Category: Value Investing

A Straw Blowing in the Wind

A Straw Blowing in the Wind

Posted on by David Merkel

I would like to point your eyes to this article:?Cash No Longer King as Stock, Asset Swaps Drive Takeovers. ?This is another sign that equity valuations are getting high. ?When equities are cheap, corporations part with cash to buy other corporations and assets. ?When equities are rich, corporations use them as a currency to buy assets. ?After all, it is a lower risk way to do things, because paying cash raises the leverage of the combined enterprise.

When acquirers are certain they pay cash. ?When they are not so sure, they pay with shares.

As such, this is another indicator that equities are expensive relative to cash. ?That’s all for now.

A Stream of Hot Air

A Stream of Hot Air

Posted on by David Merkel

Let’s roll the promoted stocks scoreboard:

Ticker Date of Article Price @ Article Price @ 6/27/14 Decline Annualized Splits
GTXO 5/27/2008 2.45 0.022 -99.1% -53.9%  
BONZ 10/22/2009 0.35 0.001 -99.8% -72.7%  
BONU 10/22/2009 0.89 0.000 -100.0% -83.4%  
UTOG 3/30/2011 1.55 0.001 -100.0% -90.7%  
OBJE 4/29/2011 116.00 0.083 -99.9% -89.9% 1:40
LSTG 10/5/2011 1.12 0.011 -99.0% -81.6%  
AERN 10/5/2011 0.0770 0.0001 -99.9% -91.3%  
IRYS 3/15/2012 0.261 0.000 -100.0% -100.0% Dead
RCGP 3/22/2012 1.47 0.080 -94.6% -72.4%  
STVF 3/28/2012 3.24 0.430 -86.7% -59.3%  
CRCL 5/1/2012 2.22 0.013 -99.4% -90.7%  
ORYN 5/30/2012 0.93 0.026 -97.2% -82.2%  
BRFH 5/30/2012 1.16 0.620 -46.6% -26.1%  
LUXR 6/12/2012 1.59 0.007 -99.6% -93.3%  
IMSC 7/9/2012 1.5 1.000 -33.3% -18.6%  
DIDG 7/18/2012 0.65 0.047 -92.8% -74.2%  
GRPH 11/30/2012 0.8715 0.077 -91.2% -78.6%  
IMNG 12/4/2012 0.76 0.025 -96.7% -88.8%  
ECAU 1/24/2013 1.42 0.047 -96.7% -90.9%  
DPHS 6/3/2013 0.59 0.008 -98.7% -98.3%  
POLR 6/10/2013 5.75 0.051 -99.1% -98.9%  
NORX 6/11/2013 0.91 0.110 -87.9% -86.8%  
ARTH 7/11/2013 1.24 0.213 -82.8% -84.0%  
NAMG 7/25/2013 0.85 0.087 -89.8% -91.5%  
MDDD 12/9/2013 0.79 0.097 -87.7% -97.8%  
TGRO 12/30/2013 1.2 0.181 -84.9% -97.9%  
VEND 2/4/2014 4.34 2.090 -51.8% -84.5%  
HTPG 3/18/2014 0.72 0.090 -87.5% -99.9%  
6/27/2014 Median -96.7% -87.8%

 

My, but aren’t they predictable. ?Onto tonight’s loser-in-waiting Windstream Technologies [WSTI]. ?This is another company with negative earnings and net worth, though it has a modest amount of revenue.

Think of it for a moment: this company has a “breakthrough technology,” and yet they were a hotel company within the last year or two. ?That’s not how real businesses work. ?I you have an incredible technology, but little capital, private equity investors will happily fund you. ?You won’t try to do it in some underfunded corporate shell which tempts crooked financial writers to write fantasy.

Now, you might look at the disclaimer in the glossy brochure which came to my house, which in 5-point type takes back all of things that they about in bold headlines and readable text. ?For example:

  • It begins with:?DO NOT BASE ANY INVESTMENT DECISION UPON ANY MATERIALS FOUND IN THIS REPORT.
  • The Wall St. Revelator is neither licensed nor qualified to provide financial advice. As such, it relies upon the “publisher’s exclusion” as provided under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws.
  • The Wall Street Revelator and/or its publisher, Andrew & Lynn Carpenter, dba The Wall Street Revelator has received a total amount of twenty five thousand dollars [DM: $25,000] in cash compensation to assist in the writing of this Advertisement, as well as potential future subscription and advertising revenues, the amount of which is not known at this time with respect to the publication of this Advertisement and future publications.
  • Mandarin Media Limited paid nine hundred thousand dollars [DM: $900,000]?to marketing vendors to pay for all the costs of creating and distributing this Advertisement, including printing and postage, in an effort to build investor and market awareness.
  • Mandarin Media Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign.
  • The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign.
  • Non-affiliate shareholders acted as advisors to Mandarin Media Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

The disclaimer exists to cover the writers from legal risk, and what it tells us is that there are largish shareholders looking to profit by running up the stock price as a result ?of the advertisement, enough to cover the $925,000 cost.

Such it is with a pump and dump. ?One thing is virtually certain, though. ?This is not a stock to hold onto. ?Look at the stocks in the table above. ?No winners, and most are almost total losses in the long run. ?Manipulators love working with stocks that have no earnings and no net worth, because they are impossible to value for the grand majority of people. ?New buyers, if they come in a group, can create a frenzy that raises prices.

That’s the goal of the advertising campaign: a short term “pop” that the sponsoring shareholders can sell into, letting a bunch of muppets take losses.

Again, never buy promoted stocks. ?If they have to buy the services of others to promote the stock, it is a fraud. ?Good stocks do not need promotion. ?It’s that simple.

PS — the pretentiousness of the word “revelator” should be replaced by the simpler “revealer.”

What to Do After a Bad Day?

What to Do After a Bad Day?

Posted on by David Merkel

As for my portfolio, June was looking pretty good, then yesterday happened. ?Worst relative performance day in 2 years. ?The US Government announced that it would allow the export of partially refined crude oil, and US refiners got hit. ?Two articles:

Sadly, this hits a concentrated area of my portfolio, which has a concentration in oil refiners. ?That concentration has benefited my clients in the past. ?So what to do now?

Nothing.

I do nothing. ?I find many refiners, particularly those that I own, to be attractive at present levels, and at slightly lower levels, I will start to buy more of the refiners.

I knew this issue was out there, and I think the reaction was overdone, as said Fadel Gheit:

Oppenheimer’s Mr. Gheit said the selloff in refiners’ shares is an overreaction, but added that the news has increased investors’ focus on the sector. “My phone hasn’t stopped ringing today,” he said.

“The market is extrapolating this one step to mean this is a prelude to lifting the oil-export ban,” he added. “It’s a knee-jerk reaction, on a very little bit of information.”

The correct reaction to most sudden market moves is nothing. ?Sit back, and analyze what the opportunity is relative to current prices, and if you conclude that?your opportunities are markedly worse at current prices, sell some. ?If opportunities are better at current prices, buy some.

I suspect I will buy more of the refiners over the next month, and I think I will do well with the position. ?Refiners are less cyclical than they used to be, and their low valuations are unwarranted. ?Also remember, many of these refiners have significant hedging operations; they are not just floating at spot.

So I do nothing at present, and I am not crying, nor compelled to action after a bad relative performance day.

“Smart Beta” and Portfolio Rule Seven

“Smart Beta” and Portfolio Rule Seven

Posted on by David Merkel

I’m not an advocate for smart beta. ?There are several reasons for that:

  • I don’t pay attention to beta in the stocks that I buy; it is not stable.
  • The ability to choose the right brand of enhanced indexing in the short-run is difficult to easily achieve.
  • I’m a value investor, a bottom-up stock picker that doesn’t care much about what the index does in the short-run. ?I aim for safety, and cheapness.

But today I read an interesting piece called?Slugging It Out in the Equity Arena. ?It talks about an issue I have been writing about for a long time — the difference between what a buy-and-hold investor receives and what the average investor receives. ?The average investor chases performance, and loses 2%+ per year in total returns as a result. ?As the market relative to the index is a zero-sum game, who wins then?

The authors argue smart beta wins. They say:

To us, the smart beta moniker refers to rules-based investment strategies that use non-price-related weighting methods to construct and maintain a portfolio of stocks.1?The research literature shows that smart beta strategies earn long-term returns around 2% higher than market capitalization-weighted indices. Moreover, smart beta strategies do not require any insight into the weighting mechanism. One can build a smart beta strategy with any stock ranking methodology that is not related to prices, from a strategy as na?ve and transaction-intensive as equal weighting to a more efficient approach such as weighting on the basis of fundamental economic scale. For example, a low volatility portfolio and its inverse, a high volatility portfolio, both outperform the market by roughly 2%?as long as they are systematically rebalanced.2??It is not the weighting method but the rebalancing operation that creates most of smart beta?s excess return. Acting in a countercyclical or contrarian fashion, smart beta strategies buy stocks that have fallen in price and sell stocks that have risen.

When I read that, I said to myself, “That is a more intense version of my portfolio rule seven:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

I learned this rule from three good managers — one growth, one core, one value. ?They were all fairly rigorous in their quantitative analyses, but they all agreed, a 20% filter on target weight added ~2%/year to performance on average. ?But unlike the current “smart beta” discussion, I have been using this idea for the last 15-20 years.

The mostly equal-weighting also induces a smallcap and value tilt, which is an additional aid to performance. ?Since I concentrate by industry, the 30-40 stocks?requirement does not lead to over-diversification, as a great deal of my returns comes from choosing the right industries.

In one sense, portfolio rule seven is an acknowledgement of mental limitations, and is an exercise in humility. ?So things have been great? ?They will eventually not be so. ?As prices go up, so does fundamental risk. ?Take a little off the table. ?Raise a bit of cash.

Things have been bad? ?Look at the fundamentals. ?How badly have they deteriorated? This can take three paths:

a) Fundamentals?have deteriorated badly, or I made an initial error in judgment. ?I would not own it now, even at the current price there are much better stocks to be owned. ?Sell the position.

b) Fundamentals are the same, a little better, or haven’t deteriorated much. ?Rebalance to target weight.

c) Fundamentals are better and people are just running scared from a class of companies — not only rebalance, but make it a double-weight. ?I only do this in crises, for high-quality misunderstood companies like RGA and NWLI in the last financial crisis. ?Some of that is my insurance knowledge, but I have done it with companies in other industries.

For fundamental investors, who think like businessmen, there is value in resisting trends. ?Having an orderly way to do it is wise. ?Don’t slavishly follow me, but ask whether this fits your management style. ?This fits me, and my full set of rules. ?Modify it as you need, it is not as if there is one optimal answer.

I’ll close with an excerpt from the first article that I cited, which was its summary:

KEY POINTS
1.?????Smart beta strategies are countercyclical, periodically rebalancing out of winning stocks and into losers. They may underperform for extended periods but they ultimately tend to prevail.
2.?????Investors? procyclical behavior, selling recent losers and buying recent winners, pays for the estimated 2% per year in long-term value added by smart beta strategies.
3.?????Smart beta investing can be reasonably expected to have an edge as long as investors persist in following trends and chasing performance.

Are you willing to take the long-term view, meaning more than 3 years? ?These ideas will work. ?Focus on longer-term value, and do your analytical work. ?And if you outsource your investing, be willing to allocate more to stocks during bad times. ?To avoid really ugly scenarios, wait until the 200-day moving average has broken to the upside, of look at the 13Fs of value managers.

Do that and prosper. ?Resisting trends intelligently can make money.

The Tails of the Distribution do not Validate the Mean

The Tails of the Distribution do not Validate the Mean

Posted on by David Merkel

17 months ago I wrote a post?How to Become Super-Rich?? Now, many of my articles are timeless — they will still have value 10 years from now. ? I like to write for the long-run. ?Teaching basic principles is what this blog is about.

The surprise for me is that article is the most?popular one at my blog. ?That says something about the desires of mankind. ?Now, if you do want a chance to become super-rich, you create your own company, and focus your efforts on it exclusively. ?Diversification is not ?a goal here. ?We are swinging for the fences here.

But just as in baseball the guys who swing for the fences to hit home runs, they also tend to strike out the most. ?The same is true of businessmen. ?Many start companies, put their all into it, and end up broke. ?Many end up with marginal businesses that give them a living, but not much more. ?A few prosper and become moderately wealthy. ? A tiny amount of them create a hugely profitable company that makes them super-rich.

Anyway, after I was cold-called by Militello Capital, I reviewed articles on the blog, including one called?CRACK THE WEALTH CODE. ?I’ll quote the most relevant portion of the post:

According to?Get Rich, Stay Rich, Pass It On: The Wealth-Accumulation Secrets of America?s Richest Families?by Catherine McBreen and George Walper Jr, ?Building up a nest egg with the equity in your home is a fine thing. But what distinguishes the model for getting rich, staying rich and passing it on is its emphasis on investing in current and future income-producing real estate?. Andrew Carnegie, the wealthiest man in America during the early 20th century, said that ?90 percent of all millionaires become so through owning real estate.? If that?s not enough to peak your interest, consider this: ?The major fortunes in America have been made in land?, coined by John D. Rockefeller. What does he know?..his net worth in today?s dollars is?onlyaround $300 billion. Invest in areas you know. Real estate gives you the opportunity to visit and connect with your investment. When?s the last time you connected with your mutual fund?

Don?t forget about the second part of the winning combo: private companies. Open your eyes to entrepreneurial opportunities. McBreen and Walper advise that at least one-quarter of your investment dollars should be in enterprises that develop products and services or invent breakthrough technologies. In?10 things billionaires won?t tell you, number seven?s title, ?We didn?t get rich investing in stocks?, hits the nail on the head. Billionaires like Steve Jobs, Bill Gates, and Mark Zuckerberg made their fortunes in start-ups, says Robert Klein, founder and president of Retirement Income Center, a retirement and income planning firm in Newport Beach, California. The article confirms that ?you?re far more likely to become a billionaire in Silicon Valley than on Wall Street.?

In one sense, I agree with what they say. ?If you want to become super-rich, pursue one goal with your one company. ?Less than 1% will succeed. ?Maybe 5-10% will attain to being multi-millionaires. ?Most will muddle or fail.

Running your own business, including real estate investing, is not a magic ticket to riches. ?A lot depends on:

  • Solving problems people didn’t know they had.
  • The time period that you invest during — were financial conditions favorable for speculation?
  • The ability to manage a large enterprise is an uncommon skill.
  • The ability to be an entrepreneur is also not common. ?Most people don’t want to take that much risk.
  • Discipline, hard effort, taking time away from family and friends.

There is a cost to trying to be super-rich, and most people die at that altar of greed. ?I suspect that most that succeed, did not aim to be super-rich, but pursued that task because they found it interesting. ?They were idealists who happened to be in business, and their ideals matched up with what would enable society to pursue its goals more effectively.

So does it make sense for average people to invest in private equity funds or private real estate funds because the wealthy ran their own companies and invested in commercial real estate?

No. ?First, remember that the super-wealthy were swinging for the fences. ?They were the rare success stories.

Second, note that those who invest in?private equity funds or private real estate funds are diversifying. ?As such, they are seeking more certainty, and will not gain an abnormally large return.

Third, recognize the data bias. ?Those who succeed with?private equity funds or private real estate funds, their data exists, while those who fail disappear.

There is no advantage to being public or private as a business. ?Private businesses can keep things secret, but public businesses have a lower cost of capital.

Conclusion

Just because the wealthy got that way by making big bets that most people lose, does not mean that average people should do that. ?Alternative investments like?private equity funds or private real estate funds are not an automatic road to wealth, and are less transparent than their liquid alternatives on the stock exchanges.

Average people should avoid low probability bets — they tend to impoverish, with high probability.

PS — that said, I like commercial real estate as a diversifier, but it won’t make you rich.

Avoid Illiquidity

Avoid Illiquidity

Posted on by David Merkel

There are several reasons to avoid illiquidity in investing, and some reasons to embrace it. ? Let me go through both:

Embrace Illiquidity

  • You are offered a lot of extra yield for taking on a bond that you can’t easily sell, and where you are convinced that the creditor is impeccable, and there are no sneaky options that you have implicitly sold embedded in the bond to take value away from you.
  • An unusual opportunity arises to invest in a private company that looks a lot better than equivalent public companies and is trading at a bargain valuation with a sound management team.
  • You want income that will last for your lifetime, and so you take some of the money you would otherwise allocate to bonds, and buy a life annuity, giving you some protection against longevity. ?(Warning: inflation and credit risks.)
  • In the past, you bought a Variable Annuity with some good-looking?guarantees. ?The company approaches you to buy out your annuity at a 10-20% premium, or a 20-30% premium if you roll the money into a new variable annuity with guarantees that don’t seem to offer much. ?Either way, turn the insurance company down, and hold onto the existing variable annuity.
  • In all of these situations, you have to treat the money as money lost to present uses. ?If there is any significant probability that you might need the money over the term of the asset, don’t buy the illiquid asset.

Avoid Illiquidity

  • Often the premium yield on an illiquid bond is too low, or the provisions take value away with some level of probability that is easy to underestimate. ?Wall Street does this with structured notes.
  • Why am I the lucky one? ?If you are invited to invest in a private company, be skeptical. ?Do extra due diligence, because unless you bring something more than money to the table (skills, contacts), the odds increase that they are after you for your money.
  • Often the illiquid asset is more risky?than one would suppose. ? I am reminded of the times I was?approached to buy illiquid assets as the lead researcher for a broker-dealer that I served.
  • Then again, those that owned that broker-dealer put all their assets on the line, and ended up losing it all. ?They weren’t young guys with a lot of time to bounce back from the loss. ?They saw the opportunity of a lifetime, and rolled the bones. ?They lost.
  • We tend to underestimate how much we might need liquidity in the future. ?In the mid-2000s people encumbered?their future liquidity by buying houses at inflated prices, and using a lot of debt. ?When everything has to go right, the odds rise that everything will not go right.
  • And yet, there are?two more?more reason to avoid illiquidity — commissions, and inability to know what is going on.

Commissions

Illiquid assets offer the purveyor of the assets the ability to pay a significant commission to their salesmen in order to move the product. ? And by “illiquid” here, I include all financial instruments that carry a surrender charge. ?Do you want to know how much the agent made selling you an insurance product? ?On single-premium products, it is usually very close to the difference between the premium you paid, and the cash surrender value the next day.

Financial companies build their margins into their products, and shave off a portion of them to pay salesmen. ?This not only applies to insurance products, but also mutual funds with loads, private REITs, etc. ?There are many?brokers masquerading as financial advisers, who do not have to?act strictly in the best interests of the client. ?The ability to receive a commission makes them less than neutral in advising, because they can make a lot of money selling commissioned products. ?In general, it is good to avoid buying from commissioned salesmen. ?Rather, do the research, and if you need such a product, try to buy it directly.

Not Knowing What Is Going On

There are some that try to turn a bug into a feature — in this case, some argue that the illiquid asset has no volatility, while its liquid equivalents are more volatile. ?Private REITs are an example here: the asset gets reported at the same price period after period, giving an illusion of stability. ?Public REITs bounce around, but they can be tapped for liquidity easily… brokerage commissions are low. ?Some private REITs take losses and they come as a negative surprise as you find ?large part of your capital missing, and your income reduced.

What I Prefer

In general, I favor liquid investments unless there is a compelling reason to go illiquid. ?I have two private equity investments, both of which are doing very well, but most of my net worth is tied up in my equity investing, which has done well. ?I like the ability to make changes as time goes along; there is value to being able to look forward, and adjust.

No one knows the future, but having some slack capital available to invest, like Buffett with his “elephant gun,” allows for intelligent investing when liquidity is scarce, and yet you have some. ?Many wealthy people run a liquidity “barbell.” ?They have a concentrated interest in one company, and balance that out by holding very safe cash equivalents.

So, in closing, avoid illiquidity, unless you don’t need the money, and the reward is very, very high for making that fixed commitment.

A Brief Note on Dividend-Paying Common Stocks

A Brief Note on Dividend-Paying Common Stocks

Posted on by David Merkel

The equity strategy that I have run for the last 13+years always has a slightly higher yield than the S&P 500. ?But I never look for dividends. ?It’s not a factor in my process. ?That said, looking for businesses that produce free cash flow, and voila, the dividends appear.

At present, with interest rates so low, many people look at dividend paying common stocks as a means of obtaining income. ?They also add REITs, MLPs, BDCs, and an assortment of other things that trade like stocks and have yield. ?I don’t think this is a safe way to get yield, at least not now. ?Here’s why:

1) Think of the 1970s, when I was a teenager. ?Not only were interest rates higher, and?inflation eating away at purchasing power, but when companies got into trouble, they would cut their dividends, and often severely. ?During that era, you had to make sure that the company was actually earning the dividend, or were they borrowing to pay it.

2) There have been many flameouts in REITs, especially mortgage REITs. ?I remember buying broken mortgage REITs in the mid-90s at less than half of their net worth after they had bought exotic CMO pieces, trying to create funds where the value rose as interest rates moved higher. ?They got crushed in the early-90s by Greenspan’s hyper-easy monetary policy. ?In 1994, as rates were rising, they rallied significantly.

Mortgage REITs also got crushed in 2008-9. ?But Equity REITs have their times of trouble as well — they tend to be bull market babies. ?When commercial real estate is doing well, they do extra well. ?When it goes badly, extra badly for the REITs because of all the leverage.

3) I mentioned 1994. ?In 1994, as rates rose, dividend paying stocks underperformed. ?The value manager that Provident Mutual used at that time was an absolute yield manager. ?In other words, that manager only bought stocks that had a yield higher than a fixed threshold. ?At that point, the threshold was 4% or so. ?From 1982 to 1993, as interest rates fell, this manager was golden, but it was an artifact of the era. ?In 1994, the?performance was abysmal. ?The manager?was replaced the next year.

High yielding stocks paying out a large portion of their earnings as dividends tend to have their dividends grow slowly, because there is little left over to reinvest into new business. ?It is akin to owning a bond disguised as a stock. ?Lower-yielding stocks often grow their dividends more rapidly, as they reinvest more free cash into new business. ?With Equity REITs, the latter strategy has generally been more successful. ?Better to buy the lower yielding REITs that grow their dividends faster.

4) The REITs, MLPs, and BDCs that pay out a a high proportion of their taxable income are weak vehicles because they are forced to pay out so much. ?During crises, that really bites them.

(This wasn’t as short as I thought it would be. ?Oh well.)

Conclusion

If interest rates rise, and I do mean if, because the economy is weak, be ready to see these modern income vehicles take a hit. ?If we have a severe recession, be aware that dividends do get cut. ?Do not rely on stocks for income. ?Bonds are designed for income and return of principal. ?Stocks are designed for gains or losses depending upon the underlying business performance. ?They aren’t income vehicles, but performance vehicles.

The Value That Investment Advisers Deliver

The Value That Investment Advisers Deliver

Posted on by David Merkel

I got cold-called this last week while I was away on business. ?I googled the phone number, and found that it came from Melitello Capital. ?I went through their site, and read most of their articles.

It’s an interesting firm, though I have no interest in working with them. ?The article I would like to comment on tonight is “HOW DOES AN RIA JUSTIFY ITS 1% FEE?”

I will explain why a 1% fee?can be justified. ?Now, I am an old school RIA [Registered Investment Adviser]. ?I only manage assets. ?I don’t allocate across asset classes. ?I don’t manage taxes in entire (though I help). ?I don’t structure the means to escape estate taxes. I don’t set up insurance schemes to minimize taxes; I could do it, but it would be boring. ?I could make a lot more money than I do, but I make enough, and I really like the challenge of outperforming the market.

RIAs offer value to clients in a large number of ways:

  1. Reducing income taxes
  2. Holding the hands of clients during the manic and panic periods of the market. ?Discourage them from taking more risk when the market is hot, and encourage them to take more risk, or at least, don’t leave when the market is panicking.
  3. Hedging risks, whether it is a collar on a large single stock position, or a macro hedge.
  4. Aiding in covering insurance needs.
  5. Setting up financial plans.
  6. Structuring estates, such that everything goes where the client wants, and estate taxes are minimized.
  7. Asset allocation, including regular rebalancing.
  8. And more… free advice on other issues, entertainment, bragging rights, etc.
  9. Putting everything together in one neat package.
  10. Oh, and in a few cases, alpha. ?(that’s my game)

Now, is that worth 1% on assets? ?Point 2 alone is worth more than 1%, so yes. ?Those who have read me for years know that people get greedy and panic. ?If you can avoid that, you are doing well, very well.

Look, it’s easy to trash talk your competition. ?Some registered investment advisers are worth their ~1% fee, and some not. ?It depends on the package of services that they deliver — alpha, taxes, insurance, legal help, asset allocation (tsst… be wary of the efficient frontier. ?It does not exist.).

In general, if the investment advisers themselves do not give in to panic and greed, they are worth a 1%/year fee. ?So seek out advisers that do not give in to market pressure.

Note: this is unpopular, because that means hanging onto advisers that underperform during hot markets. ?In the long run you will do better following advice like this– after all, they dissed Buffett in 1999, and my Mom told me I was a fuddy-duddy. ?(Note: when a parent tells you that you are behind the times, it stings. ?It does not mean that you are wrong.)

I am not telling you to invest with me; that is not what my blog is about. ?I am saying that there is value in separate accounts with RIAs. ?And, be choosy. ?Lower fees are better, subject to the same levels of competence.

Post 2500: What is the Aleph Blog About?

Post 2500: What is the Aleph Blog About?

Posted on by David Merkel

Every hundred or so posts, I take a step back, and try to think about broader issues about blogging about finance. ?Tonight, I want to explain to new readers what the Aleph Blog is about.

There have been many new followers added to my blog recently, ?through e-mail, RSS, and natively. ?This is because of this great article at Marketwatch, which builds off of this great article at Michael Kitces’ blog.

I am humbled to be included among Barry Ritholtz, Josh Brown, and Cullen Roche, and am genuinely surprised to be at number 4 among RIAs in social media influence. ?Soli Deo Gloria.

What Does the Aleph Blog Care About?

I’m writing this primarily for new readers, because I’ve written a lot, and over a lot of areas. ?I write about a broader range of topics than almost all finance bloggers do because:

  • I’m both a quantitative analyst and a qualitative analyst.
  • I’m an economist that is skeptical about the current received wisdom.
  • I like reading books, so I write a lot of book reviews.
  • I’m also a skeptic regarding Modern Portfolio Theory, and would like to see it discarded from the CFA and SOA syllabuses.
  • I believe in value investing, in both the quantitative and qualitative varieties.
  • I believe that risk control is a core concept for making money — you make more money by not losing it.
  • I believe that good government policy focuses on ethics, not results. ?The bailouts were not fair to average Americans. ?What would have been fair would have been to let the bank/financial holding companies fail, while protecting the interests of depositors. ?The taxpayers would have been spared, and there would have been no systematic crisis had that been done.
  • I care about people not getting cheated. ?That includes penny stocks, structured notes, private REITs, and many other financial innovations. ?No one on Wall Street wants to do you a favor, so do your own research and buy what you want to own, not what someone wants to sell you.
  • Again, I don’t want to see people cheated, so I write about ?insurance. ?As a former actuary, and insurance buy-side analyst, I know a lot about insurance. ?I don’t know this for sure, but I think this is the blog that writes the most about insurance on the web for free. ?I write as one that invests in insurance stocks, and generally, I buy the stocks because I like the management teams. ?Ethical, hard working insurance management teams do the best.
  • Oddly, this is regarded to be a good accounting blog, because as a user of accounting statements, I write about accounting issues.
  • I am a skeptic on monetary and fiscal policy, and believe both of them tend to sacrifice the future to benefit the present. ?Our grandchildren will hate us. ? That brings up another issue: I write about the effects of demographics on the markets. ?In a world where populations are shrinking in developed nations, and will be shrinking globally by 2040, there are significant economic impacts. ?Economies don’t do well when workers are shrinking in proportion to those who are not working. ?(Note: include stay-at-home moms and dads in those who work. ?They are valuable.)
  • I care about the bond market. ?There aren’t that many good bond market blogs. ?I won’t write about it every day, but I will write about i when it is important.
  • I care about pensions. ?Most of the financial media knows things are screwed up there, but they do not grasp how bad the eventual outcome will likely be. ?This is scary stuff — choose the state you live in with care.

Now, if you want my most basic advice, visit my personal finance category.

If you want my view of what my best articles have been, visit my best articles category.

If you want to read about my “rules,” read the rules category.

Maybe you want to read some of my most popular series:

My blog is not for everyone. ?I write about what I feel most strongly about each evening. ?Since I have a wide array of interests, that makes for uneven reading, because not everyone cares about all the things that I do. ?If that makes my readership smaller, so be it. ?My blog expresses my point of view; it is not meant to be the largest website on finance. ?I want to be special, even if that means small, expressing my point ?of view to those who will listen.

I thank all of my readers for reading me. ?I appreciate all of you, and thank you for taking the time to read me.

As one final comment, I need to say this. ?I note people unfollowing my blog at certain times, and I say to myself, “Oh, I haven’t been writing about his pet issue for a while.” ?Lo, and behold, after these people leave, I start writing about it again. ?That is not intentional, but it is very similar to how the market works. ? People buy and sell investments at the wrong times.

To all my readers, thank you for reading me. ?I value all of you, and though I can’t answer all e-mails, I read all e-mails.

In summary: the Aleph Blog is about ethics and competence. ?I want to do what is right, and do what gives the best investment performance, in that order.

 

On Value Traps

On Value Traps

Posted on by David Merkel

One thing that floors me regarding my readers, is who reads me. ?I have many professional readers who read me regularly, and I thank you for doing so. ?Tonight’s piece stems from an e-mail from one of my professional readers:

Hi David,

Big compliments for your blog, it?s probably the best on the net and one of the very few I am reading these days. I really like your overall approach to investing and I am using some of your methods myself with success in my ZZZ?Fund (ZZZ on Bloomberg) like having an even-weighted portfolio of 30-40 stocks with regular rebalancing or focusing on the strongest players in weak industries (southern European banks anyone?).

Now my question for you that might interest all reader is how you handle potential value traps like Staples that spring on you in slow motion. I think you had that one in your portfolio some time ago, but the specific case doesn?t matter that much. For full disclosure, I am holding Staples in my fund at the moment.

The typical pattern is something like this: You find a stock that has some growth issues, but is attractively valued with a 10% FCF/EV yield, which implies no growth or a slow decline forever. Then there?s a profit warning, the profit or FCF estimate goes down by 10%, but the stock price drops even more by 15% or so. And again and again? or not. It?s especially tricky in cases like Staples where it is not so obvious that their business model is becoming obsolete compared to, for example, Nokia or Blackberry/RIM a few years ago.

In my experience, that?s one of the situations where I tend to lose the most money. How do you handle them? Sell at the first profit warning, reasoning that the investment case got fundamentally altered even though the stock dropped even more? Or keep it and wait for a confirmation of the negative trend? For how long?

Out of experience, I probably should sell Staples asap and have another look in year or so. But the value guy in me can?t sell much hated stocks with high FCF yields and some potential for a fundamental turnaround.

I used to own Staples, but I think their lunch is getting eaten by Amazon. ?I sold somewhere in the $16s. ?Retailers are tough, in my opinion. ?They are so cyclical and faddish.

There are many reasons that a stock can be a value trap. ?Let me try to list them:

  • The accounting is liberal, with revenue recognition policies that let more revenue accrue than will be realized. ?Or, the assets aren’t worth as much as the book value posits. ?This is particularly common with financials.
  • Many value traps are lower quality companies. ?They may seem cheap, but there is a lot of debt, and will they earn enough to refinance the debt?
  • Some companies waste their free cash flow buying back stock, or acquiring companies that do not add to value. ?When valuations are high, issue special dividends rather than buying back stock. ?Your?shareholders have better opportunities for the money.
  • They are up against stronger competition. ?Try to understand the industry as a whole, and see whether the?company’s?profits are likely to come under pressure.
  • The high dividend has attracted a lot of yield investors who push the price up, but the yield is not sustainable.
  • And there are likely more reasons…

I’ve lost significant money in a few stocks in my life, but only once in the last 10 years. ?It was a highly levered mortgage REIT that did it “the right way” as I saw it, and was opportunistic with debt assets. ?I lost 90%+ of my money on that one, one of my worst losses ever. ?Had I paid greater attention to the amount of leverage, particularly heading into the crisis in 2008, I would not have lost so much.

As a friend of mine once said, “There are lousy companies, but to really see the price fall, it has to have significant debt.” ?I tend to buy higher quality companies. ?That’s not a panacea, but it tends to prevent large losses. ?Avoid overly indebted companies relative to the??industry.

Analyze the accounting. ?How much of income is coming from accruals? ?How often do they deliver negative earnings surprises? ?How is cash flow from operations versus earnings? ?Is book value growing a lot more slowly than earnings less dividends would indicate?

Is this a stock held by those sucking on dividends? ?Is the dividend sustainable? ?Think of the ’70s where dividend-paying stocks got whacked when they reduced their dividends.

Analyze the competition. ?It is rarely a good idea to buy the stock of a weak company in a competitive industry, regardless of the valuation. ? Better to buy the more expensive competitor.

Finally, stock buybacks and acquisitions are not always good. ?Many stocks, like IBM, tread water because of the buyback. ?The stock price is too high, and remains too high because of the buyback. ?There is no good solution to this for IBM management, aside from new avenues of profitable organic growth, and those solutions are rare. ?Thus I avoid IBM.

My methods aren’t perfect, but they are pretty good. ?I stumbled into a lot more value traps when I was younger, but not so much anymore. ?Live and learn.

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