Value Investing – Page 27

On Amazon

Posted on 26 October 2013 by David Merkel

Many people are amazed at the valuation of Amazon.com.? How can a company receive such a high valuation when it earns so little money?? And how can it grow so fast?

The second question is easier.? They are reinvesting their free cash flow, which is different than profits. You can only reinvest excess (free) cash. Profits do not measure what you can reinvest, because profits do not represent change in unencumbered cash received.

In the past Amazon grew off of its free cash flows.? In the last year, they needed to borrow $3.2 billion.? Truth, AMZN’s balance sheet is not all that strong — a lot depends on the value of their intangibles. Their brand is so strong, the intangibles have value. The question is how much.

We could figure out the value of the intangibles if Amazon raised its prices a touch, and saw how much free cash flow increased, and market share decreased.

One person asked me whether Amazon becoming subject to state sales taxes would be a good test of the franchise, even though Amazon receives none of the proceeds.? I replied,

?That could be a good test. Not sure $AMZN will share that data with us, but that would be a good thing to analyze. Doesn’t matter that the money doesn’t go to Amazon — it will show how sensitive demand is to price changes. Then Amazon could get an idea of what an additional price change would do for them.

But maybe it is Amazon’s strategy to chase out all competitors now, and wait for the payoff day to come. That said, especially on the internet, competitive advantages are hard to sustain. People adjust rapidly to changing incentives.?

That brings me back to the first question: How does Amazon get such a high valuation?? Think back to the cable company stocks, which plowed all of their debt and free cash flow into growth.? They had little if any taxable income.? They acted like private equity companies, but were publicly traded.? That is how Amazon is acting now, and so people are valuing it on the hope that when is gets to maturity, it will be an actual near-monopoly, having a lot of power to raise margins with impunity.

I should mention that this is a dangerous strategy, particularly with an internet company, because the costs of switching are low for customers.? Can Amazon make itself so irreplaceable that a future Amazon will have little difficulty passing through price increases?

As for current Free Cash Flow, Amazon does not help — they do not split out maintenance capital expense.? (Hey, let FASB justify its existence and require that maintenance capital expenditure be a separate line item.)

But imagine for a moment that Amazon’s operating cash flow is the free cash flow.? No maintenance capital expenditure.? Should Amazon trade at a 30+ multiple of free cash flow?

No.? And that is a biased measure, because maintenance capex is not considered.? I expect there to be a correction in he stock price of Amazon, unless it moves to increase its gross margins.? If it can’t do it, it will not prosper.? Good company management aims for free cash flow.? It does not aim for big returns far in the future.? The future is far more variable than most believe, so intelligent businessmen give light weight to the far future, because their view of what might happen is unlikely.

Traveling with David

Posted on 25 October 2013 by David Merkel

Sometimes I over-commit my time.? That’s been the last few days.? Recently I went to visit a friend who had lost his job at a large company, to look over his severance papers, and advise him.? He is older, a “minority,” and only been with the firm 5-6 years.

Severance agreements have gotten a lot tighter since the two that I have personally experienced.? Corporations dangle some compensation to eliminate possible future legal costs.? I pointed out to my friend the most likely reasons he might sue, but added two things:

The company has a large number of sharp lawyers, so you had better have an open-and-shut case.
We’re Christians, so we don’t go to court over small matters.

But what impressed me in reading the agreement was how airtight it was — can’t sue over Federal, State, Local, or common law offenses, or anything else.? Which made me think about another thing… the connection between entrance and exit doors.

In investing, people are more wiling to invest if they can have their money back at any time.? With employment, it is the same — employers are more willing to employ if they can fire people for any reason.

Every protection for those employed makes it harder for those without work to be employed.? This also forces jobs to go underground — if advertising them publicly subjects them to regulation, then the good jobs will be filled via “word-of-mouth.”

This takes me back to the early days of the Reagan Administration.? They deregulated a lot of things, and the economy grew far more rapidly.? We could do the same now, starting with labor and healthcare.

My friend may do fine, but the things that “protected” him at his last job now hinder him in seeking another job.? Better to eliminate the protections, and let people compete based on skill and assiduousness.

Part Two

Then I was a judge in a financial analysis competition at a local college.? The analysis involved a stock that faced a large investment decision, larger than the current enterprise value of the junk-rated company.? Should the hedge fund buy, sell short, or do nothing with the stock?? The simple part of the case study was working through the intricacies of the discounted cash flow model, together with changes to the assumptions about cash flows and the weighted average cost of capital.

What I found interesting was the lack of attention to:

Details of the case study — did you even read it?
Common sense — we are sorry, but a stock can’t lose 113%.? Perhaps you would like to tell us to short the bonds?
Limitations of complex techniques in finance.? Yes, there’s many nifty formulas available to you, but do you understand what they really mean, and what limitations they imply?? When are they not valid?
What markets can and can’t do.? No, you can’t do an public issuance of junk debt at the level of current debt.? You can’t do an issuance longer than ten years.? You can’t do one that is really big without changing market pricing (and the answers from the case study had this wrong as well).? Same applies to large secondary IPOs for equity.

Now, I know these are students.? They can’t know what an experienced market professional does.? To their credit, they dug up many bits of useful data that the case study did not contemplate.? But the case study itself should have noted these things, and to that degree I fault Darden for writing up a subpar case study.

The main thing I would say again to the students is to ignore the academic models with their false certainty, and try to understand the qualitative aspects of the business, out of which the quantitative modeling will grow.

When we were done, each of the judges gave comments to the students.? I started off with, “Sorry for being such a hard-nose.”? I got a decent laugh from the students, and then explained to them what I have said to you.

Part Three

That evening I went to a talk by CareFirst on the PPACA/Obamacare.? It was a genuinely useful 20-minute presentation, with one annoying thing: all of the pictures in the slide deck were of healthy smiling people.? If you are healthy, you will pay more, unless you are really poor.? A realistic presentation would have had people that are stoic, sad, or crying, if they are healthy and not poor.

The best part of what CareFirst gave me was premium rates for PPACA.? The lowest level plan would increase my premiums by 50%, and would increase the areas in which I would have to pay.? More expensive in every way.

It is only an affordable care act to those who were previously uninsurable; to those who were insurable it is a tax on your health and income.? In 2016, we will rip it out by its roots, and have people pay for healthcare directly, with no tax deduction for employer-provided healthcare.? That will reduce healthcare spending, and shrink healthcare to a more reasonable part of the economy.

If you want healthcare to be affordable, get the government out of it in entire.

Part Four

Dr. Kathryn Crecelius spoke to the Baltimore CFA Society on Thursday.? She is the Chief Investment Officer of my alma mater, The Johns Hopkins University.? She talked to us about endowment investing.? Very common sense stuff, very well said, and much like you would hear from me.? I found myself nodding through the whole talk.? It was all very much like my last piece on endowment investing.? I learned a lot, which makes me happy, because I always like to learn.

My travels are done for a while.? I like that too, because being home is a happy place.

Classic: The Fundamentals of Market Tops

Posted on 21 October 2013 by David Merkel

All of my articles from RealMoney have been irreparably lost because of a change in file systems.? Anything written prior to 2008 is gone.? That may not matter for most writers at RealMoney, but I tended to write things of more permanent validity.

So it is with gratitude to Barry Ritholtz that I republish a popular piece of mine that ran on January 13th, 2004.? Barry Ritholtz republished it in 2006, and captured most of it, except for one thing — at the end I said that the rally would go on, which it did.

Anyway, here is Barry’s copy of my piece, without adjustment:

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David Merkel wrote this a year ago; it?s a brilliant set of observations of what market tops look like.

David starts by noting he is “basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out.”? He adds that his methods “are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance.”

Item 1: The Investor Base Becomes Momentum-Driven

Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

You?ll know a market top is probably coming when:

a) The shorts already have been killed. You don?t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

c) Valuation-sensitive investors who aren?t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn?t get tech,” he did not mean that he didn?t understand technology; he just couldn?t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.

d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.

e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.

f) Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.

g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Item 2: Corporate Behavior

Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.

Here are ways that corporate behaviors change near a market top:

a)? The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.

b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.

c)? Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.

d)? There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.

e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can?t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.

f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.

g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

These two factors are more macro than the investor base or corporate behavior but are just as important.? Near a top, the following tends to happen:

1. Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.

2. The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed?s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.

On Liabilities in Asset Allocation

Posted on 17 October 2013 by David Merkel

From an e-mail from one of my readers:

I?m not sure if you have the time to respond to this, but figured I?d send to you and just see!…

(Just FYI, I?m not an investment professional of any sort, so I don?t have any ?skin in the game? as they say, just a geek who follows the markets and DIY financial-planning issues and long-time reader of the Aleph blog)

I recently read an FP article by a guy I?ve read a lot (Alan Roth).? He suggested that, when your analyzing an investment portfolio and making asset-allocation decisions, you need to treat mortgage debt as an ?inverse-bond? or an ?anti-bond??such that any mortgage debt held would dollar-for-dollar negate or reduce your actual bond investment holdings.? And the result is that this made the investor?s actual portfolio risker than they realized, since their ?true? bond allocation was smaller than they had considered.

I thought it was a novel concept, but I found some problems with that approach, within the context of asset-allocation.? My main point was that the primary purpose of analyzing a portfolio?s asset allocation is to manage risk through diversification of assets (generalizing here in interests of being concise).?? The pinnacle of diversification is non-correlation: generally in economic environments where equities soar, bonds will underperform, and vice versa.? However, classifying a debt as an ?anti-bond? doesn?t actually provide any portfolio diversification, or introduce any non-correlation.? It won?t actually negate the amount that your bonds would rise, and it won?t actually offset the amount your bonds would fall, in those respective market environments.? And even if you consider that the real value of the debt is decreased if inflation rises (as the NPV calculation would be using a greater discount rate), that doesn?t have any real-world effect on the portfolio and it?s risk and return behavior.? Since borrowers aren?t allowed to ?mark-to-market? their mortgages, that debt holding value does not fluctuate?it is fixed, and amortized from its historical cost, regardless of any market conditions or any theoretical NPV/DCF changes. ?Therefore, the inverse- or anti- bond holding in the portfolio has zero impact on the portfolio?s actual risk/return behavior, and so it seems to me it doesn?t add any functional value to frame debt as an ?anti? portfolio holding of some sort.

Also, if you were going to do that, to be fair and complete, you must apply that same principle to every single debt the client has (otherwise, it would be rather arbitrary just selecting the mortgage debt).? This adds unnecessary complexity in the asset allocation analysis.

Instead, the appropriate (and only) way to analyze debt is, separate from investable portfolio assets, on the cash-flow side of things.? Simply asking what is the ?optimal? use of the available capital; i.e. what net ?return? do you earn by using capital to eliminate debt, versus what net return could you earn if you kept the debt and employed the capital elsewhere (this will be different for each investor and their unique situations).? This is the way to analyze and evaluate debt, not to mingle it in with your invested assets and classify it as an ?anti-bond? holding within your portfolio.

I was just curious your take on this, and if I am misunderstanding or missing something.? Do you ever consider client?s debt as ?inverse-? or ?anti-? bonds in the context of asset allocation?

Thanks!

When you manage money financial firms, if you do it right, you consider the promises that your firm needs to fulfill.? When will cash be needed to pay obligations?? That helps drive asset allocation, because assets should broadly match liabilities.

Now, I am not a financial planner.? That said, the same principles apply to personal asset allocation.? If someone has a large mortgage or other debts, and he can’t invest his fixed income assets at levels that exceed the yields on those debts with reasonable risk, he should not invest in bonds — he should pay down his debt.? In the case of 401(k)s or IRAs, where there might be matches or tax advantages, the calculation becomes more complicated.? You have to weigh the match and tax deferral vs the negative arb on bond yields vs the mortgage and personal debts.

There is another factor here — how stable is your job?? If stable, it is bond-like, and you can take more equity risk with investments.? If your job has payoffs that vary a great deal with the market — commissions, bonuses, etc., it is stock-like, and you should take less risk in your investing — take excess earnings and pay down the mortgage.? I did that when I went from being a bond manager inside an insurance company, to being an equity analyst inside a hedge fund.? I paid off my mortgage in full, so that I would be free to take risks for my new employer.

As for the article, the concept is not novel.? It is well-known and practiced by institutional asset managers who manage money to the horizons needed by their clients.? As an example, the cash flows of a pension plan are relatively determinate, and the discount rate calculates the value of the liability.? The portfolio should throw off cash when needed in order to minimize risk.

In some cases, where bonds don’t offer enough yield, and equity prices are depressed, it might make sense to tactically mismatch, betting that equities will offer better returns versus the liabilities than bonds would on a risk-adjusted basis.

This argument has made its rounds for the last 20 years in insurance and pension management?? Do we match asset and liability cash flows, or do we trust in the equity premium, and invest in risk assets?? The correct answer is hybrid.? In general, match assets and liabilities, but if there is a significant tactical advantage to not match, then do that.? Think of buying junk bonds in late 1998.? Time to throw matching out the window.? And then in mid-1999, buy equities.

Now, not all clients will allow for that much risk-taking.? Many institutional investors will not let the asset manager take advantage of temporary dislocations.

In general, I think Mr. Roth is correct, but with an adjustment.

In extraordinary times, where bonds yield more than the earnings yields of stocks (think 1987 & 2000), buy bonds heavily, even if you have mortgage and other debts.
In extraordinary times, where stocks earnings yields are much higher than bonds, mismatch and own more stocks relative to bonds.? Just beware deflation, with falling future earnings.
In normal times, an indebted investor should not add to his leverage, but should invest in bonds, or better, pay down his debt.? Being debt-free is an excellent thing, and allows the investor to take more risks when the market is offering bargains.

Debt is either something to be funded by bond assets, or funds a margin account where you outperform the yield, or die.? All of this depends on where the market is in its risk cycle.? Only take risk where it is rewarded.

The Rules, Part LV

Posted on 14 October 2013 by David Merkel

Financial intermediation reduces volatility.? In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.? They do even better if they save and invest, but really, they don’t know what to do.? Market returns are like magic to them.? They don’t know why they occur, positively or negatively.? Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.? That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.? People need vehicles in which to park excess cash that are more predictable than direct investing.? Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.? Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.? But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.? After losses, they seek guarantees.? That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.? When easy money is being made by amateurs, the temptation comes to imitate.

If my stupid brother-in-law can make money flipping houses, so can I.
If my stupid cousins can make money buying dot-com stocks, so can I.
If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.? Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.? Don’t follow the crowd.? Develop the mindset of? a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.? Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.? The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.? Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.

Letters from Readers

Posted on 12 October 2013 by David Merkel

I’ve been reading your blog for quite sometime and I’ve always been astounded by your vast knowledge of just about everything in investments. I’m new to this game and I hope to learn from you, which brings me to the following:

I know we have to calculate “float”, “cost of float” and find the “combined ratio” for an insurance company to value it more accurately. However, I’ve spent hours googling around and I still can’t find what exactly in the balance sheet/P&L/CF statement (or even in the footnotes!) that constitutes as:

loss adjustment expense,?unearned premiums,?other policyholder liabilities,?premium balance receivable,?loss recoverable from reinsurance ceded,?deferred policy acquisition costs,?deferred charges on reinsurance,?related deferred income tax, etc.?

In most insurance companies’ balance sheets, all I see are the usual suspects “cash & cash equivalents”, “goodwill”, “intangible assets”, “derivative financial instruments”, “PPE” and the likes. I’ve never seen any of those above-mentioned terms, are there substitute words for them? I’m obviously missing something out. Thank you for your time!

Let’s clear something up here — there is no GAAP financial statement item called float.? What is float?? Let me teach you something deeper.? How does a property & casualty insurer invest?

There is some wiggle room around this, but typically, the premium reserves are invested in high quality short-term debt.? Premium reserves represent the premiums paid in advance that have not yet been taken into income, because some insureds don’t pay month-by-month, but they have paid for many months in advance.? They are often called unearned premiums.

Claim reserves are typically invested in longer-term debt, where the term of the debt will approximately match the period over which the claim will be paid.? Much of the claim reserves fall into the category “Incurred but not Reported [IBNR].? Insurance claims are not always filed immediately.

Finally, the surplus of the insurance company is usually invested in risk assets — equities, private equity, real estate — whatever area the insurance company thinks they have expertise to make money.

The first two categories, premium and claim reserves, comprise float.? You can try to measure them by looking at the statutory statements of the insurer, where those are real line items on the liabilities page, or you can approximate it by looking at the current liabilities, and adding in the claim reserve, which is usually in one of the footnotes.

Reinsurance can mess this up a little, so try to work with numbers net of reinsurance.

Property & Casualty Insurers do not have to credit interest as they delay paying claims, or receive premiums in advance.? Thus the concept of float.? Few insurers use float to be as aggressive as Buffett.? They invest more conservatively, especially among insurers where claims get paid quickly (home & auto).? With long-tailed claims, like asbestos & environmental, the claims may take so long to emerge that the insurer can be investing in stocks, and that will be the optimal investing decision.

The so-called “cost of float” is net underwriting losses.? If there are no net underwriting losses, float is free, or more often, is a source of profit.

But float isn’t worth much unless you have a clever investor investing the cash that stems from the delay of paying claims.? Even with Buffett, that advantage is uncertain.

Tell you what, I never analyze float in insurance.? I analyze management teams.? Insurance is uncertain enough, that I want a margin of safety, and the best way that I can do that is find management teams that are conservative.? Do they consistently make money on underwriting?? Do they occasionally/frequently deliver negative surprises?

I wouldn’t spend time on float.? Any insurer can generate float.? Look at how they make money.? How do they underwrite?? How do they invest?? Are they conservative in their accounting?? That is what you should look for.

Next letter:

I hope you are doing well.? I have been reading your blog for the last few years and have found myself thoroughly educated and entertained.? My favorite series of posts has been your explanation on the holders’ hands, which is a unique and more useful way of classifying market participants, rather than just using timeframe.

A little bit about myself: I am currently a student at zzzzzzzzz studying Economics and before that I was in the Marine Corps Reserves where I served a tour in Iraq.?

I managed to save some money from that time and began investing, which dovetailed nicely with my burgeoning interest in macroeconomics (particularly through the Austrian and Post-Keynesian lens).

As I learned from my mistakes and improved, I recently felt confident enough to form my own LLC in the hopes of bringing on close family and friends as part owners (essentially limited partners) and manage our savings in a more productive and less expensive manner than the current meta of mutual funds or indexing.

This brings me to the the reason I am emailing you: suppose I would like to expand this type of business…How would I go about this? Am I reliant on word of mouth via friends and family?? I also plan to talk to the Small Business Administration for investors, but I don’t think anybody will even give me a chance until at least after a few years.?

Would it be feasible to talk to pension/asset management firms for interest in investing?? I would love to hear your opinion on the matter and please let me know if there is someone more appropriate for me to send this email to.

If I have this straight, you have started a firm that invests in other firms, not all that much different from Buffett in his days after ending his limited partnership.? In this case, you are limited by the number of people that can invest in your private firm, which in these days, I believe is 1000 people.? I could be wrong here, so consult competent legal counsel to guide you.? Not sure how the SBA would fit in here, though I know they aid funding small firms together with venture capitalists.

What you are doing is too small for pension and asset managers.? Given the JOBS Act, your best option is to recruit medium-sized investors, and invest wisely.? Given that you run a private firm, you might not want to limit yourself to public companies.? You might be able to compound capital faster by buying whole small companies, or large portions of medium-sized companies.

Of course, this all presumes that you have a real talent here.? If you’re not sure, give it up now, and give the capital back to your shareholders.

I wish you well, but if you are doing public assets, far better that you do what I do and manage separate accounts for investors.? It’s a lot cleaner.

Taleb Versus Reality

Posted on 11 October 2013 by David Merkel

I looked for this article out on the web, and at the CFA Institute website, and didn?t find it.? I asked for permission to use this and no one responded after more than one week.? The following was excerpted from an interview with Nassim Taleb by Rhea Wessel in the September/October 2013 issue of the CFA Institute Magazine on pages 40-43.? CFA Institute, I consider this fair use.?? If it is not, let me know, and I will take it down.

Is there an investment strategy that fits with the idea?

I will get there. Let me make some investment rules in general.

Number 1: I introduced earlier the 1/n rule?be as broad as you can in whatever risky assets you are investing in to minimize the risk.

The second trick, or rule, [is to] implement that barbell to reduce your fragility. Because if you see the barbell, then no fragility is in the tail. In other words, if you are “bar- belied,” putting a floor on your losses at 90%, the maximum you could lose is 10%. If the markets go down 20%, you don’t lose twice as much as [you would] if the market went down 10%. You lose much less. That puts you in the antifragile category. [For a third rule] I’d say, look for companies that have optionality.

What is optionality?

Optionality means to have more upside than downside because the company has options. An “option” in this sense acts like a financial option, and a financial option is an instrument of antifragility because you pay a premium and you have all this upside and very little downside.

The companies make more from the upside of something than from the downside. Make sure the optionality is not priced by the market. And of course, go away from companies that have negative optionality.

An optionality that is priced in the market is, for example, buying energy companies and gold companies before a rally in gold. Instead of investing in gold, people invested in companies that made a lot more than gold. But after a while, this got priced in. In other words, if you’re wrong on gold, you do a lot better than those who invested in gold outright. If you’re right on gold, you do a lot better than those who invested in gold.

You have to avoid the lottery-ticket effect of investing in companies that are overpriced because people are looking at the big upside.

So, now we have three rules [1/n, implement the barbell, and pursue optionality].

Let me make one more?never invest in company stocks or strategies that have very low volatility without ascertaining that there’s a floor on the return.

[Consider that] a Sharpe ratio measures return divided by risk, as measured by past variation. You have to be wary of companies that exhibit no volatility yet have a high return, unless they are genuinely low volatility. Most of them are fake low volatility.

What do you mean by “fake low volatility?

You know the funds of Bear Stearns that blew up in the subprime crisis? They were funds that never had a down month. A lot of people who blew up in subprime did not have a down month?ever. And people rushed to invest in them because they were low volatility. And then they blew up.

Typically, I never get close to anything that has no volatility, unless it’s justified, like Treasury bonds. If you go to a balance sheet, you can see why there is low volatility, whether it is genuine. The company can have a barbell. The company can have very, very low leverage. Or you might discover that a company is doing the equivalent of selling remote options, and the company can lose a lot of money in one blow.

Let’s link it to make it more intuitive: In general, I can say that a system that has very, very low volatility is likely to blow up. Take the example of Syria. Syria had no political volatility for 40 years, and look what happened.

Forests that never have fires are likely to be completely eradicated by fires when they happen. Forests that have regular fires are much more stable.

You mentioned the concept of leverage. You could make another investment rule regarding debt?

Yes. You know the rule?what you don’t do is more important than what you do. In natural systems, you need redundancy to make the system work better. People think that redundancies are inefficient. I think they’re the most efficient thing in the world, if you do them right.

Redundancy is bad if you buy the same morning newspaper twice or if you have two subscriptions to the same website. But redundancy is fine if you have a stock of cash in the bank or if you’re a company that needs oil and you have extra oil.

Let’s assume that you have cash in the bank and there’s a big crisis. You have dry powder. It will make you antifragile to have the extra dry powder if nobody else has money. You can buy anything you want. Cash is the opposite of leverage.

In fact, the number one indicator of fragility is leverage. It can be operational or financial. Leverage corresponds to people’s overconfidence about the future.

Most people who have leverage will be completely squeezed in a crisis, and you will have cash.

Whose compensation models do you agree with?

Most investment advisers are not harmed by the downside. The only people who have a good compensation model are hedge fund managers. Typically, when I managed money, I was harmed 50 times more than any of my clients as a percentage of my net worth.

The hedge fund managers I know are typically far more invested than their average client. When that person is on board calling the shots, I sleep like a baby. You don’t get this with fund managers.

Okay, Taleb has offered up six ideas for us to consider regarding risk control.? Here they are:

1/n
Barbell ? safe & risky
Positive optionality
Want a floor ? no ?fake low volatility?
Avoid leverage ? operational & financial
Alignment of Interests

Let’s take them one-by-one, but before we do, every risk mitigation scheme has to pass the test: “what would happen if everyone did this?”

1/n

This is a fancy way of saying equal-weight everything.? In such a scheme, ExxonMobil and Apple get the same weight as Phoenix Companies and American Independence Corp.? Nifty idea until too many people follow it.? This is an idea that cannot scale.? Yes, owning small companies and the debts of small companies have yielded high returns, but if many people do that, it will cease to be true.

Barbell ? safe & risky

Yes, owning safe and risky investments is a bright idea — that’s where the 60/40 stocks/bonds came from.? You get positive optionality and your downside is clipped.? Taleb argues for a lower risk version of this.? But again, this can’t scale.? Most assets are in-between — they carry moderate risks.? What is the risk premium at which you buy moderate risks?

Positive optionality

Everyone wants the best of both worlds, but how much are we willing to pay to get it?? Options normally carry a cost.? When you can get them for free, rejoice.? The market is competitive, and there are few places where free options exist.

Want a floor ? no ?fake low volatility?

Taleb is looking for guarantees, or near-guarantees.? He does not trust low volatility investments, and I agree.? He wants something that tells him that that floor for the asset price is not too far below the current price.? Makes him sound like a value investor.

Avoid leverage ? operational & financial

Margin of safety is the credo of all good value investors.? That makes us avoid financial leverage, and to a lesser extent operating leverage.? As I have stated before, good investing takes moderate risks.? Low risks avail little, while high risks take too many losses.? Moderate risks have a greater probability that humans can deal with them.

Alignment of Interests

Yes, it is important that management and fund managers have incentives aligned with shareholders.? I aim for this and have no argument against this, unless it costs too much to get this.

The Main Point

If something in the markets is a good thing, it will get bought, and the price of it will go up.? Free optionality is rare.? Assets that offer easy guarantees are also rare.

Thus I think the advice of Nassim Taleb is vacuous, because the methods that he recommends for safety are risk factors which have prices.? They are great ideas when they can be executed at no cost.? But most of the time, there are costs.

In 2002, we had the ?we eat asbestos for lunch? trade.? After aversion to asbestos risk, some were willing to take the risk because they thought it was overstated.

Any risk can be overplayed.? There are fair levels for taking and avoiding risk.? Good investors and businessmen understand this.

A New Look at Endowment Investing

Posted on 5 October 20137 October 2013 by David Merkel

I’ve written at least two significant pieces on endowment investing:

Alternative Investments, Illiquidity, and Endowment Management
The Forever Fund
Oh, toss in one more: Managing Illiquid Assets

Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project.? This was partially in response to Matthew Klein’s excellent article,?Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.

The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions.? If you are interested, it is worth a read.? The remainder of this piece expresses ways that I think their views could be sharpened.? Here goes:

1) Don’t Think in Terms of Time Horizon, but Time Horizons

2008-9 proved that liquidity matters.? The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.

Choose a length of time over which you think you have a full market cycle, with a boom and a bust.? I like 10 years, but that might be too long for many.?? As I said in Managing Illiquid Assets:

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.? Invest that much in short to intermediate bond investments.? You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

I include all risk assets in illiquid assets here.? The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell.? There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.

2) Look to the Underlying Drivers of Value

Hedge funds aren’t magic.? They are just limited partnerships that invest.? Look through the LPs to the actual investments.? It is those actual investments that will drive value, not the form in which they are held.? Get as granular as you can.? Ask: what is the margin of safety in these endeavors?? What is the likely return under bad and moderate conditions?

3) Ignore Correlations

It is far more important to focus on margin of safety than to look at diversification benefits.? Correlation coefficients on returns are not generally stable.? Do not assume any correlation benefits from risky investments.? Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.

4) On Leverage & Insurance

Unless they are mispriced, borrowing money or getting insurance does not add value.? Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.

Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).

5) Mark-to-Market Losses Might Matter

Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.

6) Insource Assets

The best firms I have worked for built up internal expertise, rather than outsource everything.? The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced.? As you gain experience, insource more.

7) Thematic Investing is Usually Growth Investing

Avoid looking at themes.? Unless you are the first on the scene, themes are expensive.? Rather, look at margin of safety.? Look for businesses where you can’t lose much, and you might get good gains.

8) Look to the Underlying Value of the Business, or Asset Class

Cash flows are what matter.? Look at he likely internal rate of return on all of your investments, and the worst case scenario.? Buy cheap assets with a margin of safety, and don’t look further than that.? Buying safe assets cheap overcomes all diversification advantages.

Those are my differences on what was otherwise a good paper.? I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.

The Education of an Investment Risk Manager, Part IX (The End)

Posted on 3 October 2013 by David Merkel

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.? Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.? How much implicit equity exposure do we get from our variable annuities?”? The idea was this: as the equity markets go up, so does our fee stream.? If the equity market goes up or down 1%, how much does the present value of fees change?? I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.? At a small broker-dealer, all sorts of charlatans bring their ideas for financing.? The correct answer is usually no, but that conflicts with hope.? Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.? I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.? Go variable by variable, on a long term basis, and ask:

At what level does this bring line profits to zero?
At what level does this bring company profits to zero?
At what level does this imperil the solvency of the company?

5) This story is a little weird.? One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.? You are our representative.? They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.? Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.? He didn’t want to get stuck with losses.? I told him the persuasion was not my forte, but I would do my best.? I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.? Use it.”

A few days later, I was on the Metroliner down to DC.? I tried to understand both sides of the argument.?? I even prayed about it.? Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?? What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.? We had worked together, and AIG didn’t like the idea either.? In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.? Not promising.? We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.? I raised my hand and said something like, “You have to think of the law of unintended consequences here.? What will be the impact on competition here?? What if one us, a large company decides to be more aggressive as a result of this?? What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance??? The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.? The next day I told my boss we had won against hard odds.? He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.? This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.? I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.? Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.? What I found was that I did best buying strong companies in damaged industries.? That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.? In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?? Not many, and even I did not anticipate the intensity of the bust.? At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.? We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.? It is not what you earn, but what you keep that matters.

Classic: How to Size Your Portfolio to Fit

Posted on 26 September 201326 September 2013 by David Merkel

I wrote the following at RealMoney on 4/10/2007

I’ve written two columns already about “spring cleaning” a portfolio, walking you first through the criteria I use when reshaping my holdings and then through the stocks and decisions those criteria pointed to. But there’s one aspect I didn’t cover: What’s the best way to size positions for a long-only equity portfolio?

In order to answer this question, I use the Kelly criterion (popularized in the excellent book Fortune’s Formula), which says that a position size should be equal to (edge/odds). Edge is the excess return that you expect to earn on average. Odds describes the likelihood of winning. A 50/50 bet makes odds equal to 1.

There is added complexity in applying this to stocks, because in gambling, each game is (mostly) uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another.

That’s particularly true for me, because I concentrate sectors. I believe that my portfolio acts more like a portfolio with half the number of positions because of the correlatedness of the various names in the portfolio. Thus, the 35 names in my portfolio behave more like 18 uncorrelated names.

The Kelly criterion applied to stock investing would recommend a fixed-weight portfolio. Optimally, you would rebalance daily to those fixed weights. But two factors interfere: First, there are costs to trading, and second, momentum tends to persist in the short run.

To me, those realities mean that you can have fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller-percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. What are they?

Industries are under-analyzed relative to the market on the whole and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries where the trends are not fully discounted.
Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean a low price-to-earnings ratio, low price-to-book value ratio, low price-to-sales ratio, low price-to-cash flow from operating activities, low price-to-free cash flow or low enterprise value-to-EBITDA.
Stick with higher-quality companies for a given industry.
Purchase companies appropriately sized to serve their market niches.
Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
Analyze the use of cash flow by management to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
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.
Make changes to the portfolio three or four times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

I need to calculate what I think my edge is. My procedure will be messy and somewhat ad hoc, but I would rather be approximately right than precisely wrong. How much is each rule worth?

The offensive rules are 1, 2, 7 and 8. Each of those generates roughly 2% of alpha annually. The defensive rules are 3, 4, 5 and 6. Each of those generates roughly 0.5% of alpha annually. Now, that would be an alpha of 10% annually for a portfolio that followed all those rules perfectly. My alpha over the last six years and seven months has been greater than that, but I will chalk up the overage to happenstance. Maybe more should go to happenstance, but I will discuss that below.

If my edge is 10% per year, what are my odds? I have long maintained that the idea I believe is best probably is as good as my 35th idea. Too many portfolio managers naively believe that they can identify their best ideas, when there are so many unknowns to an outside, passive, minority investor. My methods work on average, over the intermediate term. Most of my investments work if I give them two to three years to develop. Time is usually on my side with my methods. That would imply that my odds might be 50/50, or 1:1. That’s a coin flip, but one that, repeated often enough, leads to an extra 10% per year. Using the straight Kelly formula, that would mean I should have 10 positions; 10% divided by 1 is 10%, and for each position to be 10% of my portfolio, that would mean 10 positions. But I own 35 positions. What do I do?

As I mentioned above, because I concentrate industries, my 35 stocks behave more like 18. An equal-weight 18-stock portfolio has weights of 5.5%, and that’s still not 10%. Again, what do I do?

Good investing is based on humility, a willingness to accept that there are many things that you don’t know and that many successes may not be due to skill. Many who use the Kelly criterion decide to go “half Kelly” and cut position size in half because it also cuts volatility in half — but it also diminishes the expected returns by 25%. It’s a humble way to go.

Another way to think about it is that with quantitative investing, when you find a good strategy and have vetted it though back-testing, typically the alpha achieved when the strategy goes live is half of what the model would have predicted.? Though I have already given my edge a haircut, perhaps more of the success needs to be attributed to happenstance.

Whether due to happenstance or conservatism on my part, cutting the 5.5% in half leads to positions of 2.8% in size. How many equal-weighted positions is that? 36. That’s about what I have, and when conditions are bullish, I contract the number down to 30. When conditions are bearish, I hold up to 40 positions. Most of the time, I keep it at 35. That keeps me disciplined, which is a virtue that yields dividends in its own right.

That’s what I do. But what should you, my reader, do?

I encourage you to calculate your edge.

Look at your annualized returns over the past few years, and compare them with the index that you want to beat. Take the? excess (assuming there is one), and cut it in half. Some things went well for you that are not attributable to your skill.

I encourage you to calculate yours odds.

Look at your trading. Divide it into two categories, winners and losers. How often do you win (relative to the index)? When you win (vs. the index), how much do you win on average? When you lose (vs. the index), how much do you lose on average? (Make sure you use your annualized results for this exercise.)

If you consistently lose vs. the index, I’d buy the index instead of continuing to lose capital trying to do it myself. If you beat the index, then work out the calculation that I went through for my portfolio. Take into account your conservatism, but even if you are aggressive, I strongly discourage you from using portfolio weights higher than the full Kelly criterion; it’s too dangerous.

In general, I believe skilled investors with moderately sized portfolios are best served by diversification equal to what I use.? On the raw Kelly criterion, it’s equivalent to saying that one has an alpha between 2.5% and 3.3%. Hey, that’s hot stuff!? Most mutual fund managers would kill for those returns.

In summary, size your positions inversely to your expected alpha. To the extent that you are less certain of your skills, expand the number of your positions.