? The process goes into the reverse gear where the strategy is garbage, until enough parties abandon it and the prices of stocks that would be a part of the strategy are attractive.

So when you hear:

  • Value is dead
  • Growth is dead
  • Large caps are dead
  • Small caps are dead (rare)
  • Momentum is dead
  • Low volatility is dead.
  • Quality is dead.
  • Low Quality is dead.
  • XXX industry or sector is dead.

Be skeptical, and begin edging into companies that you like in the “doomed” strategy.? Make sure they have strong balance sheets and competitive positions.? That will protect you if the trend persists.

One more note: this doesn’t work in reverse.? A strategy that has been working for a little while will likely streak.? Resist the trend when it is old, not when it is young.

Finally, remember: there are only tendencies, not laws: markets exist to surprise you.? There are theories that work in the market over time, but they do not work year after year, the results come in lumps, unlike the projections of the financial planners.

And I close by saying to all of my readers — is this not how the market works?? There is momentum, but it sometimes fails dramatically.? Ideas streak, and then collapse far faster.? I say be aware of what has been rewarded and what has not.? Sell stuff that has been rewarded too long, and that which has been recently trashed.? Buy the stuff that has come into favor, and strong companies that have been unduly trashed.

The Rules, Part XLIV

The Rules, Part XLIV

Posted on by David Merkel

Expectations are a part of the game.

As expectations change, so do the markets.? What could be simpler?? Markets are discounting mechanisms, so why aren’t expectations the whole game?

Expectations are the whole game for widely traded assets that are analyzed by many.? But there are complex assets and smaller assets for which expectations, should they exist, are not well-defined.? A large example would be Berkshire Hathaway.? When the stock of Berkshire Hathaway begins to care about making/missing earnings estimates, that will be a real change in the way the stock is viewed.

I have a number of other stocks in my portfolio that have no analyst coverage, so whatever expectation their is for the company is ill-defined.? Earnings shrink?? Stay flat? Rise a little, lot, or more?? Often the reactions are muted, because expectations are ill-defined.

With cheap stocks, I often view results in two ways:

  • Expectations mode: are they beating earnings expectations or not?
  • Book value mode: are they earning enough to justify the current market price?? (And are the earnings real?)

It’s hard to lose money on companies that trade below book and have a single-digit P/E.? The value accretes and eventually market prices follow.? You just have to be happy with firms that are boring, but profitable.

Cheap stocks with good balance sheets do not get killed when there are earnings disappointments.? With those stocks, we can sit back and wait for a better day.

All that said, earnings estimates provide a feedback mechanism for those stocks that have an adequate number of analysts following them.? Imperfect as it is, it guides the way we react to quarterly releases of adjusted earnings.? And when companies attempt to show adjusted earnings that are liberal, it is no surprise when the market rejects their presentation, and the stock goes down.

But this rule applies to policymakers as well.? Over the last 27 years, the Federal Reserve has placed a greater emphasis on communications.? I think that was a mistake, but the Fed made it a goal to shape the expectations of the market.? And they did so.

But once you sharpen the focus of the market to your promises, should it surprise you that when you give the least bit of equivocation, that the market reacts badly?? Hey, you made your bed, now sleep in it.? You trusted in your ability to communicate, and now you reap the result.

Even with no current change in policy, a change in expectations can have a huge effect on markets, particularly when novel policy tools are being used.? Ben Bernanke should not have been surprised by the reaction of the market to his comments to the press after the last FOMC meeting.? All of the efforts since that time to take it back have bolstered the stock market, but have not affected the bond market much.? Remember that the bond market is usually smarter than the stock market, thus I remain bearish.

 

 

Full disclosure: Long BRK/B

The Rules, Part XLIII

The Rules, Part XLIII

Posted on by David Merkel

Modify Purchasing Power Parity by adding in stocks and bonds

An optimal currency board price basket would contain both assets and goods.

In one sense, assets are future goods.? Assets throw off an uncertain stream of future benefits, which can be used to purchase goods at that time.? Based on the demographics of an economy, if marginal dollars tend to be saved versus spent, stimulus would affect the economy differently:

  • Spent: we get goods/services price inflation.
  • Saved/Invested: we get asset price inflation.

Asset price inflation is different.? It is difficult to transfer resources from the present to the future.? Even a zero coupon bond relies on the solvency of the issuer, and the realized goods/services inflation.? Hoarding gold/commodities relies on the idea that they will be more scarce in the future, which is unlikely as prices rise to encourage more supply.

Cash rarely earns more than the CPI.? Bonds have long cycles where they are alternatively “certificates of confiscation” or “beneficiaries of deflation.”

Asset prices rising is not always a good thing.? The rise in prices may reflect additional productivity or they may reflect a higher price for transferring goods to the future.

When I was a bond manager for an insurance company that had long-dated promises to pay, I bought a variety of fixed-rate bonds that that appreciated dramatically in value in a falling interest rate environment.? What did that do to my expected cash flow stream?? Nothing.? If anything, it meant we would earn less because we would reinvest excess cash flows at rates lower than the market yield of the bonds.

This is a reason why QE from the Fed is questionable.? Their asset purchases push up the price of assets, but the cash flows don’t change.? Maybe a few more entities decide to issue debt in the process, but that doesn’t mean the debt gets used for expansion.? It may well replace equity, given its cheapness.

Maybe the answer here is to look at inflation as a credit phenomenon, whether the credit is used to purchase assets or goods/services.? At present, assets are inflating more than goods/services, and that has been true for some time.? I suspect that relationship will reverse, but when that will come I can’t predict.

The Rules, Part XLII

The Rules, Part XLII

Posted on by David Merkel

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.? I’ve been through it.? He would not bite.

The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.

The Rules, Part XLI

The Rules, Part XLI

Posted on by David Merkel

If businesses anticipate a flow of financing, they will depend on it.? Then a diminution or increase in the flow of investable funds will affect markets, even if the flow of investable funds remains positive or negative.

Most of the sayings from the “rules” posts came from things I thought of while managing investment risk 1998-2004.? I think I wrote this one late in 2002, or early 2003.? I’ll apply this three ways — what I would apply this to now, then, and in-between.

Then: the Fed funds rate was below 2%, and the yield curve was steeply sloped.? The corporate bond market had gone through an incredible bust, but almost all the companies that would fail had already failed, and a big rally was just starting.? Banks were still in good shape, with plenty of lending capacity, which was being applied to residential and commercial lending.? The securitization markets functioned and financing was easily available for residential & commercial mortgages, and many types of consumer lending.

In-between (1): Now I’m talking about 2006-7.? Fed funds rate was rising to an eventual 5.5%.? The curve is flat to inverted, and corporate spreads are very tight.? Issuance of low grade paper is rampant, and covenant protections are declining.? Risk is chasing reward, and gaining.? Everything is overlevered.? Any attempts at prudence are financially punished.? That said, the securitization market slows; deal are harder to do.

In-between (2): Now I am talking about late 2008 to early 2009.? Fed Funds had shifted to its current near zero state, but the Fed had not begun playing with the asset side of its balance sheet.? The yield curve was relatively wide but bull flattening.? Nothing was getting done in lending, and credit spreads were as wide as wide can be.? Securitization drops to near zero. Bank lending is non-existent, aside from buying Treasuries on credit provided by the Fed.

Now: The Fed funds rate is still in the gutter, and the Fed dreams that QE will do a lot for the economy.? (It works in theory! Stupid economists.)? Corporate credit spreads are wide, covenant protections are low, and yields relative to intrinsic risk are low.? Securitization markets are functioning at a reduced level, while banks aren’t lending much to the private sector.? Most housing loans are backed by the US government.

So here is the graph:

The point of this piece is to tell you not to look at the level of risky interest rates, but to look at the rate of change in risky interest rates. It tells a lot regarding future prospects of the stock and bond markets.? The rate of change matters a great deal, not the absolute level of rates.

So, the implication is watch for a sustained rise in in high-yield bond yields.? When those yields cross their 10-month moving average, it is time to be gone from risk assets.

The Rules, Part XL

The Rules, Part XL

Posted on by David Merkel

Unions create inefficiency.? This creates an opportunity for new technologies that perform the same function, but aren?t as labor-intensive.? (E.g. integrated steel vs. mini-mills)

Unions were a useful force in the US in their early days.? They helped get safe working conditions, and helped workers get the Sabbath off, so that they could go to church.? Those were admirable goals, but after that, unions outlived their usefulness.

Unions restricted my father and uncle on whom they could hire, yet required them to be a part of the union, but gave them no vote because they were owners (they hired one worker at most).? My mother was particularly annoyed at the union, but today she draws a pension from it.

The main inefficiency of unions comes from work rules.? In most other ways, unionized workers are not inefficient.? But the inefficiency of unions attracts efforts from employers to substitute capital for labor.? One of the best examples is listed above — unionized steel gets its market share eroded by mini-mills, using a lot more science, fewer people, and producing steel a lot cheaper.

There are other examples of this, but if in the private sector attempts to raise wages above levels justified by productivity, or limit flexibility of work processes, there will be the tendency for non-union firms to come in and take market share.? Example: non-union auto parts companies now provide most of the parts to auto manufacturers.

This is one reason why I think non-union technology has been more harmful to unions than foreign competition.? Creativity is not union, by and large, though I know there are exceptions.? In an era of technological improvement, non-union firms have more quickly embraced change.? This is what has hollowed out the unions, leaving them largely to serve governments, where technological improvement plays little role, because there is no possibility of competition in government, mostly.

Yes, there may be modest changes here and there, but when was the last time you heard of a municipality breaking a police, fireman, or teachers’? union?? Until pensions break the states and municipalities, that will not happen.

Thus I expect unions to continue to decrease in power for the near term, aside from government employment.? Unions will always occupy the most backward parts of the economy.

The Rules, Part XXXIX

The Rules, Part XXXIX

Posted on by David Merkel

The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.? Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.? The same factors that lead to buying to an unfair level also cause selling to an unfair level.

Benchmarking and risk control through VAR only work when few market participants use them.? When most people use them, it becomes like the portfolio insurance debacle of 1987.? VAR becomes pro-cyclical at that point.

Sometimes I think the Society of Actuaries is really dumb.? The recent financial crisis demonstrated the superior power of long-term actuarial stress-testing versus short-term quant models for analyzing risk.? The actuarial profession has not taken advantage of this.? Now, maybe some investment bank could adopt an actuarial approach to risk, and they will be much safer.? But guess what?? They won’t do it because it will limit risk taking more than other investment banks.? Unless the short-term risk model is replaced industry-wide with a long-term risk model, in the short-run, the company with the short-term risk model will do better.

The reason why VAR does not effectively control risk is simple.? VAR is a short-term measure in most of its implementations.? It is a short-term measure of risk for short- and long-term assets.? Just as long-term assets should be financed with long-term liabilities, so should risk analyses be long-term for long-term assets.

This mirrors financing as well, because bubbles tend to occur when long-term assets are financed by short-term liabilities.? Risk gets ignored when long-term assets are evaluated by short-term price movements.

And, as noted above, these effects are exacerbated when a lot parties use them; a monocultural view of short-run risk will lead to booms and busts, much as portfolio insurance caused the crash in 1987.? If a lot of people trade in such a way as to minimize losses at a given level, that sets up a “tipping point” where the market will fall harder than anyone expects, should the market get near that point.

The idea that one can use a short-term measure of risk to measure long-term assets assumes that markets are infinitely deep, and that there are no games being played.? You have the capacity to dump/acquire the whole position at once with no frictional costs.? Ugh.? Today I set up a new client portfolio, and I was amazed at how much jumpiness there was, even on some mid-cap stocks.? Liquidity is always limited for idiosyncratic investments.

The upshot here is simple: with long term assets like stocks, bonds, housing, the risk analysis must be long term in nature or you will not measure risk properly, and you will exacerbate booms and busts.? It would be good to press for regulations on banks to make sure that all risk analyses are done to the greater length of the assets or the liabilities (and with any derivatives, on the underlying, not contract term).

The Rules, Part XXXVIII

The Rules, Part XXXVIII

Posted on by David Merkel

There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

  • Chasing performance
  • Over-diversification
  • Benchmarking / Hugging the index
  • Over-trading
  • Relying too heavily on earnings growth
  • Analyzing the income statement only
  • Refusing to analyze industries
  • Buy newsy companies
  • Relying on the sell-side
  • Trusting management too much

 

Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.? I am against regret.? Don?t buy something after you have missed most of the move, as if future stock price movement is magically up.? Unless you can identify why the stock is underappreciated after a strong move up, don?t touch it.

Over-diversification

Most managers hold too many stocks.? There is no way that a team of individuals can follow so many stocks.? Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.? Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.? You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.? Aim for a large active share, differing from the benchmark index.? Make some real nonconsensus investments.???? Show real moxie; don?t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?? More volatility in search of better overall returns is what investors need.? If they can?t bear short-term volatility, they should not be invested in stocks.

Over-trading

We don?t make money when we trade.? We make money while we wait.? Ideas take time to work out, and there are frequently disappointments that will recover.? If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.? For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.? Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.? For value companies, far less so.? Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.? In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.? Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.? One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.? Macroeconomics rarely translates into useful portfolio decisions in the short run.? Even when you are right, it may take years for it to play out, as in the global financial crisis ? the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely ?bottoms up,? and not gaining the broader context of the industry.? As a young investor that was a fault of mine.? As a result, I fell into a wide variety of ?value traps? where I didn?t see that the company was ?cheap for a reason.?

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.? I think most of those companies are overanalyzed, and as such, don?t offer a lot of investment potential unless one thinks the news coverage is wrong.? I actually like owning companies that don?t attract a lot of attention.? Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.? What are the key drivers to watch?? What management teams seem to be building value the best?? This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.? Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren?t.? Who is honest, and who bluffs?? This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever ? you might lose some advantage doing that, but you won?t be tricked by a slick-talking management team.? Trusting management implicitly is the big problem to avoid.? They are paid to speak favorably regarding their own firm.

Summary

This isn?t an exhaustive list.? I?m sure my readers can think of more foibles.? I can think of more, but I have to end somewhere.? My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

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