Value Investing – Page 30

The Rules, Part XLVI

Posted on 20 July 2013 by David Merkel

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

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

Here are my five points:

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

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

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

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

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

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

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

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

The Rules, Part XLV

Posted on 20 July 2013 by David Merkel

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

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

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

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

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

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

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

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

So when you hear:

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

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

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

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

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

The Rules, Part XLIV

Posted on 19 July 2013 by David Merkel

Expectations are a part of the game.

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

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

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

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

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

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

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

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

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

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

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

Full disclosure: Long BRK/B

The Problem of Small Accounts

Posted on 17 July 201319 July 2013 by David Merkel

We all want financial advice.? Good advice.? And we want it for free.? That’s why we come to the Aleph Blog, where advice is regularly dispensed, and at no cost.

But… I can’t be personal, and give you advice that is tailored to your situation.? And in my writing here, much as I try to be highly honest, I am not acting as a fiduciary, even though I still make my writings hold to such a standard.

Ugh.? Here’s the problem.? Good advice costs money.? Really good advice costs a lot of money, and is worth it, if you have enough money to spread the cost over.

But when you have a small account, you have a problem in getting advice.? There is no way for someone who is fiduciary (like me) to make money addressing your concerns.? That is why I have a high minimum for investing: $100,000.? With that, I can spend time on clients, even helping them with assets from which I make no money.

How can you get advice to those who will not actively seek it??? From those who are commissioned to sell to them.? It may not be the best advice, but it *is* advice.? For the lazy, investment advice is sold not bought.

And so, I give you the following articles, most of which disagree with me:

First, on financial advice, you should always be skeptical, even with me.? There is no one who is truly disinterested who has smarts, and so “ya pays yer money and ya takes yer chances.”? If you don’t pay money, your odds are worse.? I write this as one who only makes money off of assets under management.? Most people are better off hiring a CFP, and getting tax savings.? They might not be great on investing, but they may make up for it by lowering your tax rate.

I’m a CFA Charterholder, and an old-style? RIA.? I make money by finding undervalued stocks and buying them.? I focus on value.? That is my sole focus.? I am out to beat the? market regularly, and I do it over market cycles.

It is expensive to be? a fiduciary.? It takes time and effort, and there are many who will pay you to push products.? If we require all investment professionals to be fiduciaries, those who are less well off will not be served.

And, as an aside, this is why you should study the economics of any policy question.? It will tell you what will naturally happen.

Much as I want all people to get good investment advice, there are no incentives to make that take place.? If we try to force it by law, then few will get quality advice.? It will go into hiding.

Distinguishing Alpha from Noise

Posted on 17 July 2013 by David Merkel

I read a paper today that I thought was pretty interesting — A Consultant?s Perspective on Distinguishing Alpha from Noise. [8 pages PDF]? I have been on both sides of the table in my life.? I have hired managers, and I have tried to sell my equity management services.

In general, managers that thought would offer value would venture off the beaten path.? They might own some well-known names, but they would own far more that would make me say, “Who is that?”? The companies would be less known because they are smaller, foreign, have a control investor, etc.

Those portfolios would look a lot different than an index fund.? They would be more concentrated by sector, industry and company.? They would have a process that analyzes what the market is misvaluing, whether by sector, industry, or company.? They would stick to their discipline through thick and thin, realizing that all anomalies in the market go in and out of favor.

The process would specify what anomalies of the market, or what information advantages the fund would attempt to exploit.? But once you specify that, you stick to that as your strategy.? There is no room for tossing an asset in “because it looks good.”

There is a balance in good strategies that allows for minor modifications around core principles.? All good strategies have to adapt, but there has to be a strategic core from which the strategy will never vary.? Absent that core, the strategy will give in to fear and greed — buying high and selling low.

Quoting from the paper:

I am amazed at all the managers that make an assertion of the type “In the long run X always wins”, where X could be dividend yield, earnings growth, quality of management, a quantitative factor or mix of factors, etc., yet are unable cite a reason why X should be systematically under-priced by the market.

My view is twofold.? There are some ugly situations involving financial stress that most investors don’t want to take on.? There are also less glamorous companies that few want to buy.? Those can be excellent investments.? My second point is tougher to make, but industries go in and out of favor.? So do market factors.? Buy that which is safe, and out-of-favor.

Now, for managers, I would recommend keeping a trading journal, where you record why you think your investment hypothesis will succeed.? If your investments succeed for reasons that you specified in advance, that is an indication of skill.? There is a lot of what is called “luck” in investing.? If you are beating the market, and it is not for reasons that you specified in advance, you do not have skill, you have luck, and luck strongly tends to mean revert.

My view comes down to this: I like to see a long track record of outperformance, an unusual portfolio, and a strategy that convinces me that you have discipline, and a constructive way of finding undervalued assets. ? Absent that, I will probably think that you are a pretender than an outperformer.? There are always some that outperform for a short time, and then underperform as the underlying economics shift.? Markets are volatile enough that there are always some with three-year track records that are stunning, and very lucky.

Separating luck from skill — that is the toughest aspect of investing.? But it is needed because there are so many investment managers touting skill, and what do they really offer?

In Defense of Concentrated Portfolios

Posted on 10 July 201310 July 2013 by David Merkel

I was traveling most of yesterday on an odd bit of Church business, but I am back home now, late as it is.? I listen to the radio as I travel to meeting like this, and much of it reminds me of why I don’t like many aspects of talk radio.

Arguments that don’t take into account the complexity of the issues
Advertising that may cheat your hearers
Arguments that assume the worst of your adversaries
Callers that are sycophants
Views that are too cynical.? Don’t assume a conspiracy when mere incompetence will do it.

Today, I heard a lot of odd things, but one hit me hard because it is what I do.? I caught a small part of Dave Ramsey’s show, where he was ignorantly criticizing stock-pickers like me, that we can’t outperform the S&P 500 or a growth stock index fund (which is easier).? He further criticized concentrated portfolios, saying that they were far too risky, saying that you had to have at least 100 stocks in a portfolio to achieve diversification.

Now, fellow Christians often ask me what I think of Dave Ramsey, and I often say to them that his emphasis on paying down and avoid debt is a good one, but that he doesn’t have much to say beyond that.? Now, that’s my perspective from listening? to snippets over the years.? I don’t claim to understand him fully, but after listening to him, I can’t get what the thrill is — it is all rather basic.

But then, basic is what most people need, and that is why cash & debt management is the first priority for most people.? Many of my personal finance articles deal with that.

Ramsey is out of his league when trying to opine on whether concentrated portfolios offer value of not.? There are two philosophies here:

Don’t put all of your eggs in one basket
Put all of your eggs in one basket, and watch that basket like a hawk.

These two philosophies show the tradeoff of diversification for knowledge.? From an interview with Marty Whitman in Barron’s:

Why do you prefer to run funds that are concentrated, rather than diversified? And how do you protect against risk when you do this?

We get protection by being price-conscious and by being extremely knowledgeable about our holdings. And diversification is a surrogate?and a [very] poor surrogate?for knowledge, elements of control [of a company] and price-consciousness. If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time.

The idea is that value investors gain detailed knowledge of companies that they invest in.? That takes time and effort, so they limit the number of companies that they invest in.? The idea is to do so much research, that you have an information advantage over 99% of the market.? It pays off.

Buffett himself wrote an article called, “The Superinvestors of Graham and Doddsville [PDF],” which was published in Hermes [Columbia Business School], and republished as a forward to later versions of “The Intelligent Investor.”? Most of the “Superinvestors” ran concentrated portfolios by today’s standards.? Some were highly concentrated — the one common thing among them is a value style that focuses on a margin of safety to avoid large losses, and purchasing shares of companies whose assets are out of favor, where a bargain price can be obtained.

Now not everyone is cut out to be dispassionate about investing, treating it like a business where you are trying to buy safe assets cheap, and sell them dearly when they come back into favor.? You often look wrong before you are right.

I myself run a concentrated stock portfolio, 36 stocks at present with significant industry concentrations in energy, insurance, and technology, and have done well versus the S&P 500 over the last 13 years.? I think this is considerably less risky than buying an S&P 500 index fund, much less a growth stock index fund.? The value stock index fund?? That’s a good option for those wanting passive equity exposure.? On the whole, I like what I do better.? My portfolio never looks like the index.

If you own actively managed funds, though, particularly large cap funds, take a look through them, and see if they look like an index fund to you (but with much higher fees).? The term is called “active share.”?? How different are they from an index fund? Look for funds that do it differently, and have succeeded in the process.? That’s what I do for friends when I look over their actively-managed mutual funds.

All for now.

Sorted Weekly Tweets

Posted on 29 June 201330 June 2013 by David Merkel

Wrong

Wrong: A Hawkish Signal Bernanke Didn’t Send stks.co/sISp No, Fed misunderstood the markets, & what their “transparency” said $$
Slow-minded: Fed Presidents Say Dodd-Frank Failed to Dispel Too-Big-to-Fail stks.co/fbLA No, duh. U r only realizing this now? $$
Wrong: Pension funds may see the silver lining on the interest rate cloud stks.co/gbLA As interest rates rise, assets go down $$
Wrong: The Last Mystery of the Financial Crisis stks.co/aZl7 Shallow analysis that does not take account of regulatory needs $$
Wrong: Long Live Synthetic CDOs – Bloomberg stks.co/ianr Levering up risky debts exacerbates the credit cycle; should b ended $$

Market Dynamics

Traders Trapped in Scandinavia Discover No Easy Sell stks.co/tIUb Low-liquidity currencies, big moves when all rush 2the exit $$
Why ?average? returns aren?t good enough stks.co/fbLB Arithmetic avgs r less accurate than geometric averages & more $$
Royal Bank of Canada Gains by Putting the Brakes on Traders stks.co/qIXh Over the long haul they will prosper vs HFT $$
Billionaire Ron Baron: The Dow?s A Double stks.co/cZbY He’s delusional, and does not get how stretched prices are vs book/sales $$
Holding bonds today is a disaster in the making stks.co/iatP I think the economy will b weaker than Fed expects, could c rally $$
Closed-End Funds Bite Back stks.co/garg Leverage Juiced Returns When Rates Were Moored; Now It Is Magnifying Losses $$ #BlameDaFed
Apollo Fueled by $9.6 Billion Profit on Debt Beats Peers stks.co/pI7U Strength of investing across capital structure evident $$
State Street Temporarily Stops Cash Redemptions For Muni-Bond ETFs stks.co/pHnc Dealers can’t presently swap ETF shares 4 cash $$
Billionaire Fisher Says U.S. Still in Middle of Stock Rally stks.co/hanR He is stuck in a mindset of a low debt world $$
Housing Seen Shrugging Off Loan Rate Rise as Banks Loosen stks.co/jaQY Easier financing returns, tho Tsy yield rise undoes more $$
Treasury Yields Surge Most Since 2003 as Fed Previews Tapering stks.co/sHeT When cheap forward financing ends, prices go south $$

Metals

Gold-Price Decline Uncovers Mining Companies’ Debt Woes stks.co/tIUa Debt in cyclical industries is always a problem in a bust $$
Gold Drops to 34-Month Low as Precious Metals Slide on Fed View stks.co/cZdI All risk assets have been hit since Fed meeting $$
Gold Bear Market Hits Hardest in South Africa Mines stks.co/eZl1 Mines r high cost per ton, no surprise they r affected early $$
Bottom Falling Out of Copper Prices stks.co/jbDz When Dr. Copper speaks, we can sense the pulse of the economy, getting weaker $$
Gold Miner Writedowns at $17 Billion After Newcrest stks.co/aZDq Beginning of a process reconciling dud mining assets $$

Monetary Policy

Risk of 1937 relapse as Fed gives up fight against deflation stks.co/ibLa Deflation is inevitable given present policy $$
2 Fed Presidents Emphasize Stimulus 2Persist After QE Taper stks.co/cZ7b & stks.co/aZHK Fisher & Kocherlakota obfusc8 $$
BIS fears fresh bank crisis from global bond spike stks.co/eZGv Banks r mismatched long; will have trouble in run on liquidity $$

China

Credit Warnings Offer World a Peek Into China?s Secretive Banks stks.co/cZdL & more extreme: stks.co/dZdV Bad future $$
China breaks silence on cash crunch stks.co/fasu Nation’s lenders approach crisis point as part of crackdown on shadow finance $$
China?s alarming credit crunch stks.co/sHxk This could have been exacerbated by a reversal of a popular yen-yuan carry trade $$
China Loses Control of Its Frankenstein Economy stks.co/faqF Things r likely 2b shaky in China’s short-tern lending markets $$
Financial reform cannot wait stks.co/jaiU But the Party, is it ready to give more freedom to its people & transparency 2 banks $$

Energy

How BP Got Screwed on Gulf Oil Spill Claims stks.co/tISo Free $$ brings out the worst in people | FD: +$BP
Frack Music Attracts Halliburton to Submarine Spy Tool stks.co/hb7I “The hills r alive, w/the sounds of fracking…” $$
In Moving US Oil, ‘Flexible’ Rail Bests Pipelines stks.co/pI7j Railroad tank cars:low fixed, high variable costs, more flexible $$
New Pipelines to Bring Landlocked Oil to Texas-Coast Refineries stks.co/jakj Pipelines: high fixed cost, low variable cost $$

Insurance

Berkshire?s Tracy Britt In, Lynn Swann Out at Heinz?s Board stks.co/bZh0 Whiz Kid gets 1st board seat $BRK.A M&A | FD:+ $BRK.B $$
Regulators put chill on US private-equity insurance deals stks.co/dZbX Those who might undo the conservatism should not buy $$
$HIG to Sell Unit to Berkshire stks.co/pIb8 I do not get how $BRK.B benefits from this; its worse than the $CI transaction $$
7 Annuity Mistakes to Avoid stks.co/sHxj Illiquity, wrong payout type or guarantees, switching, w/d 2much, taking buyback, etc. $$
Misjudged Annuity Guarantees May Cost Life Insurers Billions stks.co/rI1Z Why I don’t invest life insurers w/much variable biz $$

Other

Working Poor Losing Obamacare as States Resist Medicaid stks.co/dZdW A rare case where states avoid Federal $$ | avoiding a trap
Four Reasons Non-GAAP Metrics Are Exploding stks.co/cZbX Non-GAAP measures r an attempt to make acctg reflect free cash flows $$
Another shameful day for Europe as EMU creditor states betray South stks.co/pIb9 Germany crams down on Greece & euro-fringe $$
Holder Says US Seeking More Disclosure on Surveillance stks.co/aZ10 U can disclose it now; U r a bigger threat than terrorism $$
Sorry, but Do You Speak English? stks.co/pHna Not surprising; cultural differences drive differences in English dialects $$

Full disclosure: long BP, BRK/B

Risk Control Upfront, Redux

Posted on 28 June 2013 by David Merkel

Each of the situations I used as examples yesterday, I have personally run into, and I could write about more of them.? Good investment and risk control shops do their home work in advance.? They ask questions on what could go wrong with a given investment or product; they are willing to negatively but not unreasonably imaginative.? Buffett has said something to the effect of, “We’re paid to think about the things that can’t happen.”

What I said about life & commercial insurers goes double for the banks.? Those insurers have long liabilities, which gives them more time to bounce back from asset disappointments.? The short liability structures of the banks give them less time to deal with asset problems.

All of this implies having disciplines for buying assets, and re-evaluating assets in any portfolio.? My discipline evaluates these at mid-quarter, when few others are doing their evaluations.

The idea is to be ever and always forward-looking.? The past doesn’t matter, except to serve as grist for the mill, showing us what can happen.

Good investing does not care about entry prices.? Good investing is like the great Wayne Gretsky, who did not care about where the puck was, but where it would be.? This is why when I invest I am always comparing the assets in my portfolio versus alternatives.? I look for what will do well in the future.? I do not care about past gains and losses.

Good investing cares about trading what is good for what is better.? This is easy for bond managers.? A bond manager with skill, and freedom to execute can make many wise trades to improve a portfolio.? All he has to do is buy bonds with yields that compensate for the risks, and sell bonds that don’t compensate.

For equity investors the calculus is more vague, but it still exists.? Look to where you can earn returns on average.? Find enough of those areas so that diversification works.

I have never run an index-like portfolio, unless it was an accident.? I will occasionally throw a company in for diversification reasons, but my main goal is owning cheap assets that will earn far more than the index.

Good investing involves business knowledge.? That means you understand how money is made across the set of companies that you invest in.

Whether you are an investor or not, if you want to make greater progress in your career, you should try to learn the financial aspects of your company.? That will stand you in good stead for those that look for managers, because those who understand the profit model are far more valuable than those that don’t.

I stand with Buffett, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”? Outside money and inside money can learn from each other, leading to a better investing result.

Summary

I offer to all investors this simple idea, trade what is less good for what is better. It will improve your returns.? Continually improve your portfolio, and do not be married to any ideas.? The idea of relative improvement of the portfolio has aided me greatly in portfolio management.? It is easy to swap bond for bond, and relatively easy to trade stock for stock.? Asset allocation decisions are more difficult.? Figuring when to trade stocks, bonds and cash between one another is far more difficult.

Risk Control Upfront

Posted on 25 June 2013 by David Merkel

In my career as an asset manager, and as a manager of financial risk, I have learned that all good risk management is done upfront, before the first purchase is made or product is sold.? Secondarily, good risk management relies on the concept of feedback, i. e., are the results expected at inception happening?? If not, are they happening in a way that makes us doubt the margin of safety that we thought we had?

I’ll give you some examples:

1) There are two ways to offer disability insurance (this applies to high-end P&C products for the wealthy, and other financial products):

Rigorous underwriting that does not cover groups & individuals that could be high risk.
Underwrite freely, and then attempt to deny claims that happen with higher than expected frequency.

2) After designing a living benefit for an annuity, you notice that one option is being chosen by policyholders, and the rest not.? Do you:

Retest the option being chosen, to see that you are not giving away the store?
Do nothing.? After all, it’s the only product of its class selling, and marketing is off your back for now.? Why spoil the party?

3) You discover that you are the only company willing to offer a certain type of reinsurance, or a certain type of coverage.? Do you:

Try to analyze why? your competitors don’t do it.? If there’s no special and durable barrier to entry that you possess, make the pricing jump through harder hoops.
Congratulate yourself for your unique perspective, and willing to take risks that others won’t.

4) On your new insurance product, the claims area sends you early claims data, showing you reasons for the claims.? They reasons aren’t what you would have expected from the quality of the clientele that you thought you were marketing to.? Do you:

Begin analyzing marketing data, to see if the product is being offered more to those less intended.? Analyze what agencies are doing who sell a disproportionate amount of the product.
Attribute the claims to the “Law of Small Numbers.”? Hey, it’s a weird world, and odd stuff happens.

5) You’re part of a team of value investors.? A news event hits, showing that the company will be less profitable than expected by a wide margin.? Do you:

Analyze what the company is worth presently.? If it is no longer safe or cheap, sell.? If the market has over-reacted, buy.? Oh, and feed back the lessons from this episode into the process for evaluating new investments.
Automatically sell, because it has breached your loss limits.
Just hang on, because we have more than enough capital versus investable ideas.
Complain about the event, the potential dishonesty of management, and the analyst that recommended purchase.? Ask why we didn’t sell this last week.? Decide to go activist on the company, because it obviously the assets would be managed better in hands that you select.

6) The credit cycle has gotten long in the tooth, and securities that offer a decent yield versus risks undertaken have become few.? You manage money for income seeking investors.? Do you:

Edge away from risky bonds, slowly upgrade quality, and pare yields.? Communicate to clients why you are doing this, even if it means you might see assets walk.
Stay fully invested in the best quality bonds you can find, subject to a given yield hurdle.
Just facilitate the demands of clients, and invest as if you faced normal yield tradeoffs for risks undertaken.? After all, they want you to take risks.? If clients lose, that is their problem.

7) As a value manager, you have been underperforming for clients.? Though you have tested and re-tested your processes, you can’t? find anything wrong.? You think there is a speculative mania going on.? Several other managers that do things your way have been fired.? Do you:

Stick to your guns.? Safe and cheap will eventually win out.? Communicate that to clients.
Tweak your portfolios to make them more index-like.
Switch to growth or momentum investing.? If you can’t beat them, join them.

There will be a part 2 to this piece.? I will finish up and summarize there.

On Researching Industries

Posted on 22 June 201323 June 2013 by David Merkel

From a reader:

Hi David,

I’ve been a classic “bottom-up” investment advisor for a few years now, but I agree with your assessment that industries, in general, are under-analyzed by the masses.

What is the best way to learn about a particular industry? Are you aware of any comprehensive publication that sheds light on both the qualitative characteristics of an industry and the appropriate valuation methods?

Thanks!

There are several ways to learn industries.? I’ll try to explain:

1) You can choose a bunch of companies in an industry, email the investor relations area, and ask for packet equivalent to what they send buy-side analysts.? I’ve done that at various points in time for industries I wanted to learn.? Compare and contrast.? Who is doing well, badly and why?? In the mid-90s, I did this for the trucking industry, and learned a ton of information.? I also talked with some trucker friends of mine who gave me on the ground data.

2) You can read industry publications.? When I was a buy-side analyst for the insurance industry, I read those regularly.? They exist for almost every significant industry.

3) You can go to industry meetings.? Almost every industry has meetings where they discuss industry conditions.? Just don’t be too pushy in trying to get information.? Be interested in the industry as a whole, and don’t try to gain material nonpublic information.

4) Value Line & Morningstar both provide industry analyses.? So do most major investment banks.? You can review those and compare and contrast.

5) You can use the quality screen to look at what industries have a rising ratio of gross profits from operations, versus a falling ratio of gross profits from operations.? Here is a chart from the last seven years:

The colored field reading “Chg” is the difference between the average of years 1-3 and years 5-7.? Profits are noisy, that’s why I did an average.

Gross profits from operations as a fraction of assets [GP/A] is a good measure of the quality of an industry, and whether their sustainable competitive advantage is is improving or declining.

Now, when I look at a measure like that, I do one of two things:

I buy cheap companies with strong balance sheets among those industries where GP/A has fallen hard, and buy them, knowing that they are survivors, and will rebound.
I buy moderately strong companies in industries where GP/A has been improving, and after research, the trend is not well understood.? It helps if the industry is dull, and few people follow it.

That’s what I do.? Whatever you do, size it to your own abilities, or the abilities of your firm.? Beyond that, look at cheapness of a company relative to normalized earnings, i.e., average earnings over a full market cycle.