Value Investing – Page 14

Avoid Buying Individual Stocks in Distress

Posted on 14 August 2014 by David Merkel

There is a temptation, particularly among novice value investors, to throw money at a stock that has fallen hard. ?Bargains are hard to pass up.

It can be worse if you owned the stock prior to the fall, and kept investing as it went down. ?There is the temptation to follow blindly the axiom, “Well, if you liked it before, you must love it now! ?Load the boat!” ?Far better to sit down and talk with a friend who has more skill than you, who does not own the stock, and if he/she has time, ask for his opinion. ?While you are waiting, go out to the web, and listen to the opinions (perhaps triumphal opinions) of those that did not like the stock. ?Particularly take note of:

Allegations that the accounting is aggressive, or worse, crooked
Claims that the management team has goals different than that of shareholders.
Check to see that the balance sheet isn’t weak. ?Compare it to the balance sheets of competitors.
Is there too much debt? ?Is there too much debt potentially coming due soon, and too little resources to pay the debt?
Is revenue falling dramatically? ?What competitor is benefiting from the firm’s troubles?

But even if you didn’t own the stock, you might be wary of a stock that has fallen hard for a number of reasons, if the fall indicates the company may be in danger of default.

It’s likely that the management team that is responsible for the problem is still in charge.
Most ordinary management teams are not used to managing a company that is in distress.
Suppliers become less likely to extend favorable credit terms to the firm.
Rival companies spread rumors that you are going under and try to attract your best customers away.
Talented employees look for greener pastures as opportunities dry up. ?It’s no fun to turn from growing a profitable business, to putting out fires.
Management will be distracted with staying alive, maybe vulture investors, analysts seeking more data, regulatory requests, lenders seeking assurances, etc.
Credit will be harder to get from bonds, loans, etc., and if the firm gets?it, it will be expensive. (Especially if the firm uses?the Financing Methods of Last Resort.)
And, management may make things even tougher by having a round of layoffs. ?Less people to do the same work.
Not only that, but even if you are right about the stock, there will be a lot of sellers selling as the stock price rises, because they got back to even.

When a company is in distress, everything fights against it. ?All of the normal courtesies are gone, replaced by a haze of suspicion. ?At the time it most needs friends, they vanish. ?Tempting as it may be to buy the stock quickly, it might be worth it to wait and see whether things get worse, and analyze who would like to buy the company to use?some subset of the assets for their?own company.

Now recently I read a classic Journal of Finance article called, “In Search of Distress Risk, by?Campbell, Hilscher, and Szilagyi.” [Download is for wonks only, I will summarize.] ?Distress tends to happen to firms that have negative price momentum, are small, and are classified as value stocks because of the high ratio of net worth to market capitalization. ?As a result, some suggested that the risk premiums that exist for owning small and value stocks must be related to distress. ?But firms under distress tend to do badly, while small and value stocks tend to do well. ?Negative momentum fits, but distress is a small part of that anomaly.

So maybe if you are a value investor or a small cap investor, you might be able to improve your performance by screening out distress situations. ?The simplified variables used in the paper are (and their effect on the probability of distress [page 2910]):

Net Income / Total Assets (lower means higher probability of distress)
Total Liabilities?/ Total Assets (higher means higher probability of distress)
Three month total returns?(lower means higher probability of distress)
Realized stock price volatility over the last three months?(higher means higher probability of distress)
Market capitalization?(higher means higher probability of distress)
Stock price under $15??(yes means higher probability of distress)
Cash and near cash as a fraction of total assets (lower means higher probability of distress)
Market to Book?(higher means higher probability of distress)

Most of these make intuitive sense. ?The one for market capitalization doesn’t except the the effect of a stock being under $15/share is more closely related to distress.

One thing that might make you change you mind is if a new management team is brought in. ?Every quarter I pull together a list of companies that have fired or replaced their CEO, and I throw them in as competitors against the existing companies in my portfolio. ?[there were about 80 over the last three months] A fresh set of eyes, a fresh mind can change things, but analyse to see whether the new man or team has the right ideas.

To close with an example: don’t buy Seaworld [SEAS] after the negative surprise of yesterday, at least not yet. ?Analyze for solvency. ?Try to figure out whether the actions management is proposing will actually make things better, or whether the company’s prospects have been permanently reduced.

Don’t try to catch a falling knife. ?Rather, analyze, and if it makes sense when the panic has died down, buy some as a part of a diversified portfolio.

PS — In distress, the real pros look down the capital structure to see whether the preferred stock, junior debt, senior debt, bank loans, or trade claims look attractive. ?That’s beyond the average investor, but in times of distress, those securities trading at a discount may be where the real action is. ?The securities that get hurt but not destroyed will typically control the firm post-bankruptcy.

Full Disclosure: No holdings in any securities mentioned

Industry Ranks August 2014

Posted on 9 August 2014 by David Merkel

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 healthcare and consumer 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 is pretty cyclical at present. I will be very happy hanging out in dull stocks for a while.

That said, some dull companies are fetching some pricey valuations these days, particularly those with above average dividends. This is an overbought area of the market, and it is just a matter of time before the flight to relative safety reverses.

The Red Zone has a Lot of utilities and other dividend-paying industries; as I said, be wary. ?What I find fascinating about the red momentum zone now, is that it is loaded with cyclical companies.

In the green zone, I picked almost all of the industries. If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

Will cyclical companies continue to do well? Will the economy continue to limp along, or might it be better or worse?

But what would the stock screening model suggest that I have displayed the last few times I have done this post?

Wish I could tell you. ?In an “upgrade” Value Line’s stock screener can’t do the Value Line subscription that it used to, because its 3-5 Year Projected Annual Total Return field is blank for the screening software.

Maybe next time, but until then, play it conservative in your industry and stock selections — look for companies that can easily survive if industry conditions worsen. ?Once weaker players are marginalized, they will do well.

On the Recent Anxiety in High Yield Bonds

Posted on 8 August 2014 by David Merkel

Quoting the beginning of a recent article at Bloomberg.com:

As?junk bonds?plunge in value, many investors are wondering why.

There?s no obvious explanation for the 1.5 percent decline in U.S. high-yield securities in the past month, or the $9.9 billion of cash pulled from mutual funds that buy the debt. The most likely reason is that investors are increasingly uncomfortable hanging onto bonds that are expensive by historical measures.

Chalk this one up to a collective bout of angst that looks quite different from the 3.2 percent drop in speculative-grade bonds in May and June of last year. That rout was triggered by the prospect of less Federal Reserve stimulus and, while a withdrawal of easy-money policies still weighs on investors? minds, that?s not the full story now.

On June 24th, the junk bond markets were fairly tightly bid, and volume in the main high yield ETFs [JNK & HYG] were moderate. ?By August 1st, that bid had seemingly disappeared, but volume in the main high-yield ETFs were high. ?Many running for the exits. ?Things have calmed down?since then, at least it seems that way. ?Have a look at this set of credit yield curves:

Source: FRED

Credit quality goes down as you go from left to right on my chart. ?The lower rated the?bonds, the more they fell, which was the opposite of slower moving but long-lasting bull phase. ?Let’s look at what the losses/gains were like in percentage terms:

Date	5-yr Tsy	AAA	AA	A	BBB	BB	B	CCC	JNK ($/sh)	HYG ($/sh)	SPY ($/sh)	DVY ($/sh)
6/24/14	1.70	2.57	2.44	2.67	3.44	4.20	5.09	7.91	41.80	95.24	194.70	76.51
8/1/14	1.67	2.54	2.45	2.70	3.50	4.89	6.05	9.16	40.21	92.04	192.50	73.67
8/6/14	1.66	2.52	2.44	2.68	3.50	4.83	5.97	9.11	40.54	92.64	192.07	72.79
Divs									0.86	0.39
Return to 8/1	0.30%	0.39%	0.21%	0.16%	0.12%	-2.32%	-3.31%	-4.18%	-1.75%	-2.95%	-1.13%	-3.71%
Return to 8/6	0.36%	0.50%	0.29%	0.27%	0.17%	-2.03%	-2.92%	-3.87%	-0.96%	-2.32%	-1.35%	-4.86%

The return calculations are approximations. ?These are indicative, not exact. ?The losses on high yield debt haven’t been horribly large over this period — around 3% give or take, and the ETFs surprisingly did a little better. ?No panic in investment grade bonds, and the losses of the stock market have been minor over that time, leaving aside the fact that the market rallied for a few more weeks after high yield began to slide.

But here’s an odd bit — take a look at the last column in my table. ?That last column is the iShares Select Dividend?ETF [DVY], a very popular place for getting alternative yield. ?It yields about 3.1% now — a little less than you can get on BBB bonds, but ?maybe the dividend will grow. ?(It usually does.)

When you have many different parties going into the markets seeking income, not caring where they get it from, and a shock hits one part of the market, the effect flows to other areas ?If all of a sudden yields on junk bonds look cheaper, the yield trade-offs of buying junk and selling dividend paying common stocks looks attractive.

Now there are few permanent rules for yield relationships — even in corporate debt on its own. ?We can calculate average spread differences, sure, but there is a LOT of variation around those means (which may even bear no resemblance to future means). ?If it is that difficult asking what the right spread tradeoffs are?with?bonds different qualities, then how would we ever come up with the right tradoffs for common stocks, preferred stocks, REITs, MLPs, bonds of varying qualities, etc?

The best we can do is something like GMO does, and go to each asset class?and try to estimate the free cash flow yield of each asset class over the next full market cycle (5-10 years) given the current prices being paid. ?The higher the price paid, the lower future returns will be, and vice-versa. ?Assume that valuations will normalize over the forecast horizon, and don’t just look at valuations using earnings. ?Try book, free cash flow and sales as well. ?Results will vary.

So remember,?The Investments Matter More than their Form. ?Also remember,?Ignore Yield. ?Focus on what is building value for you in every investment. ?I like to own stocks where earnings quality is high,?valuations are low, and free cash flow gets put to good use. ?Do I always get that? ?No. ?But if I get it right enough of the time, then returns will be good enough.

Back to the beginning, though. ?Is this move in the junk bond market a hiccup, or the start of something big? ?I’m open to other opinions, but for it to be something big, you have to have a lot of things that look misfinanced. ?Where are there economic entities with short-term debt financing long term assets that look overvalued? ?Where have debts grown the most? ?I can’t identify a class like that unless we try student loans, or government debts. ?Corporate debt has grown, but doesn’t seem unreasonable now.

So, with high yield, I lean toward the hiccup. ?But even at current yields, it is not cheap. ?Speculators may play; I will stay away.

On Genworth

Posted on 7 August 2014 by David Merkel

Another letter from a reader:

Hi David

Hope you are having a good summer.

Would love to hear your thoughts on recent developments at Genworth.? My sense has always been that LTC care insurance is a really tough business for the underwriter.? How can one possibly know how LTC costs will trend in the future – yet that unknown is what the insurer is agreeing to cover.? And some states aren’t even allowing them to raise prices?? Why would I want any exposure to this!!

Dear Friend,

Yes, LTC [long term ?care] is an ugly liability and it has been consistently underpriced for the last 25+ years. ?This has lad to the demise of some small companies (like Penn Treaty), with many more exiting or limiting the business. ?I try to avoid companies that don’t reserve conservatively, and that has been true of Genworth over the last ten years. ?Both LTC and Mortgage Insurance produced more claims than anticipated.

I’m not saying that things will get worse from here, but I put this in my “too hard” pile. ?I would need a lot more information before committing money to a stock like this. ?There are companies that are easier to understand, that also offer good potential returns.

If you can’t understand it, don’t buy it.

Sincerely,

David

Ignore Yield

Posted on 6 August 2014 by David Merkel

Yield is not an inherent feature of an asset. ?Why?

Dividends can be cut.
Bonds can default.
Taxable income can fall for REITs, BDCs, and MLPs, thus lowering their distributions.
Bonds sometimes have funny features where they can be called away from you, and you get to reinvest in a lower yield environment.
With structured notes, your income or principal can be considerably reduced when bad events happen that you thought were unlikely, but really aren’t so unlikely.

Rather, focus on the things that drive the increase in value of an asset. ?You can create your own “dividends” by selling off pieces of investments that you own. ?Commissions are small if you have the right broker.

Why do I write this, this evening? ?I keep running into writers and investment advisors that say, “You need a certain yield? ?I can get you that yield!”

Yes, and I can get you that yield too, but I would hate doing it because it would expose you to risks that I would not like to take with my own money. ?People forget all of the dividend cuts in the ’70s. ?They forget how many times REITs have failed as a group over the past 50 years. ?They forget how much money was lost on Limited Partnerships in the ’80s while trying to cheat the taxman.

Even Jonathan Clements, a writer who I would recommend to everyone, is somewhat duped by the need for yield. ?Getting yield from stocks is an uncertain proposition. ?Focusing on the highest quality stocks, and it is less uncertain, but still uncertain.

One thing is a constant with stocks and dividends — it is better to focus on stocks with low dividends that are growing rapidly, than on stocks with high dividends that grow slowly. ?The reason for this is that good management teams pay out a conservative amount of free cash flow as dividends, and reinvest most of the free cash flow to grow the company.

It is also not certain that bond yields will rise. ?The US economy is not strong, and there is no great demand for business loans at banks.

At a time like this, charlatans arrive telling you how high yields can be achieved in a low yield environment. ?Investment banks offer structured notes with high yields. ?Don’t believe them. ?Instead focus on the investments that might preserve or increase value best.

Now for the controversial bit: time to increase allocations to cash and gold (or commodities). ?You might think, “Wait, are you you saying in a low yield environment, I ought to drop my yield further?” Yes. ?I am also saying that when yields are too low, the opportunity costs of holding gold or cash are also low, and maybe that will help to preserve value if things go wrong.

I manage stocks and bonds for total return. ?I don’t look at yield as an important guide to future?total return in an environment like this. ?I try to ?view all investments through a “What could go wrong?” lens, rather than a “How much cash will this investment send to me next year?” lens.

Here’s a way to think about it. ?Pretend that all investments don’t make distributions. ?What investments would you want to own? ?Which grow value the best? ?That is your first pass in how you should think about investments. ?The second refines it by adjusting for tax rules, because some types of income are tax-favored. ?That said, put value generation first, and tax consequences second.

On Management Fees

Posted on 6 August 2014 by David Merkel

Yet another letter from a reader:

Hi David –

Thank you for your commitment to sharing your wisdom, ideas, and experience.? I aspire to one day enjoy the success and happiness that you have in your life and career as an investor.

My question may be a bit more tactical than others that you have profiled: In our current world of 2% & 20% fee structures and where in past eras Buffett promoted a 25% performance fee above a 6% threshold (with the objective of aligning partners’ wealth creation incentives), why do investment managers choose to promote % of AUM only fee structures?? I believe you also promote a similar fee only structure??

I’m curious about your insights on the rationale for fee only versus performance only structures.? Does your philosophy have anything to with your faith or past experience working at a hedge fund??

Many thanks and much continued success to you!!

Personally, I like the flat 1% of assets?fee (0.3% for bonds), because it does not make me swing for the fences. ?I don’t take extra risks or chances with client assets because of a performance fee. ?The main goal of investing is to avoid losing money. ?That is what I aim to do over a full market cycle, and I have been successful at it over the last 20+ years.

I respect those who do performance only, like Buffett’s formula, but?my value proposition is that those who invest alongside me get what I get, less the small fee. ?If I underperform in the future, I will be dejected, and it will hurt me far more, than any money I receive in fees. ?I aim to do as well as Buffett, but charge less. ?I am not driven by profits, but by service to clients.

Another way to say it is to hire guys who will do this business even if they weren’t paid. ?That is the way I feel about investing.

I am out to do well, and?not to give my clients a bad deal.

Can the “Permanent Portfolio” Work Today?

Posted on 6 August 20146 August 2014 by David Merkel

Another letter from a reader:

Dear Mr. Merkel:

I just discovered your blog through Valuewalk, which I read most days. I haven’t read much yet on your blog, but from what I’ve seen, I really like your insights and comments.

I’ve been thinking for a long time about the idea of a permanent portfolio concept, based on writing from years ago of an investment analyst, Harry Browne, now deceased. I’ve been thinking about this for my own investment requirements and also because I intend to write a book on the subject.

The big problem with a permanent portfolio today, versus 30 years ago, in my judgement, is identifying a long term fixed income vehicle would survive a major financial collapse. Browne always used 30 year US Treasury bonds, in an era when it seemed clear those bonds could survive a monetary deflation.

Of course, the Fed isn’t about to institute a policy of sustained monetary deflation any time soon, on a voluntary basis. Any such deflation would occur, either because the Fed were unable or unwilling to monetize assets fast enough to head off cascading cross defaults and massive bonk failures; or because the Fed decided to let the house of cards collapse, in some future recession-panic, because it became obvious to a plurality of Fed governors that to prop up the house of cards would guarantee hyper inflation in short order. Of course, a hyper inflation would not only destroy the financial system, including the central bank; it would overturn the established political order, and cause a famine as the division of labor fell apart.?

I think a monetary deflation will happen sooner or later, because of a financial “accident” (that reasonable people can foresee). Even if the central banks were to cause a hyper inflation, when that inflation ends after two or three years, the currency must be renounced. Then we would get deflation for a while via some new currency.

Since I think the deflation risk is realistic, I’m trying to figure out what-if any-bond instruments could survive deflationary destruction. Obviously, in a monetary deflation, all investment prices plummet, except default-free bonds. Default free bonds would rise in price, as interest rates plummeted. However, I’m not clear as to what bonds might work as vehicles in a permanent portfolio, because T bonds are no longer a reliable safe haven from eventual political default.

There might well be sovereign bonds in other countries that are more friendly to free enterprise and private property than contemporary US, and hence less prone to sovereign bond default,? but this introduces the risk of currency fluctuations. So it’s not a perfect solution. Perhaps some foreign sovereign debt combined with US Treasury debt would partly work. It has also occurred to me that some US utility or pipeline firm etc. might offer debt or preferred stock or other forms of fixed income debt/equity ownership that would survive default. In a terrible depression, I’d assume some utility companies would continue to function although, of course, not flourish. Obviously, any such debt or equity would be a very special situation, since most firms are now loaded to the gills with debt, making them poor risks to survive a crushing deflation.

My impression is all this is right up your ally. (Except for my musing-theorizing about the risk of monetary deflation, which no doubt makes me seem like a religious fanatic or political crazy.) Anyway, I’d be interested if you think this problem can be solved. In other words, do you think some private debt issues that are long term or even medium term exist to be discovered that could avoid default in a huge deflationary depression? How would you go about conducting a search for such safe U.S. corporate bonds or other fixed income instruments?

What I really need to do is immerse myself in reading about fixed income analysis. Which I hope to get to in a few months.

None of my fixation with bonds has to do with forecasting a decline in interest rates; until the next crisis, rates on the long end could easily climb. I’m looking for a secure volatile instrument that would gain in price as other investments were falling during a financial panic and subsequent depression.

Thanks for reading through all this. I look forward to spending a lot of hours in the future on your blog.

Yours truly,

Dear Friend,

I have written about the Permanent Portfolio concept here. ?I think it is valid. ?At some point in the near term, I will update my analysis of the Permanent Portfolio, and publish it for all to see, which I have not done before.

In a significant inflation scenario, gold would soar, long T-bonds would tank, T-bills would actually earn nominal but not real money, and stocks would likely trail inflation, aside from investors that invest in low P/E stocks. ?The permanent portfolio would likely do okay.

Same ?for a deflation scenario. ?Stocks will muddle. T-bonds will do well. ?T-bills will do nothing. ?Gold will do badly. ?That said, the permanent portfolio concept is meant to be an all-weather vehicle, and has done well over the last 44 years, with only 3 losing years, and returns that match the S&P 500, but with half the volatility.

I’m usually not a friend of ideas like this, but the Permanent Portfolio chose four assets where the price responses to changes in real rates and inflation fought each other. ?The rebalancing method is important here, as it is a strategy that benefits from volatility.

With respect to where to invest in fixed income?to benefit from a depression is a touchy thing — it’s kind of like default swaps on the US government, which are typically denominated in Euros. ?How do you know that the counterparty will be solvent? ?How do you know that the Euro will be worth anything?

Personally, I would just stick with long US Treasuries. ?The US has the least problems of all the great powers in the world. ?You could try to intensify you returns by overweighting long Treasuries, but that is making a bet. ?The Permanent Portfolio makes no bets. ?It just takes advantage of economic volatility, and rides the waves of?of the economy. ?As a group, stocks, T-bonds, T-bills, and gold, react very differently to volatility, and as such do well, when many other strategies do not.

Warren Buffett is “scary smart,” so says Charlie Munger, who is “scary smart” himself. ?I think Harry Browne was “scary smart” with respect to the Permanent Portfolio idea. ?But am I, the recommend-er “scary smart?” ?I do okay, but probably not “scary smart,” so take my words with a grain of salt.

Sincerely,

David

PS — As an aside, I would note that if everyone adopted the “Permanent Portfolio” idea — gold would go through the roof, because that is the scarcest of the four investments.

On Setting Up New Accounts

Posted on 5 August 2014 by David Merkel

Another great letter from a reader:

Hi David,

I enjoy your writing. I find myself of a similar mindset. I am an investment advisor running my clients individual accounts in a value fashion. I am currently have my clients invested in about 20 positions. My question is in regards to a new account….I have held off on buying the same positions in that new account unless any of the 20 positions still fall within my estimated “buy” range. Therefore, a new account opened today may sit in cash for some time until new ideas are found, or the 20 positions from the other accounts fall back to a buy range. How do you handle this? Do you use a model portfolio and all accounts consistently look alike?

Thank you and keep up the good work,

Dear Friend,

My value proposition is that clients get a clone of my accounts. ?I am my own biggest client; what I get, they get, less fees. ?I set them up to mirror my account within a week of receiving the assets.

The main reason I do it this way is that there is little rhyme and reason to target prices. ?I don’t have any target prices. ?Rather, I compare stocks against each other using a scoring system quarterly, and I sell companies that are relatively ?expensive and buy companies that are relatively cheap. ?Read my article Portfolio Rule Eight to understand this better. ?I realize few managers manage money this way, but I think it is a way that reflects how the markets really work. ?We should not compare individual stocks against cash, but compare stocks against each other. ?We should compare the stock market as a whole against cash, to analyze whether it is absolutely rich or cheap.

Sincerely,

David

The Investments Matter More than their Form

Posted on 2 August 20143 August 2014 by David Merkel

Open-end Mutual Funds, including index funds
Closed-end Mutual Funds
Exchange Traded Funds, including index funds
Separately Managed Accounts
Unit Investment Trusts
Hedge Funds
Private Equity
Other Limited Partnerships [LPs], including MLPs
Variable Annuities (and Life Insurance)
Equity-Indexed Annuities (and Life Insurance)

What do all of the above have in common? ?The first one is the easiest — they are all investments. ?The second one is harder — they are all ways of investing in the ownership interests of corporations.

Think of the underlying investments within these investment forms when analyzing the forms as investments. ?Now the forms aren’t entirely neutral:

Index funds don’t take a lot of fees.
Hedge Funds, Private Equity, and Insurance Products do take a lot of fees.
Insurance Products are tax favored. ?LPs,?MLPs and Private Equity have some tax advantages. ?Separately managed accounts can have tax advantages, if managed right. ?If you make the right investment, buying and holding has tax advantages, especially if you take it to the grave.

Thus, you should look at the manager, to try to analyze if he has skill. ?You should look at the fees to see what you are giving up. ?You should look at the tax advantages.

You should also think about the sensitivity of the investments to the overall risk cycle. ?I don’t like the concept of beta, because it is not a stable concept, but in broad hedge funds have low beta, and private equity has high beta, relative to an S&P 500 index fund. ?But neither in aggregate have much outperformance, after adjusting for the beta.

There are many clever investors scouring the world of investments looking for underpriced assets. ?At a time like now, there aren’t a lot of underpriced assets. ?I might find 2-4 per quarter, but they are only relatively underpriced, not absolutely underpriced (I.e. at this price, you should buy it regardless the the economic environment).

Every now and then, the market falls apart. ?At such a time, two things happen.

1) Because some sector of the economy had too much debt, prices for the stocks and corporate bonds (or trade claims) fall, and the market as a whole falls along with them, though to a lesser extent.

2) During the crisis, many assets get oversold, and those with better knowledge can profit from the overselling. ?The best example I can think of all of the hedge funds that bought non-agency mortgage-backed securities, when they were thrown out the window indiscriminately in 2008, and many of those securities have returned to par.

The ability to achieve alpha (outperformance) increases after a crisis. ?Some who prepare for that, like Seth Klarman and Warren Buffett, create their own outperformance by taking more risk when other investors are running away in panic.

As my boss asked me in 2007, “Why have you not done so well for us the last few years, when you did so well 2003-5? ?I answered, “When I came to you, the market was like an apple cart ?that had fallen over and I picked up the undamaged apples. ?Today, the market is rational, and there are not a lot of easy pickings to be had. ?That is the difference between the bust and the boom. ?It is much easier for a fundamental investor to act during the bust.

Thus I would encourage the following:

Pay attention to fees
Pay attention to tax advantages.
The time at which you invest matters ?a great deal: try to invest when opportunities are the greatest (and others are scared stiff)
Ignore the form of investing, but invest with skilled managers (if you can find them, otherwise index funds).

Think of Seth Klarman who hands back money to his clients when markets are not promising. ?Few professionals have the intelligence?to do that. ? Fewer have the ethics and courage to do so.

For my equity clients, I have reduced exposure, and I am close to my maximum cash level of 20%. ?I am watching the market, and am willing to add to my positions, 10%, 20%, and 30% lower. ?I own good companies. ?As has been true in the past, I get close to zero cash as the market bottoms. ?The market is somewhat high now — I think of it as the 80th percentile. ?But it is not at nosebleed levels.

Analyze your investments, and sense the skill of managers, and lack thereof, and the degree of sensitivity to the market as a whole, which is likely higher than you expect.

Then adjust as you see fit. ?Every situation is different, except for the parts that are the same.

All for now.

A Different Look at Neglect

Posted on 1 August 2014 by David Merkel

It’s good to look at stocks that not everyone else is looking at. ?A little neglect can be a good thing.

Companies that are a little illiquid.
Companies with a dedicated shareholder base; they don’t sell at the drop of a hat.
Companies with control investors that don’t give outside passive minority investors the short end of the stick.
Companies that have odd business models that have most investors ignore them
Companies in boring businesses.

Let’s look at this top down, looking at neglect by market sector. ?Days to turn over indicates how rapidly stocks are traded. ?A high number means they trade more slowly.

Sector	Market Cap ($M)	Dollar Volume ($K)	Days to turn over
05 – Consumer Non-Cyclical	1,536,807	7,274,592	211
07 – Financial	3,511,041	16,767,713	209
12 – Utilities	1,051,811	5,348,267	197
06 – Energy	2,425,787	14,781,550	164
02 – Capital Goods	1,253,361	7,882,012	159
08 – Health Care	2,428,969	16,080,916	151
Grand Total	23,817,027	161,861,109	147
01 – Basic Materials	947,830	6,770,631	140
11 – Transportation	594,989	4,279,380	139
03 – Conglomerates	15,805	116,462	136
09 – Services	4,936,835	37,308,869	132
10 – Technology	4,368,575	38,382,921	114
04 – Consumer Cyclical	745,217	6,867,798	109

In general, colder sectors attract more long-term holders. ?Sectors where competitive conditions change more rapidly turn over faster.

An aside before we go on — I excluded from this analysis:

Foreign stocks trading on US exchanges
Over the counter stocks
Stocks with less than $10 million in market cap
Exchange traded products

That left me with around 3900 stocks. ?As an aside, stock turnover seems have to increased, and I wonder if high frequency?trading and ETP creation/liquidation might be driving that. ?147 days for an average holding period means stocks trade their entire market capitalization ?around 2.5x per year. ?Cue up the commentary from Buffett and Munger about how most trading in the stock market is wasted effort.

But now let’s look at industries:

Industry	Market Cap ($M)	Dollar Volume ($K)	Days to turn over
0715 – Insurance (Property & Casualty)	632,449	1,730,968	365
0112 – Fabricated Plastic & Rubber	3,298	10,484	315
1206 – Natural Gas Utilities	435,106	1,407,846	309
0506 – Beverages (Non-Alcoholic)	354,710	1,217,841	291
1103 – Air Courier	139,858	505,601	277
0521 – Personal & Household Products	434,008	1,574,389	276
1209 – Water Utilities	17,103	64,198	266
0724 – Money Center Banks	223,336	877,033	255
0524 – Tobacco	272,385	1,170,334	233
0606 – Oil & Gas – Integrated	438,181	1,900,557	231
0957 – Retail (Grocery)	398,981	1,740,963	229
0712 – Insurance (Miscellaneous)	51,749	227,575	227
0218 – Misc. Capital Goods	417,891	1,859,649	225
0975 – Waste Management Services	59,927	283,562	211
0730 – S&Ls/Savings Banks	1,887	9,013	209
1112 – Railroads	186,397	902,219	207
0809 – Major Drugs	227,419	1,135,147	200
0915 – Communications Services	692,373	3,519,894	197
0503 – Beverages (Alcoholic)	52,692	273,645	193
0727 – Regional Banks	1,227,813	6,422,106	191
1030 – Scientific & Technical Instruments	265,595	1,393,898	191
0706 – Insurance (Accident & Health)	247,622	1,310,785	189
0718 – Investment Services	554,225	2,934,362	189
0418 – Footwear	80,706	428,470	188
0512 – Fish/Livestock	1,917	10,383	185
0703 – Consumer Financial Services	405,697	2,203,610	184
0203 – Aerospace and Defense	402,223	2,254,100	178
0960 – Retail (Home Improvement)	169,283	956,876	177
0127 – Misc. Fabricated Products	77,222	439,594	176
0221 – Mobile Homes & RVs	5,297	31,414	169
0612 – Oil Well Services & Equipment	574,292	3,407,144	169
0106 – Chemicals – Plastics and Rubbers	173,053	1,038,370	167
0954 – Retail (Drugs)	230,495	1,417,370	163
1109 – Misc. Transportation	73,963	456,181	162
0103 – Chemical Manufacturing	353,360	2,227,847	159
0709 – Insurance (Life)	166,263	1,052,261	158
0803 – Biotechnology & Drugs	1,613,675	10,424,895	155
1203 – Electric Utilities	599,603	3,876,223	155
0415 – Auto & Truck Parts	203,596	1,324,773	154
0509 – Crops	4,889	31,874	153
0918 – Hotels & Motels	94,044	616,953	152
0609 – Oil & Gas Operations	1,386,175	9,141,482	152
0209 – Construction – Supplies and Fixtures	140,270	934,529	150
1006 – Computer Hardware	72,374	487,123	149
1036 – Software & Programming	1,152,944	7,816,781	147
Grand Total	23,817,027	161,861,109	147
0921 – Motion Pictures	159,568	1,105,864	144
1024 – Electronic Instruments & Controls	182,569	1,279,912	143
0515 – Food Processing	403,598	2,854,143	141
0909 – Business Services	446,084	3,157,933	141
0812 – Medical Equipment & Supplies	436,733	3,130,033	140
0930 – Printing Services	7,170	51,557	139
0109 – Containters & Packaging	81,869	590,633	139
0933 – Real Estate Operations	594,286	4,295,888	138
0206 – Construction & Agricultural Machinery	137,131	991,809	138
0303 – Conglomerates	15,805	116,462	136
0969 – Schools	21,108	160,274	132
1115 – Trucking	44,104	336,398	131
0939 – Rental & Leasing	238,564	1,828,936	130
0130 – Non-Metallic Mining	4,789	37,031	129
0942 – Restaurants	219,661	1,709,208	129
1118 – Water Transportation	32,241	255,920	126
0406 – Appliances & Tools	55,182	456,389	121
0927 – Printing & Publishing	91,943	760,613	121
0133 – Paper & Paper Products	30,855	256,597	120
0936 – Recreational Activities	75,698	643,463	118
0124 – Metal Mining	98,839	864,894	114
0430 – Recreational Products	54,015	474,019	114
0421 – Furniture & Fixtures	31,741	279,508	114
0948 – Retail (Catalog & Mail Order)	266,904	2,421,091	110
0806 – Healthcare Facilities	151,142	1,390,841	109
0121 – Iron & Steel	76,186	704,432	108
0924 – Personal Services	41,546	386,447	108
0403 – Apparel/Accessories	89,378	848,477	105
1018 – Computer Services	1,023,238	9,989,880	102
1003 – Communications Equipment	837,801	8,227,385	102
0972 – Security Systems & Services	8,892	88,979	100
1021 – Computer Storage Devices	124,136	1,290,696	96
0963 – Retail (Specialty Non-Apparel)	216,223	2,271,386	95
0945 – Retail (Apparel)	160,390	1,696,879	95
0906 – Broadcasting & Cable TV	471,387	5,029,758	94
0433 – Textiles – Non-Apparel	11,455	123,789	93
1033 – Semiconductors	670,980	7,309,563	92
0951 – Retail (Department & Discount)	102,849	1,133,640	91
1012 – Computer Networks	14,378	159,288	90
0903 – Advertising	39,473	442,180	89
0409 – Audio & Video Equipment	11,660	130,676	89
0518 – Office Supplies	12,608	141,981	89
0215 – Construction Services	119,782	1,361,922	88
0912 – Casinos & Gaming	109,703	1,259,520	87
0424 – Jewelry & Silverware	6,527	78,568	83
0603 – Coal	27,139	332,366	82
0118 – Gold & Silver	20,871	256,842	81
0115 – Forestry & Wood Products	27,489	343,907	80
1027 – Office Equipment	4,010	51,064	79
0412 – Auto & Truck Manufacturers	189,092	2,548,454	74
0436 – Tires	8,943	126,838	71
0212 – Construction – Raw Materials	30,768	448,589	69
1106 – Airline	118,426	1,823,061	65
0966 – Retail (Technology)	20,283	329,637	62
0427 – Photography	2,923	47,837	61
1015 – Computer Peripherals	20,549	377,330	54

Again, the pattern is more volatile and controversial industries trade more frequently than the more stable industries. ?One one sense, this is obvious, because the stock market can be used for two purposes — investing and gambling. ?Gambling is much more attractive when prices are volatile, and the prospects for making a big win are significant. (Even if the possibility of big losses is high as well. ?Oh well, profits tend to flow to those ?who eliminate the downside.)

Finally, let’s look at individual stocks, segmented by market capitalization.

Behemoth Stocks

Company	Ticker	Sector	Industry	Days
Berkshire Hathaway Inc.	BRK.A	07 – Financial	0715 – Insurance (Property & Casualty)	6,579
Wal-Mart Stores, Inc.	WMT	09 – Services	0957 – Retail (Grocery)	542
Exxon Mobil Corporation	XOM	06 – Energy	0609 – Oil & Gas Operations	453
Johnson & Johnson	JNJ	08 – Health Care	0803 – Biotechnology & Drugs	427
PepsiCo, Inc.	PEP	05 – Consumer Non-Cyclical	0506 – Beverages (Non-Alcoholic)	365
Procter & Gamble Company, The	PG	05 – Consumer Non-Cyclical	0521 – Personal & Household Products	362
General Electric Company	GE	02 – Capital Goods	0218 – Misc. Capital Goods	353
Wells Fargo & Co	WFC	07 – Financial	0727 – Regional Banks	345
Coca-Cola Company, The	KO	05 – Consumer Non-Cyclical	0506 – Beverages (Non-Alcoholic)	341
Chevron Corporation	CVX	06 – Energy	0606 – Oil & Gas – Integrated	339

Comcast Corporation	CMCSA	09 – Services	0915 – Communications Services	196
QUALCOMM, Inc.	QCOM	10 – Technology	1033 – Semiconductors	193
Citigroup Inc	C	07 – Financial	0727 – Regional Banks	175
Cisco Systems, Inc.	CSCO	10 – Technology	1003 – Communications Equipment	161
Intel Corporation	INTC	10 – Technology	1033 – Semiconductors	146
Bank of America Corp	BAC	07 – Financial	0727 – Regional Banks	138
Gilead Sciences, Inc.	GILD	08 – Health Care	0803 – Biotechnology & Drugs	123
Amazon.com, Inc.	AMZN	09 – Services	0948 – Retail (Catalog & Mail Order)	105
Apple Inc.	AAPL	10 – Technology	1003 – Communications Equipment	93
Facebook Inc	FB	10 – Technology	1018 – Computer Services	50

The table above lists the biggest stocks — the top ten that are less traded, and the top ten that are most traded. ?No surprises, those that are most traded are more controversial than those that are traded less. ?Also, some companies have investors with control positions, which further slows down trading as most control investors rarely trade.

Large Cap Stocks

Company	Ticker	Sector	Industry	Days
Cheniere Energy Partners LP Ho	CQH	12 – Utilities	1206 – Natural Gas Utilities	1,709
CNA Financial Corp	CNA	07 – Financial	0715 – Insurance (Property & Casualty)	1,647
Icahn Enterprises LP	IEP	09 – Services	0963 – Retail (Specialty Non-Apparel)	1,355
Spectra Energy Partners, LP	SEP	12 – Utilities	1206 – Natural Gas Utilities	1,190
Enable Midstream Partners LP	ENBL	06 – Energy	0606 – Oil & Gas – Integrated	1,166
Cheniere Energy Partners LP	CQP	12 – Utilities	1206 – Natural Gas Utilities	1,041
Thomson Reuters Corporation (U	TRI	09 – Services	0927 – Printing & Publishing	1,012
Western Gas Equity Partners LP	WGP	06 – Energy	0609 – Oil & Gas Operations	969
Enterprise Products Partners L	EPD	12 – Utilities	1206 – Natural Gas Utilities	956
Plains GP Holdings LP	PAGP	06 – Energy	0612 – Oil Well Services & Equipment	953

Citrix Systems, Inc.	CTXS	10 – Technology	1036 – Software & Programming	54
United Continental Holdings In	UAL	11 – Transportation	1106 – Airline	53
LinkedIn Corp	LNKD	10 – Technology	1018 – Computer Services	47
Yahoo! Inc.	YHOO	10 – Technology	1018 – Computer Services	47
Whole Foods Market, Inc.	WFM	09 – Services	0957 – Retail (Grocery)	45
Micron Technology, Inc.	MU	10 – Technology	1033 – Semiconductors	39
CBS Corporation	CBS	09 – Services	0906 – Broadcasting & Cable TV	37
Tesla Motors Inc	TSLA	04 – Consumer Cyclical	0412 – Auto & Truck Manufacturers	21
Netflix, Inc.	NFLX	09 – Services	0906 – Broadcasting & Cable TV	19
Twitter Inc	TWTR	10 – Technology	1018 – Computer Services	19

What fascinates me here about the low turnover stocks is the dominance of energy limited partnerships. ?Since they are income vehicles, they don’t trade as much stocks used for speculative gains.

Mid-cap Stocks

Company	Ticker	Sector	Industry	Days
CIM Commercial Trust Corp	CMCT	09 – Services	0939 – Rental & Leasing	9,382
Crown Media Holdings, Inc	CRWN	09 – Services	0906 – Broadcasting & Cable TV	4,333
Clear Channel Outdoor Holdings	CCO	09 – Services	0903 – Advertising	2,258
American National Insurance Co	ANAT	07 – Financial	0715 – Insurance (Property & Casualty)	1,756
Gamco Investors Inc	GBL	07 – Financial	0718 – Investment Services	1,627
Valhi, Inc.	VHI	01 – Basic Materials	0103 – Chemical Manufacturing	1,385
OCI Partners LP	OCIP	01 – Basic Materials	0103 – Chemical Manufacturing	1,205
Summit Midstream Partners LP	SMLP	12 – Utilities	1206 – Natural Gas Utilities	1,199
TFS Financial Corporation	TFSL	07 – Financial	0727 – Regional Banks	1,193
Global Partners LP	GLP	06 – Energy	0609 – Oil & Gas Operations	1,131

FireEye Inc	FEYE	10 – Technology	1036 – Software & Programming	21
AK Steel Holding Corporation	AKS	01 – Basic Materials	0121 – Iron & Steel	21
Ariad Pharmaceuticals, Inc.	ARIA	08 – Health Care	0803 – Biotechnology & Drugs	21
Zillow Inc	Z	09 – Services	0933 – Real Estate Operations	20
Trulia Inc	TRLA	09 – Services	0909 – Business Services	20
Sunedison Inc	SUNE	10 – Technology	1033 – Semiconductors	19
J C Penney Company Inc	JCP	09 – Services	0951 – Retail (Department & Discount)	17
SolarCity Corp	SCTY	10 – Technology	1033 – Semiconductors	17
GT Advanced Technologies Inc	GTAT	10 – Technology	1033 – Semiconductors	15
Yelp Inc	YELP	09 – Services	0927 – Printing & Publishing	12

Again. hot stocks with uncertain returns at the bottom, and stocks with more certain prospects at the top. ? Note the income vehicles in the less traded stocks.

Small Cap Stocks

Company	Ticker	Sector	Industry	Days
PHI Inc.	PHII	06 – Energy	0612 – Oil Well Services & Equipment	13,434
First Mid-Illinois Bancshares,	FMBH	07 – Financial	0727 – Regional Banks	10,674
QAD Inc.	QADB	10 – Technology	1036 – Software & Programming	8,529
Intermountain Community Bancor	IMCB	07 – Financial	0727 – Regional Banks	8,374
Greene County Bancorp	GCBC	07 – Financial	0727 – Regional Banks	7,021
Oconee Federal Financial	OFED	07 – Financial	0727 – Regional Banks	6,143
Bel Fuse, Inc.	BELFA	10 – Technology	1024 – Electronic Instruments & Controls	5,131
PrimeEnergy Corporation	PNRG	06 – Energy	0609 – Oil & Gas Operations	4,303
Community Financial Corp	TCFC	07 – Financial	0727 – Regional Banks	3,608
Transcontinental Realty Invest	TCI	09 – Services	0933 – Real Estate Operations	3,168

PowerSecure International, Inc	POWR	12 – Utilities	1203 – Electric Utilities	20
Penn Virginia Corporation	PVA	06 – Energy	0609 – Oil & Gas Operations	20
Pixelworks, Inc.	PXLW	10 – Technology	1033 – Semiconductors	20
IsoRay, Inc.	ISR	08 – Health Care	0812 – Medical Equipment & Supplies	18
Quantum Fuel Systems Tech Worl	QTWW	04 – Consumer Cyclical	0415 – Auto & Truck Parts	17
Pacific Ethanol Inc	PEIX	01 – Basic Materials	0103 – Chemical Manufacturing	17
Glu Mobile Inc.	GLUU	10 – Technology	1036 – Software & Programming	15
Achillion Pharmaceuticals, Inc	ACHN	08 – Health Care	0809 – Major Drugs	14
Walter Energy, Inc.	WLT	06 – Energy	0603 – Coal	14
Plug Power Inc	PLUG	10 – Technology	1024 – Electronic Instruments & Controls	8

Look at all of the regional banks amid those that turn over less. ?Look at all of the controversial stocks amid ?those that trade frequently.

Microcap Stocks

Company	Ticker	Sector	Industry	Days
Bridgford Foods Corporation	BRID	05 – Consumer Non-Cyclical	0515 – Food Processing	20,286
Magyar Bancorp, Inc.	MGYR	07 – Financial	0727 – Regional Banks	8,948
Bowl America Incorporated	BWL.A	09 – Services	0936 – Recreational Activities	8,599
MSB Financial Corp.	MSBF	07 – Financial	0727 – Regional Banks	5,562
Siebert Financial Corp.	SIEB	07 – Financial	0718 – Investment Services	5,136
Pathfinder Bancorp, Inc.	PBHC	07 – Financial	0727 – Regional Banks	4,764
Jacksonville Bancorp Inc	JXSB	07 – Financial	0727 – Regional Banks	4,567
Oak Valley Bancorp(NDA)	OVLY	07 – Financial	0727 – Regional Banks	4,363
Howard Bancorp Inc	HBMD	07 – Financial	0727 – Regional Banks	4,308
Bay Bancorp Inc	BYBK	07 – Financial	0727 – Regional Banks	4,240

Hyperdynamics Corporation	HDY	06 – Energy	0609 – Oil & Gas Operations	16
InterCloud Systems Inc	ICLD	09 – Services	0909 – Business Services	14
BioFuel Energy Corp.	BIOF	01 – Basic Materials	0103 – Chemical Manufacturing	10
India Globalization Capital, I	IGC	02 – Capital Goods	0215 – Construction Services	8
LiveDeal Inc	LIVE	10 – Technology	1018 – Computer Services	8
Giga-tronics, Incorporated	GIGA	10 – Technology	1024 – Electronic Instruments & Controls	7
Digital Ally, Inc.	DGLY	04 – Consumer Cyclical	0409 – Audio & Video Equipment	5
DARA Biosciences Inc	DARA	08 – Health Care	0803 – Biotechnology & Drugs	4
Spherix Inc	SPEX	09 – Services	0909 – Business Services	4
USEC Inc.	USU	12 – Utilities	1203 – Electric Utilities	3

Look at all of the bitty banks that don’t get traded. ?Perfect for some of my friends who buy and hold such banks, if they can get the trade on. ?And then, look at all of the controversial companies whose stocks trade trade like a spinning top.

I encourage all of my readers to analyze situations where there are fewer eyeballs looking. ?Analyze situations where control investors limit the trading relative to the size of the firm. ?Go where others don’t go, because it is dull. ?Look for advantage where few others do. ?And after that, be willing to hold for a while — years, not months. ?Pay attention as to whether the company has a defensible business model — strong balance sheet, moat versus competition, etc. ?Then look for a reasonable to low price. ?There is the making of a good investment.

Full disclosure: long CVX & BRK/B