Value Investing – Page 53

Book Review: The Era of Uncertainty

Posted on 19 August 2011 by David Merkel

Many fundamental investors have been shaped by Peter Lynch.? Invest from the bottom up.? Analyze companies, not the economy. Time spent on analyzing the economy is wasted time.

This book takes the opposite approach.? If you understand the economy, and think you know how GDP growth and inflation will go, you have a better chance of choosing the right industries and outperforming.

Like my methods of investing, he looks to understand where we are in the business cycle.? After that, look for good companies that exploit the tailwind.

I became familiar with the main author in the mid-2000s, when he worked for ISI Group.? I appreciated his approach to the markets, which was similar to mine, as the bubble grew, and he and I warned about it.

Think of it this way.? If you had been reading the main author in mid-2006, and had listened to him, how much better off would you be now?? Considerably better off and I offer many warnings over at RealMoney.com before the crisis emerged.

The book will help you understand the sectors and factors in the market that affect returns, and what elements lead those returns.

Beyond that the book expresses skepticism over many of the current economic policies of the US and other governments amid the overindebtedness of much of the world.

At the end, rather than saying, “This is what you should do,” the book asks what your views are, and says if you believe in “such and so” as an economic future, this is what you ought to do.

I liked the book a lot.? I think it is of value to most fundamental investors.

Quibbles

None

Who would benefit from this book: Most fundamental investors could benefit from this book.? If you want to, you can buy it here:?The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Book Review: Expected Returns

Posted on 12 August 2011 by David Merkel

How do we estimate what returns are reasonable to expect?? Most investment counselors fall back on easy rules of thumb, but is there a way of doing better?

In this book, the author takes academic research on investment returns, and tries to make it practical.? What are the main findings of the book?

Momentum works.
Value works.
Illiquid assets can work very well if you have a balance sheet that can hold them.
Carry strategies work most of the time, but when they fail, they fail big.? Same for strategies that sell volatility.

The book does a very good job in establishing that the excess returns of stocks over bonds are a lot lower than most believe.? It also supports the idea that moderate risk taking is the superior strategy.? Those that take high risks lose too often.? Those who take no risk don’t make anything significant.? Moderate risk-taking is the sweet spot.

One of the strengths of the book is that it considers almost all assets, and analyzes how many factors affect those asset classes.? The book is comprehensive; it covers everything, even if it is only an inch deep in spots.

I liked this book a lot, but it’s not for everyone.? You won’t find a lot of difficult math here, but you will find a lot of numbers.

Quibbles

I don’t agree with the idea of levering up low risk assets.? Yes, if you are? the only one doing it, fine, be a non-regulated pseudo-bank.? The trouble comes when many do it.? Eventually a liquidity crisis hits, and those levering up low risk assets get hosed.

The same is true of university endowments.? Too many thought it was easy money to invest in illiquid assets, and when the liquidity panic came in 2008-2009, they were forced to borrow, and/or sell illiquid assets at an inopportune time.

The book does cover everything, but it doesn’t cover everything deeply.? I think it is a valuable book to most who do asset allocation, but the author knows his limits, and does not claim to be expert in a number of areas.

Who would benefit from this book: Fundamental investors who want to understand the factors behind return generation can benefit from this book.? If you want to, you can buy it here: Expected Returns: An Investor’s Guide to Harvesting Market Rewards (The Wiley Finance Series).

Full disclosure: The publisher sent me a copy of the book for free.

Book Review: Secrets in Plain Sight: Business & Investing Secrets of WARREN BUFFETT

Posted on 10 August 2011 by David Merkel

I consider myself a lesser light compared to many following Warren Buffett.? Yes, I am a value investor and an actuary, so I guess I have some punch in attempting to analyze the actions of one far greater than me.

The book is organized around two main trips that the author made to the Annual Meeting of Berkshire Hathaway, with some notes from the the 2011 tacked on.

This book tries to distill the ideas of Buffett into simple concepts, and largely succeeds.? It also alleges weaknesses? in Buffett’s reasoning.? Why not consolidate similar, less profitable businesses?? Why not invest a little more in existing businesses? I partially agree: I used to call Berkshire Hathaway “a grab bag of undermanaged businesses.”? But I’ve changed my mind, mostly.

The cost of doing the first of those could be considerable.? Buffett gets certain deals because the seller knows that he will leave the business alone.? The unique culture, friendships, family relationships will be maintained.? The seller doesn’t get top dollar, but he gets the satisfaction that he was true to those he worked with and served him.? Getting these businesses cheaply is a competitive advantage for Berkshire Hathaway, even if it means a certain amount of inefficiency.? Personally, I expect the next CEO or two will centralize the company, and turn it into a normal company.

As for investing more in existing businesses, all the manager has to do is put forth the case to his boss, Buffett.? Buffett will give him a quick decision.

But the author is right, in general, Buffett has not focused on organic growth.? He has acquired all of the businesses that the owns, aside from the reinsurance business.

This book has many strengths:

It recognizes that there is a cult following around Buffett.? He’s a bright guy, no doubt, but few questions get asked him by shareholders about his main duty, that of being CEO of Berkshire Hathaway.
It points out the significance of Charlie Munger, who got Buffett to think more broadly about value, served as a “Dr. No” to Buffett’s more optimistic demeanor.
It doesn’t spend a lot of time on Buffett as an investor in public equities, which has contributed much less to the growth of Berkshire than the acquisition of whole companies.
The demographics of Berkshire’s Annual Meeting are older and white, and in general, are the patient shareholders that Buffett likes.
Omaha is an unusual place for such a large company, but the isolation is a plus if you are trying to do something different.
Understands the basic safety rules of Buffett’s investing: margin of safety, patience, think like a businessman, simplicity, read a lot, be a good judge of character, think independently, get the big ideas right, the value of cash, don’t risk the firm, etc.
Notes the value of ethics at Berkshire, even when significant mistakes are made, like the handling of the David Sokol incident.? Reputation matters; you only get one reputation, and it affects all aspects of your business.

Quibbles

Berkshire is primarily an insurance company.? I would have spent more time on that.
I would have spent less time on non-business ethical issues, like abortion, religion, etc.? Buffett is no good guide there; he is merely justifying his past actions.
The bit about the Hoopa Indians was interesting, but when Buffett said, ?I agree that we will not exercise decisions except those ministerial in nature,? he was being very clear and simple.? Buffett is not a Christian, but he was raised in a Presbyterian household.? A minister is one who does things on behalf of another.? The issue is that there are 4 California hydroelectric plants that are old.? If the Federal government destroys them, it may help in salmon production, or farmers might like the extra water for their own use.? Buffett will simply do what the authorities want done if they are willing to pay to do it.? It is not his call in a regulated industry.
Buffett’s hypocrisy on taxation is not addressed.? He backs high estate taxes and high personal income taxes, but he doesn’t pay those.? The increase in his wealth though Berkshire, which does not pay a dividend is sheltered from tax, because he never sells a share.

Who would benefit from this book: Anyone who wants to invest better could benefit from it. At five bucks, it?s cheap. A Kindle application for my laptop was free with the purchase.? If you want to, you can buy it here: Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett, 2011 Edition (eBooks on Investing Series).

Full disclosure: I bought the e-book with my own money.

Take Prudent Risk

Posted on 4 August 2011 by David Merkel

This post is for average 401(k) investors.? I’m going to let you in on a secret that is not so secret, but does not get talked about much.? It’s a simple idea as well, and would be common sense, if sense were common.

401(k) investors tend not to change their allocations often, except to panic when things are going bad, or arrive late in bull market, and buy near the top.? In general, if you don’t have a lot of investment knowledge, it is good to come to a place where you “set it, and forget it.”? Remember, those with no experience are far more prone to the errors of fear and greed than most experts are.? Those arrive late to a rise or a fall in the market, and say, “Look what I have missed out on,” or ‘Look at how much I have lost,” are going to make the wrong move again and again.

There are temptations as an investor to not diversify.

“I’ll just hold all my assets in a money market fund.? I don’t want to lose anything.”? Money market funds preserve value at best.? They won’t help you build value.
“I’ll just hold all my assets in gold.? I don’t want to lose anything.”? Gold preserves value at best.? It won’t help you build value.
“This manager is the greatest.? I’m putting it all on him.”?? Sadly, managers have hot and cold streaks.? Many people join in near the end of hot streaks.? The quote I heard this from was a professional in 1999, deciding to invest all his money with Bill Miller.? Bad timing.
“Stocks win in the long run.? I am investing only in stocks.”? If you have a really long time horizon, and you are certain that your nation will not go through a revolution, or something close to it, that will work.? Otherwise, you are taking a risk.

There are more, but I think you get the point.? In most of life, those who do the best are the ones that take prudent risks.? Prudent risks are where the likely rewards outweighs the likely risks.

Think of it: in business, the guy who never takes risk does not do well.? The guy who takes huge risks blows up frequently, and does not do well on average.? The guy who takes moderate, prudent risks tends to do well.

The same is true of bond investing.? Those who invest in bonds of medium risk (BBB/Baa) tend to do best, those that play it safe or risk it all do less well.

The same is true of stock investing.? Stock investing is risky by nature, and in general, those who take less risk tend to earn better returns over time.? Ignore the canard: more risk, more return.? It ain’t so.

So what would I do if I were a 401(k) investor facing a limited menu of choices?

Put 60-70% in conservative, value-oriented stock funds. (US and Foreign)
And 25-35% in moderately risky bond funds. (US and Foreign)
And 5% in cash.
And rebalance yearly.? Do it after you complete your taxes, or something like that.

Avoid complexity.? Even if the plan offers a wide number of choices, winnow it down to a few funds, say five at most.? Over the long run, your investments should prosper, because you are doing things that few investors will do, and enjoy? returns from bearing risk successfully.

Where to Hide?

Posted on 27 July 2011 by David Merkel

We can’t rely on US Treasuries?? If so, what can you do to preserve purchasing power?? I will ignore a variety of exotic strategies/derivatives and focus on things that can be executed by individuals and small institutions.

The first idea that comes to mind is gold, silver and commodities.? Commodities don’t lie, they just sit there.? But the prices don’t just sit there.? They go up and down with demand and supply.? I’m not an expert there, so I would say keep positions small, enough for diversification relative to volatility.

Idea two is foreign debt of unquestionable solvency.? Well, that takes much of the world off the table, leading to investment in the developed fringe currencies — Canada, Australia, New Zealand, Norway, Sweden, and the Swiss Franc.? Toss in the Yen, though it isn’t fringe.? Not a very large group, and their currencies have run like mad.? Could they fall?? Imagine a US default, where aggregate demand drops across the world because the Treasuries in the banks of other nations are only worth 70% of face value.? Deflation would drive commodities and fringe currencies lower.

Idea three is an echo of two — buy the debts of emerging markets with more orthodox economics than the US, Eurozone, and China.? Nice, but their currencies are high as well.? Same problem as two.

Idea four is buy high quality equities that pay dividends.? There’s a plus and a minus here.? Minus: Equities are highly sensitive to confidence / trends in aggregate demand.? Plus: equities, if conservatively financed have positive optionality, subject to the same problem you have: what is a good store of purchasing power?

Even buying needed resources ahead might not work because demand conditions might be lower going forward.

Idea five is buying high quality non-Treasury domestic debt.? Along with ideas 2, 3 and 4, this seems to be Pimco’s strategy.? But our payments system is interconnected.? Any non-payment, or serious threat of non-payment will disrupt the ability and willingness of others to pay.

Idea six is stay in US Treasury debt — where else can you go?? You’ll get paid back eventually, with interest, most likely…? Hey, TIPS could work in an inflationary scenario.

Idea seven is hold physical US cash.? That should retain value of a sort until the debt ceiling situation is settled.

My main point is that there is nowhere to hide with certainty.? There are places to diversify into, and maybe you should consider some of them as part of a broader asset management strategy.? But avoid changes motivated by panic.? They almost never work.

In a debt-driven world, with fiat currencies, everything is confusing because there is no obvious store of value offering some small (but not near-zero) yield.? A small positive inflation adjusted return is healthy for savers, and good for the economy.? Let the Fed adjust its policy, and then the hiding place would be simple — CDs.

Cash Versus Valuations

Posted on 23 July 201123 July 2011 by David Merkel

From reading your blog, it isn’t clear whether you are a value investor or a valuation based investor. When you wrote that you would sell something only if you had a better opportunity, it sounds different from a traditional value investor (buy at a discount to fair value and sell when it approaches fair value, all assuming you can determine a fair value that the market is not properly recognizing). That is, perhaps you have x% in equities, split among a variety of holdings, and you are generally keeping an eye out for new opportunities, so that when a stock become really attractive, you will sell your least attractive (from a future returns perspective) holding in order to fund the new purchase.

Elsewhere, though, you wrote about the benefits of holding cash.

Perhaps you could write a post clarifying how these might relate. If you have cash, you don’t need to sell something (potentially good, or you wouldn’t have been holding it in the first place) in order to buy when a good opportunity comes along. When do you deploy cash (change the % of equity vs cash or bonds) rather than swapping equities? Or raise it? Do you have a macro view that governs when to increase/decrease your equity exposure? Or would you consider selling stock to “buy” cash (ultra short duration fixed income) as a “better investment opportunity”?

Are moves like this more selling driven (i.e. time to lighten up on equity, or this stock has gone up to a level of very low future returns)? Or are they buying driven (i.e. ABC is a great opportunity at this price, how should I pay for it? Cash or swapping out a position?)? Or is it just a complicated circumstance based mix?

Thanks for considering these issues.

ps I really appreciate the honesty and integrity you appear to bring both to your investing and your writing about investing.

pps Do you index at all? Or only hold individual securities?

This reader asks some interesting questions, and I want to give him some answers.

First, I am a value investor — I try to buy equities that have a margin of safety, with some potential for positive surprises.? I don’t buy securities where the balance sheet is weak.? But I have a more expansive view of value, because I am willing to buy into industries that have good growth prospects relative to their valuations.? In 2002, my biggest sector was technology.? Today, with big company technology so cheap, it is my third largest sector.

I do vary my stock holdings versus cash, but I limit my cash to 20% of my stock portfolio at maximum because I have been generally good at picking stocks over the years.? Cash is useful, but I try to vary it in proportion to valuations.

Take a look at my eight rules, they will tell you a lot.? One of my main ideas is that people aren’t good at making decisions when they have a big menu in front of them, but they are good at binary comparisons.? They can say, “This is better than that” with reasonable accuracy.

So most of the time, I do swap trades, trading things I like better for things I like less, much like a bond trader would.? When I am more bullish on the market, I add in an extra buy, and when I am bearish, I add in an extra sell.? But I stick with the essential idea of swap trades, because it forces the idea of the binary tradeoff.

That’s how I do it.? Now I wish it were working better for me over the last year, but I’m not worried because my methods have worked well for a long time.

PS — I never index.

Got Cash?

Posted on 29 June 2011 by David Merkel

Ecclesiastes 10:19 (NKJV)

A feast is made for laughter, And wine makes merry; But money answers everything.

There has been a small flurry of posts off of James Montier’s piece on the virtues of cash.? I wrote a piece like it recently (not as comprehensive, but possessing brevity): Chasing Your Tail Risk.

Like gold, cash is special because it doesn’t do anything.? Even money market funds do nothing, or almost nothing.? It just sits there, waiting.? It waits for the day when the Fed is forced to raise rates because inflation is running faster, even though the economy is still underemployed.? It waits for the day when bond yields rise and stock prices fall, where there are good opportunities to use the cash.

Having cash on hand allowed my church to buy a building cheaply in March 2009, and allowed me to help rescue a friends business, as well as buy some cheap stocks.? The same was true for me in October 2002, when I fully deployed my cash into stocks.

Cash is flexibility.

Cash says, “I don’t know.”

Cash says, “I don’t care.”

Cash says, “I’m ready.”

When opportunities are numerous, I am more than willing to part with my cash.? But when yields are low, and valuations are high if profit margins mean-revert, I would rather have more of a cash buffer.

For my account, and client accounts, I did buy some stock last week.? If the weakness had persisted, I would have bought more.

I still have an above average amount of cash (for me).? I am waiting for opportunities to get better before I deploy it.

Never Got Kodak

Posted on 29 June 2011 by David Merkel

I remember looking at Eastman Kodak a number of times over the last decade.? Often a few metrics would look cheap, but when I would look at the bevy of factors in the financials and consider the effects of technology, I could never get myself to be a buyer.? To me, it seemed to be the ultimate value trap — a modern buggy whip company.

That’s why the behavior of Bill Miller, a so-called value investor, was so surprising to me.? He had a saying, “lowest average cost wins,” but that implies that the stock will rise at some point.? For stocks that keep falling, the average cost does not matter.? And lest I seem to be boasting, I made the same mistake on Deerfield Capital.

But he did the same thing on Freddie Mac, though that was more dramatic.

The core idea of value investing is NOT “buy cheap,” (lowest average cost) but margin of safety.? My greatest mistakes in investing came from not seeking enough margin of safety.? Same for Bill Miller, though the effect on his track record was far greater.

Wait to Buy Berkshire Hathaway

Posted on 18 June 2011 by David Merkel

Catastrophes come in clumps.? Part of that is the correlatedness of weather.? When disasters are occurring, it may pay to wait until the season is near its end to buy reinsurers.? Who can tell what additional losses will arise in a year where losses are shaping up to be bad?

When there have been many tornadoes, and powerful ones, there are often many hurricanes, and powerful ones.? Wait to see if the hurricane season has some punch, and if it does, wait until October to buy BRK or other reinsurers.

If the season doesn’t have punch, start buying a little in late August or early September, and complete the job in October.

Don’t get me wrong, I like BRK, and would buy it at book value, or near it.? There are many other pure play reinsurers I might buy instead, if they survive the hurricane season.? They would have much more upside.? But in a really bad scenario, after the damage, BRK would be a low risk bet.? In 2005 as the last hurricanes were hitting, I urged my boss to buy BRK — they would be the last man standing in reinsurance.? And indeed BRK moved steadily up from there, without us.

BRK is much more than a reinsurer, but reinsurance will be the main focus for the next four months, so be aware…

Industry Ranks June 2011

Posted on 10 June 201110 June 2011 by David Merkel

I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and to a lesser extent Reinsurance, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word about reinsurance: I suspect this year will have yet more property catastrophes, particularly from hurricanes.? A lot of flexible capital has rolled into Bermuda over the last few months, so I would be disinclined to play too heavily there until late in the year.? There’s too many financial players that think there is easy money to be made in reinsurance after the recent spate of catastrophes, but that added capital is eliminating any hard pricing environment that might have emerged.? Maybe if they take losses later this year, capital won’t flow so freely for a while… I can dream.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.? The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I?m looking for undervalued and stable industries.? I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is pretty cyclical at present.? I will be very happy hanging out in dull stocks for a while.

That?s why I?m not digging through any red zone stocks this time.? I don?t see the value, especially if we have a slowdown globally, and/or in the US.? I don?t trust this economy.