Value Investing – Page 54

Post 1500, Post Launch

Posted on 25 May 2011 by David Merkel

Every 100 posts, I take a step back and try to think about where we have been over the last five months.? The investment world has been bullish, favoring stocks and commodities, and not bonds.? Money market rates have been driven to zero or so. (Have they tried to bill you yet for holding your money? 😉 )

I have a wide array of interests, which is what makes my blog a little different.? I’ve been doing more with stock and bond investing, which reflects the work that I do, but I still have time for commentary on Macroeconomics, banking regulation, and monetary policy.? I know that there are few who want to read everything I write, but there are many who want to read a few things I write.

The biggest things I have written recently have been:

Impossible Dream, Part 1 5,385 Views
Critical Analysis of Buffett?s Annual Letter 4,882 Views
Impossible Dream, Part 2 3,815 Views
Most People are not Better off Buying Common Stocks on their own 2,437 Views

That doesn’t count RSS and the many places where my blog is syndicated. I’m relatively free with my content.? But if you are reading me elsewhere, if you want to make a comment, please come to my site.? I do not interact with readers outside of my own site, and that includes Seeking Alpha.? I don’t have time for it, so if you want my attention, come to my site.

Away from blogging, my asset management business has launched.? let me quote from an e-mail to a more successful friend of mine:

I have had a lot of lessons over the past four months, and I don?t think they are over.

1) Unrealistic expectations: partly because there was quite a lag between my announcement and my start up, a lot of people that I think lost interest because of the lag.? But when I talked with other investment advisors later, they told me I had:

More prospects than I should reasonably expect for a new advisor, and

A better conversion percentage of prospects to clients than most, and

Chosen an underserved section of the market ($100-500K).

So, after four months, I am managing a little more money than my own assets at the firm, with about 12 clients, and 5 more on the way.

2) I did not realize that I would need to create fixed income management so early.? But for those that can?t hedge, I had to have another way of reducing equity market risk.? No track record there, but a lot of experience doing it, both with bonds and ETFs.

3) The most common objection of potential customers is that the market is too high, and so they don?t want to invest.? Still more asked for a Tactical Asset Allocation strategy, which I eventually created.? No telling whether it will work well, or build assets.

4) Custodial issues have not been absent.? Getting set up with Interactive Brokers is more difficult than with most because everything is automated; if one thing is wrong, it rejects and you have to try again.? Once Interactive Brokers is set up though, things work easily, the trading tools are great, and they are cheap, especially for clients in $100-500K range.? So I try to help clients as much as I can going in; so far, so good, with a little annoyance to me and clients.

Aside from that, I have been underperforming of late.? Not by much, but it feels bad to be missing the benchmark with the money of others.? I did not enter this business to lose.? After beating for so many years, it is a test to be missing now, largely because my posture is the most conservative it has been for the last eleven years.Anyway, that?s how I am doing.? I think I will reach viability by the end of 2012, but who can tell?

Indeed who can tell, but I got another new client today, equal to my largest external client, and there may be more if I do well.? I am grateful for their confidence.? Hey, perhaps one day I might get investors larger than me.? I hope so.? If I get to double my current size, I will try to hit up the emerging manager funds — there aren’t many emerging managers with 11 year track records.? And from there, who can tell?

I have an intern (child #7) and she is a very bright young woman who wants to learn investing.? She may have the “gene” that I got from my mom, but she sees this as the best way to be economically productive as a future wife and mother.? My Mom and Dad were equals economically, though Dad’s work made more difference early with his work — Mom earned more in the later years from the investing.? Give Mom credit for wisdom, and Dad credit for setting her free to do it (more or less).

I am enjoying this a lot, and am not worried about recent underperformance.? It has always corrected in the past, and then some.? If nothing else, it makes me work harder.? I like working hard.

Book Review: The Ivy Portfolio

Posted on 11 May 2011 by David Merkel

This is an unusual book, and a good book.? Unlike the book, “Outperform,” which reviews lesser known endowments, and endowment investing generally, this book reviews the Harvard and Yale endowments, which up until 2008, the year before the book was published, were among the best in terms of performance.

But this book is more than that.? It goes through the strategies of the major endowments, and looks for ways that average people can try to replicate the results.

But average investors don’t have the same set of investments available to them as the large endowments do.? If you aren’t a qualified investor who has access to the full range of investments ordinary mortals are denied — private limited partnerships (hedge? funds, private equity, commodity funds, etc), what can you do?? This book discloses investments that are similar if not equivalent, and versions that are lower cost through ETFs.

After that, the book takes a direction that would initially seem different than endowment investing.? It discusses trend following, which endowments do not in general use as a strategy.? Now, some hedge funds use it, but few endowments actively embrace it.? The book shows how return can be enhanced and volatility reduced by buying investments that are over their 200-day, or 10-month moving averages.? From my own research I can partially validate the approach.? It is a clever way of implementing a form of momentum investing, which may be a cheap way for average investors to mimic hedge funds who follow trends.

Then mimicry moves to a new level as the book goes through the basics of mining data out of 13F filings, where large investors file their long investments with the SEC.? Guess what?? Imitating bright people can help an investor beat the market — it can allow a bright person to mimic the long side of equity investing on the cheap, but with a lot of data analysis (or you can pay up for Alphaclone).

In one sense, the book seems like two books — one on endowment investing, and another on tools for clever investing available to average investors.? My way of reconciling the two is that the authors are clever guys who are trying to give their best ideas to retail investors so that they can do as well as sophisticated institutional investors who have a wider array of investments to choose from.? The retail investors don’t have the same array of investments to choose from, but they have the advantage of flexibility that institutions don’t and can more quickly trade out of investments that may be on the way to underperformance via trend-following.

And so with much effort, if you apply their ideas, you have the potential of doing as well in investing as the major endowments.? Or, absorb one of their passive strategies with little effort, and maybe you will do as well.? Strategies that have done well in the past may not do so in the future.

But on the whole, I heartily recommend this book.? There is a lot for investors of all types to learn from it.

Quibbles

Those reading the book should also read my essay, “Alternative Investments, Illiquidity, and Endowment Management. (Google it if there is no link)”? Taking on illiquidity is not a free lunch.? It can impose real costs when there is a need for cash among those endowed.? Personally, I think that ten years from now, illiquid investments will only be taken on by those that can lock them away.

Who would benefit from this book:

Those wanting to potentially mimic the high returns of the Harvard and Yale endowments could benefit from the book, but realize that a lot of the past is an accident, and that it might be difficult to achieve high returns in the future from strategies that worked in the past.? That said, the authors have offered strategies that take some degree of work to apply, so there may be barriers to entry for applying some of the strategies.

If you want to, you can buy it here: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.

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.

Why Amateurs Should Invest in Common Stocks

Posted on 5 May 20115 May 2011 by David Merkel

There is a benefit to investing directly in common stocks as an individual.? I’ll let Buffett help me explain this:

?I am a better investor because I am a businessman and I am a better businessman because I am an investor.?

My own life is one of having been an amateur investor, and became a professional investor over time.? My mother is an excellent amateur investor, one whose record would put 90%+ of professionals to shame.? I know some great amateur investors, but they are not the norm.? If they were the norm, we would not have lots of financial intermediaries trolling for business.

After yesterday’s piece, I want to say that though most amateur investors do not beat index funds, there is still one big reason to buy individual common stocks: it can make you a better businessman.

As an example, I had? never worked in a marketing department in my life, but because of my investing, and study of marketing on the side, I was able to lead a revamp of a marketing department, leading to a threefold increase in sales in five years.? Return on equity went from 10% to 50%, aided by the booming stock market of the ’90s, but that was only a help.

Technical specialists have to ask, “Do I want to remain a technical specialist, assuming that I have that option, or do I want to broaden my skill set and learn the economics of the business that I serve?”? Those that invest in stocks, and study them carefully learn practical economics.? You may earn money or you may not.? You may beat the market or you may not.? But you will become a more valuable employee, because you will grasp more and more about what makes your company tick economically.

I can tell you that while I was in insurance, the brightest move I made was investing in stocks privately, and studying equity and bond investment intensively.? It made me more valuable to my bosses, and helped me understand my own company better.? It made me better in interviews as well.? Questions that were designed to see if I could think beyond my narrow specialty became easier for me.

Now, some of the successes came with failures.? For a while, I told my kids never to mention the name “Caldor” to me.? Yeh, Michael Price may have lost a billion on that one, but I more than took my licks.? Until you lose a decent amount, you don’t really understand how the market works.? You can call it market tuition, but like tuition at college, you don’t know how much value you will get out of what you have paid.

I encourage new investors to paper-trade.? I did that when I was young.? It allows you to experiment and learn about what you think works in the market, without consequences.? I think it helps ease the transition into investing.? When you start investing, your emotions will be a lot higher, but it helps a lot to have a guiding theory going into it, it helps control the emotions that will come.? It took me 5-10 years to discipline my emotions, and think about markets rationally, not emotionally.

So, there are benefits to investing in individual common stocks, but they may not be the ones you expected.? It will help you understand your business better, your industry better, and perhaps even your nation and the world.

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But, this is not to say that if you act as a bettor, rather than an investor, that you will benefit.? Think of Buffett’s quote above — business and investing go together.? Inside a corporation, one of the highest levels of what is done is the investing.? Buffett looks for businesses that will throw off gross profits well in excess of financing costs — that is different than most investors think, because Buffett is a businessman.

For budding businessmen, you could ask where business value is growing the most rapidly relative to the price that you pay — Earnings relative to price helps but there are sometimes aspects of businesses where growth in value does not reflect in the earnings statement.

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And, all of this is not to say that professionals do better than amateurs.? Professionals don’t do well, and they add on fees.

There is one area where professionals seem to do better, but I could be wrong.? If I am wrong, could someone send me some research?? As I pointed out yesterday, amateur investors tend to become greedy and fearful at the wrong times.? Professionals seem to be less prone to this problem, perhaps because of discipline.

As Baruch commented at my blog:

I think it is also something you can learn, because so much of investing skill is not innate, in my opinion, rather it really comes from an attitude, and an act of will. Discipline comes from will. The rest comes from a basic knowledge of accounting, markets and finance which anyone with a university education is capable of grasping. A lot of people without a university education are as well.

To which I will agree — it’s not that you need a high IQ, but a lot of general learning, wisdom on accounting, markets, and finance, and common sense.? Read stuff by Charlie Munger, the man is under-rated in the shadow of Buffett, but at least he has written? a book.? Would that Buffett would do the same.? There are many that interpret him, but I would like to hear how he views investments in theory in full, so that the rest of us could benefit.? In many ways he has surpassed his teachers, Ben Graham and Phil Fisher.

So Warren, could you give us the 21st century version of “The Intelligent Investor?”? That could be an invaluable legacy that many would thank you for, as much as they do for Ben Graham today.

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Final note — if you invest in common stocks, it is likely you will underperform the major averages until you gain wisdom and discipline.

Most People are not Better off Buying Common Stocks on their own

Posted on 4 May 2011 by David Merkel

Human nature is not changeable.? If people do significantly less well managing defined contribution assets on average than a comparable index fund, then they should not be managing their own assets, much less concentrating into a small number of stocks.? I don’t care what Baruch says (whoever he is), or what my friend Josh says.? Markets are complex, and investing is hard, not easy.

Just as I believe that most people don’t have the capacity to run their own businesses, the same is true of investing.? Both require a lot of discipline, and most people do not have a lot of discipline.

It takes time to learn how to analyze investments.? I think of people taking the CFA courses/exams, and I say to myself, “”Yes, better than nothing, but we need practical experience to truly train them.”

As an aside, when I went to take CFA exam level one, a few younger people snickered at me and said, “Who’s the old guy?”?? (Note: I was 34 at the time; the beard probably didn’t help, and I sometimes let it grow longish back then.)? I turned to them and said, “I am an actuary.? I have already been through a set of ten-plus exams far more difficult than the CFA exams.? I am skilled in compound interest, accounting, statistics, economics, modern portfolio theory, and mathematics to a degree that AIMR does not consider. I am battle-tested in exams more difficult than this, where we had to read far more, and wonder whether we would be tested on minutiae such that AIMR would never consider for CFA candidates.? Further, I have lived under an ethics code for ten years, so I get the AIMR code.? Do you get it?”? After an uncomfortable silence they looked away, and I did too.

My portfolios are concentrated by industry, but diversified within industries.? I have worked hard at my theories for around 18 years now, with my current strategy running for 10+ years.

It is not easy to do well in investing.? First, you may not understand the basics of valuation.? Second, you may not understand what factors can drive stock prices.? Third, you may not understand how industries move a groups.? Fourth, you may not understand how changes in the economy may affect your investments.? ANd there is more.

What’s that, you say?? You don’t need to know those things because you can read a chart?? Okay, good.? Momentum tends to work, but chart-reading after momentum may not work.? Yes, things that have gone up tend to go up further, because of disbelief among investors.? Here’s the test — how often have you made money buying negative momentum, or selling positive momentum?? My guess is that momentum incorporates most of technical analysis, and that most of the detailed technical analysis ideas are empty.? Test: show your technical analysis idea to technicians of a different flavor, and see what they say.? It’s like Evolution versus Special Creation — Evolutionists trash Creationism, but they don’t agree among themselves to any significant degree.? There are few, if any ideas, that all Evolutionists agree on except the negative, “Not Creation.”? (I had a more offensive version using Canadians and Americans.? I passed.)

I incorporate momentum into my fundamental investing.? It helps to erase the problem of value investors always being early.

Most people that I have known that have ventured into individual stocks gave up because they lost money, or didn’t make much money.? Skilled amateur investors are few.? This is my razor: if they can’t manage owning an S&P 500 index fund, what makes us think that they can manage a more volatile portfolio of common stocks?

The Jeans for the Scene — In, Out, or Ob?

Posted on 29 April 2011 by David Merkel

I was minding my own business, doing research when I saw an ad that showed a back view of a woman in very tight jeans, with the text: “If you think I?m hot you should see this stock! OBJE”

Remember my rule, “Don’t buy what someone wants to sell you.? Buy what you have researched for yourself.”? It is true with physical objects, but even more true where the goods are immaterial, and quality cannot be easily verified, as with stocks.? So when I hear a pitch for a stock through advertising, I am immediately skeptical.

Now, I am not the first to the scene here, partially because I delayed. 24/7 Wall Street noted that OBJE has a going concern problem.? Good job, Doug.

But there is more: where is the company located?? In a residence in Florida.? Not much for a company with a market cap of 30MM+.? But what else is located there?? These businesses:

Quite a lot to be going on in one residence.? But wait, the woman who lives there, who was a crucial part of OBJE’s strategies has been let go by OBJE.? Curious, huh?

Now the current CEO, Robert Federowicz has done many things, but nothing worthy of being a CEO of a small public company.

He previously served as Chief Information Officer of a start-up international power development company and as government affairs liaison for an international power company. From 2005 to 2009, Mr. Federowicz was an Owner and Operator of a fitness gym in Houston, Texas. During 2010, he served as an Account executive for Screentek, Inc., a seller of LCD screen technology for laptop computers.

Of course the company has press releases touting its non-existent products.? And there are penny stock touts that pick up the furor.? Just because a stock has a low price does not make it a buy.

Then there is the investor relations page at their website.? No credible company lays on the “buy us” mantra so thick.

That leaves us with the hard data.? Let me start with the opening lines from the risk disclosures in the 10K:

BECAUSE WE HAVE NOT PRODUCED A SAMPLE OF OUR OBSCENE BRAND JEANS AND COMPLIMENTED PRODUCTS, THESE PRODUCTS, MAY NOT WORK OR FIT PROPERLY AND/OR THE PRODUCTION COST CAN EXCEED EXPECTATIONS

OUR LACK OF AN OPERATING HISTORY GIVES NO ASSURANCE THAT OUR FUTURE OPERATIONS WILL RESULT IN PROFITABLE REVENUES, WHICH COULD RESULT IN THE SUSPENSION OR END OF OUR OPERATIONS

WE ARE A NEW COMPANY WITH NO OPERATING HISTORY AND WE FACE A HIGH RISK OF BUSINESS FAILURE WHICH WOULD RESULT IN THE LOSS OF YOUR INVESTMENT

As of the date of this prospectus, we have earned no revenue. Failure to generate revenue will cause us to go out of business, which could result in the complete loss of your investment.

BECAUSE OUR CURRENT OFFICER AND DIRECTOR DOES NOT HAVE SIGNIFICANT EXPERIENCE IN STARTING A JEANS PRODUCTS COMPANY AND WE LACK CUSTOMERS AND SUPPLIERS, OUR BUSINESS HAS A HIGHER RISK OF FAILURE

BECAUSE WE ARE SMALL AND DO NOT HAVE MUCH CAPITAL, WE MUST LIMIT OUR MARKETING ACTIVITIES. AS A RESULT, OUR SALES MAY NOT BE ENOUGH TO OPERATE PROFITABLY. IF WE DO NOT MAKE A PROFIT, WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS

OUR PRODUCTS MAY NOT FIND ACCEPTANCE FOR OUR PRODUCTS IN HIGH END BOUTIQUES AND DEPARTMENT STORES.

OUR OPERATING RESULTS MAY PROVE UNPREDICTABLE WHICH COULD NEGATIVELY AFFECT OUR PROFIT

OUR SOLE OFFICER AND DIRECTOR MAY NOT BE IN A POSITION TO DEVOTE A MAJORITY OF HER TIME TO OUR OPERATIONS, WHICH MAY RESULT IN PERIODIC INTERRUPTIONS AND EVEN BUSINESS FAILURE

(and she has been let go)

KEY MANAGEMENT PERSONNEL MAY LEAVE THE COMPANY WHICH COULD ADVERSELY AFFECT THE ABILITY OF THE COMPANY TO CONTINUE OPERATIONS

IF OUR COMPANY IS DISSOLVED, IT IS UNLIKELY THAT THERE WILL BE SUFFICIENT ASSETS REMAINING TO DISTRIBUTE TO OUR SHAREHOLDERS

IF WE ARE UNABLE TO GAIN ANY SIGNIFICANT MARKET ACCEPTANCE FOR OUR PRODUCTS OR ESTABLISH A SIGNIFICANT MARKET PRESENCE, WE MAY BE UNABLE TO GENERATE SUFFICIENT REVENUE TO CONTINUE OUR BUSINESS

MANAGEMENT’S ABILITY TO IMPLEMENT THE BUSINESS STRATEGY MAY BE SLOWER THAN EXPECTED AND WE MAY BE UNABLE TO GENERATE A PROFIT

IF WE ARE UNABLE TO MANAGE OUR FUTURE GROWTH OUR BUSINESS COULD BE HARMED

OUR PRODUCT MAY NOT BE ABLE TO DISTINGUISH ITSELF IN THE MARKET AND WE MAY BE UNABLE TO ATTRACT ENOUGH CUSTOMERS TO OPERATE PROFITABLY, WITHOUT A PROFIT WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS

WE MAY BE UNABLE TO MAKE NECESSARY ARRANGEMENTS AT ACCEPTABLE COST, WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS ENTIRELY WHICH COULD RESULT IN A TOTAL LOSS OF YOUR INVESTMENT.

COMPETITORS MAY ENTER THIS SECTOR WITH SUPERIOR PRODUCTS, INFRINGING OUR CUSTOMER BASE, AND AFFECTING OUR BUSINESS ADVERSELY.

SINCE OUR SOLE OFFICER AND DIRECTOR CURRENTLY OWNS 100% OF THE OUTSTANDING COMMON STOCK, INVESTORS MAY FIND THAT HER DECISIONS ARE CONTRARY TO THEIR INTERESTS YOU SHOULD NOT PURCHASE SHARES UNLESS YOU ARE WILLING TO ENTRUST ALL ASPECTS OF MANAGEMENT TO OUR SOLE OFFICER AND DIRECTOR, OR HER SUCCESSORS

Notable, because she was let go with little fanfare, aside from an 8K.

THERE IS SUBSTANTIAL UNCERTAINTY ABOUT OUR ABILITY TO CONTINUE OUR OPERATIONS AS A GOING CONCERN

THE ENACTMENT OF THE SARBANES-OXLEY ACT MAY MAKE IT MORE DIFFICULT FOR US TO RETAIN OR ATTRACT OFFICERS AND DIRECTORS, WHICH COULD INCREASE OUR OPERATING COSTS OR PREVENT US FROM BECOMING PROFITABLE.

SINCE WE ANTICIPATES OPERATING EXPENSES WILL INCREASE PRIOR TO EARNING REVENUE, WE MAY NEVER ACHIEVE PROFITABILITY

IF WE CANNOT SECURE ADDITIONAL CAPITAL, OR IF AVAILABLE CAPITAL IS TOO EXPENSIVE, OUR BUSINESS WILL FAIL.

WE DO NOT HAVE SUFFICIENT CAPITAL TO CONTINUE MAINTAINING OUR REPORTING STATUS.

What do you see when you review the most recent 10K and 10Q?? They are starving for liquidity, and have negative earnings and a negative net worth.? This is not a recipe for success.

This would have been obvious from the share offering as well, which was done at far lower prices.

If I worked for the SEC, I would ask this question — who was willing to buy the shares after the offering, creating prices that would deceive others?? Answering that question could reveal networks that cheat.

Regarding David Sokol, Part 3

Posted on 28 April 2011 by David Merkel

I would like to start this with the public counterarguments from Sokol’s attorney:

I am profoundly disappointed that the Audit Committee of Berkshire Hathaway would authorize the issuance of its report to the public without the care and decency to ask even a single question of Mr. Sokol. Mr. Sokol had been associated with the Berkshire Hathaway companies for 11 years. During this time, his indefatigable efforts helped create enormous value for the Berkshire shareholders. He deserved better. While I take issue with much of the Committee?s report, I briefly make the following points. If the Audit Committee had asked, it would have learned that:

Mr. Sokol had been studying Lubrizol for personal investment since the summer of 2010; such investments are specifically allowed by his employment agreement.

Mr. Buffett was told twice, not once, about Mr. Sokol?s ownership of Lubrizol stock before Mr. Buffett engaged in any discussions with Lubrizol.

Contrary to the Audit Committee?s statement, Mr. Sokol?s Lubrizol shares were not acquired pursuant to a ?100,000 limit order.? Rather, they were purchased as a result of several limit orders, over a period of days, at specified prices, for the day only, in order to acquire the stock at low prices. At that time, Mr. Sokol had no reason to anticipate that Mr. Buffett would have any interest whatsoever in Lubrizol.

I have known Mr. Sokol and have represented his companies in business litigation since the mid 1980s. I know him to be a man of uncommon rectitude and probity. He would not, and did not, trade improperly, nor did he violate any fair reading of the Berkshire Hathaway policies.

Okay, let’s take the three points in order:

1) Yes, Sokol may have looked at Lubrizol prior to December 2010, but he only chose to invest in Lubrizol in December 2010.? Personal investments might be allowed by his employment agreement, but not those where BRK might have an economic interest, at least not without full disclosure to the relevant powers inside BRK.? Remember, though Buffett acts as a sort of King inside BRK, even he is subject to the corporation and the committees set up by the board.

2) And that is relevant to Sokol telling Buffett twice, something that was already known.? Buffett is not the head of compliance.? Sokol needed to give full disclosure to the CFO and the Audit Committee

As the audit committee wrote:

?All actual and anticipated securities transactions of Berkshire and its subsidiaries that have not been publicly disclosed should be considered material.?

?Other public companies to which this prohibition is applicable include those that may be involved in a significant transaction with Berkshire. . . .?

?If a . . . Covered Employee is aware that Berkshire has taken or altered a position in a public company?s securities or that Berkshire is actively considering such action, trading in any securities of such public company ... [trading in the securities] is expressly prohibited prior to the public disclosure by Berkshire of its actions . . . (or until the [employee] becomes aware that Berkshire did not take and is no longer actively considering such action).?

and wrote again:

?Covered Parties who have access to confidential information are not permitted to use or share that information for stock trading purposes or for any other purpose except the conduct of the Company?s business.?

?Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company.?

And further wrote:

All of these internal policies are underscored by the law of Delaware, where Berkshire Hathaway is incorporated. Under Delaware law, corporate representatives owe their company a duty of loyalty. The duty of loyalty includes? a duty of candor, which requires them to disclose to the corporation all material facts concerning corporate decisions, especially decisions from which they might derive a personal benefit. Mr. Sokol?s actions did not satisfy the duty of full disclosure inherent in the Berkshire Hathaway policies and mandated by state law. His remark to Mr. Buffett in January, revealing only that he owned some Lubrizol stock, did not tell Mr. Buffett what he needed to know. In the context of Mr. Buffett?s question how Mr. Sokol came to know Lubrizol, its effect was to mislead: it implied that Mr. Sokol owned the stock before he began considering Lubrizol as an acquisition candidate, when the truth was the reverse. A candid disclosure would have revealed the timing and size of the purchases, and the communications with Citi concerning obtaining a meeting to mutually explore interest in a potential acquisition that had preceded them. Knowledge of those facts would likely have prompted further questions by Mr. Buffett and could have allowed Berkshire Hathaway to evaluate measures that could have been taken to alleviate the problem before negotiations proceeded with Lubrizol.

Mr. Sokol?s answer to Berkshire Hathaway?s CFO, Mr. Hamburg, concerning the investment bankers similarly fell short of the degree of candor required of a corporate fiduciary, and suggests his answer to Mr. Buffett?s earlier inquiry noted above was intended to deceive.

The main idea here, as I have written about before, is that Sokol owed a duty to BRK as an employee.? Could he buy stocks of companies, as specified by his employment agreement?? Sure, but within limits which he violated.? BRK deserved the initial benefits of his work, when the data was intended for BRK and not for Sokol.

3) That the orders were not 100,000 share limit orders is not relevant to the case at hand.? Mr. Sokol, if your attorney is making such bogus arguments, either you have a really bad case, and should compromise, or you need a better attorney.

As I commented to the excellent Colin Barr, in his early piece on the topic:

I don’t think we need a new law here. If Buffett wants, he has grounds for a tort against Sokol on his misappropriation of data that rightfully belonged to BRK. I suspect Warren will just let it slip — Sokol did a lot of good for BRK, and Buffett has loyalty to managers generally. At least, that’s how it seems today. His ruthlessness for the reputation of BRK is subordinate it seems to his loyalty.

Which leaves any complaints that shareholders might have against BRK. Now, those complaints are not against Sokol, but against Buffett and his management team’s oversight of Sokol and his activities.

So, let’s be careful here. BRK is a conglomerate that owns insurers, and not an asset manager per se. The SEC and other regulators probably do not have something actionable here. But the two actions that I mentioned above could be taken in the civil courts, should Buffett or a group of shareholders decide to pursue those remedies.

Well, now we have a court case against BRK and the possibility of BRK proceeding against Sokol.? Both of my tort remedies might happen.

But What About Buffett?

I think Warren Buffett can defuse most of his troubles through a heartfelt apology at his annual meeting.? Something like, “Yes, I blundered.? I should have asked Sokol for details, but I was rushed that day.? I still firmly believe in the ethics that I have promulgated for BRK, but I slipped in not enforcing them as best I could.? I gave him the benefit of the doubt, because he was so valuable to us, and I should not have done that.”? And before that, go to those suing BRK and seek a resolution.? Your reputation would prevail, Warren.

Look, I try to be an ethical guy, but I make mistakes also.? The greater error as to deny guilt/fault when it is obvious to many.? I have confessed fault freely during the times I have blown it, and have ended up stronger for it.? Warren, the same would be true for you.? People will forgive you if you accept your responsibility in the matter.

Remedies

This is not the end of the Audit Committee?s work. Still under way are:

Work with Company management and legal counsel to identify and implement lessons learned from these events, including possible enhancements to its procedures.
Cooperation with any government investigations relating to this matter, and monitoring any developments that may emerge from them.
Consideration by the Board, or the Audit Committee, or such other committee as the Board may think appropriate, of possible legal action against Mr. Sokol to recover any damage the Company has sustained, or his trading profits, or both, and of whether the Company is obligated to advance Mr. Sokol?s legal fees associated with proceedings in which he is named.

They may go after Sokol.? The damages are far greater than the gain of $3 million on the takeover.? As Buffett said he cannot afford to lose any of his firm’s reputation.? Now may Buffett heed his own advice.

Book Review: The Financial Numbers Game

Posted on 25 April 201126 April 2011 by David Merkel

I think that accounting quality is the single most neglected area of investing.? There are few that spend time trying to analyze whether the financial statements are fairly presented.? For value investors like me, that can be the difference between a value investment and a value trap.

Accrual entries on the balance sheet can be true or false, but cash rarely lies.

Are the accounts truly receivable?
Will the inventories sell?
What is the property, plant and equipment truly worth?
Do the goodwill and intangibles have any value?
What are the revenue recognition policies?
Some expenses can be capitalized as assets because of cash flows that are expected in the future.? How reasonable is that expectation?

And with financial companies, the questions are different — what are the nature of the cash flows promised and purchased?? Tough questions for anyone to answer, but at least the questions point us in the correct direction.

There are also the gambits to distract us from whether value is being created or not.? Operating earnings are not wrong, but many companies abuse the concept.? The idea should be to estimate what earnings are repeatable in future quarters/years.

There is a lot to chew on in this book, but it all boils down to:

1) What do we allow to be accrued for cash flows in the future?

2) How do we adjust those accruals as events change?

This is a great book — worthy of being in every person’s library.

Quibbles

None.

Who would benefit from this book:

All individual and institutional investors would benefit from this book, bar none.

If you want to, you can buy it here: The Financial Numbers Game: Detecting Creative Accounting Practices.

Full disclosure: I bought this book with my own money.

When Everything is Strong, Redux

Posted on 23 April 201124 April 2011 by David Merkel

It has been a long day, but I want to add one note to Thursday night’s piece: I would not sell the market immediately.? The summary of my recent research is that market moves from undervalued to overvalued, to more overvalued.? At more overvalued, momentum of the market slows down.? This is the time to exit before the correction occurs.? Momentum is still strong enough, but when momentum gets average when valuations are high like today, it would be a time to exit.? We are not there yet.

As for what is weak, there is housing.? Dark supply.? Many investments in housing are pre-planned losses.? Probably better to be in money market funds.

Gains and losses are not purely random, they tend to streak.? Here’s my stylized view of how an equity/credit cycle works:

After a washout, valuations are low and momentum is lousy.? People/Institutions are scared to death of equities and any instruments with credit exposure.? Only rebalancers and and deep value players are buying here.? There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks.? Liquidity is at a premium.
But eventually momentum flattens, and yield spreads for the survivors begin to tighten.? Equities may have rallied some, but the move is widely disbelieved.? This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.
Slowly, but persistently the equity market rallies.? Momentum is strong.? The credit markets are quicker, with spreads tightening to normal-ish levels.? Bit-by-bit valuations rise until the markets are fairly valued.
Momentum remains strong.? Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures.? Liquidity is cheap, and only rebalancers are selling. ?(This is where we are now.)
The market continues to rise, but before the peak, momentum flattens, and the market meanders.? Credit spreads remain tight, but are edgy, and maybe a little volatile.? This is usually a good time to sell.? Remember, tops are often a process.
Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue.? Some think that the problem is an isolated one, but search begins for where there is additional weakness.? Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high.? A few institutions and investors fail who you wouldn’t have expected.? Momentum is lousy.? We are back to part 1 of the cycle.? Remember, bottoms are often an event.

You could call part 4 of my stylized cycle “borrowed time.” But it is borrowed time that can last a long time.? At the end of the bull cycle, the equity market catches up to the credit market, creating a situation where the valuation of the equity can no longer be sustained by further increases in leverage (part 5 leading to part 6).

Note to readers

I will be sending part 1 of my Impossible Dream research to clients this coming week.? In the next week, those that have asked for the research will get part 1, and clients will get part 2.? The week after that, those that have asked for the research will get part 2, and I will publish part 1.? The week after that, I will publish part 2.

When I was a corporate bond manager, I was relatively open about my ideas, because I knew that imitation was a lot more difficult than it seemed.? That is still true now.? But out of honor to my clients, they get the first look, and requesters get second look, and casual readers get third look.

When I was Young

Posted on 18 April 2011 by David Merkel

I can’t place it, but when I was 5 years old or so, sometime in 1966, my Mom showed me The Milwaukee Journal, and pointed me to an entry for Litton Industries preferred stock.? She told me that I owned some shares of the stock, and that it was good for me if the stock went up, and bad if it went down.? This was repeated two years later with shares of Magnavox common stock.

Both ended up being large losses, and I puzzled about it when I was young.? It did not dent my confidence in the markets because my Mom was such a good investor, looking for? growth at a reasonable price.? And to me, 10-18 years old, watching Wall Street Week with Louis Rukeyser on Friday nights, I gained insights into the markets, and began to appreciate the wisdom of my mother.? The 70s were a tough time to gain a love for the markets, but I played around with paper portfolios until 1982, when I did my last paper portfolio, before heading of to grad school.? (Value Line helped — if you have time, curl up with it and look for neglected companies that offer promise.)

Before that, I took one of my Mom’s former favorite stocks which had dipped, James River, and used it in a class at Johns Hopkins, and made a case that an acquisitive paper company could be a good investment.? My case was good to my professor, Carl Christ, “I never heard of this corporation before, what a great company.”? And my Mom, who had sold out of the company, reconsidered and bought again at a lower price, making money until the firm itself was bought out.? (Hey, gotta help with the tuition.)

The paper portfolio that I created in August of 1982 proved to be fun for my students when I was a TA at UC-Davis in Corporate Financial Management.? I mentioned the portfolio in class, and a subset of students asked to see it.? By the time the class ended, the market was up 20%, but the portfolio was up 40%.? By this time the professor had heard about it, and he said, “Oh, you have a portfolio with a beta of two.”? I tried to explain to him that the beta estimates of the portfolio were much lower than that, and that I had “bought” the names cheaply.? but to no avail… once the religion of efficient markets takes hold, no amount of? facts will prevail.

Then there was the Value Line contest around 1984-1985, where I was in the top 1%, but missed the top 25.? I used the top 100 from Value Line (Timeliness Rank 1), but screened them for value in their volatility buckets, as the contest went.? To this day, I think that stockpicking contest was the best ever designed.? If I ever get wealthy, I want to do a series of such contests, using the same principles.

After that, I married my wonderful wife Ruth, and began investing for real, first with mutual funds, and then with individual stocks.? But I failed to follow through in one way — I bought penny stocks through a “bucket shop” and lost a moderate amount of money, which fortunately was dwarfed by the purchase of a home in Davis, CA at just the right time, such that two years later when we had to leave for a new job (AIG), we had made 4x our capital, net of CA taxes.

Then my Mom gave me a copy of Ben Graham’s “The Intelligent Investor,” and my life changed again.? I spent the next seven years analyzing small company value stocks in the midst of a market that favored large caps, and growth.? Still, my picks were good, and kept up with the S&P 500 (beating the Russell 2000 Value by 5% per year).

I appreciate the past, and use the lessons for growth today.? Mom, she keeps investing well, though she has more of a desire for yield today.

Today I think my best skills are company and industry analysis.? Yes, I am a quant, and can design clever ways to outperform the market with some probability, but prefer my own insights to mathematical likelihoods.

As for what I wrote yesterday, I prefer my own stock investing to moving between equity and debt markets, because my alpha exceeds that of the switching strategy, at least for now.? Volatility is higher, but I am in Buffett’s camp, where I will take a noisy 15% over a calm 12%.

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I did not bump into investing as an adult, but had to wrestle with it as a child.? I got to view it through the lenses of practical people who were bright, rather than academics who have a blunted view of investing.? This will bite the academics, but there is more wisdom outside of academia on investing than there is inside academia on investing.? Far better that you leave the confines of academic research and try to apply your methods to investing, messy as it is.? I dare you.? It takes a while to develop the practical knowledge behind good investing.? I’ve seen it from so many angles; if there is anyone with a more diversified career in financial services, I have not met him yet.

I was never attracted to MPT because I had seen my Mom beat the market regularly.? It was confirmed to me, when I found that I could do it also.

But still, I like MPT, and indexing — it sidelines a lot of the competition.? And for most, buying an index is the right way to go.? They don’t have an edge, so why pay the fees and accept the added volatility?

But to those that think they understand investing in academia, I would simply say, “Join the party.? If your ideas are? good, you will do well.? It is a lot harder to turn theories into hard cash, or gold, if you are so inclined.”

When I was young, I trusted my Mom.? That trust was rewarded.? Today, the game is a lot tougher, but I persevere because I know my principles work on average over time.? I have had a poor last eight months, but I will come back in time, because my methods have worked in the past, and nothing that I can see has changed that environment.

PS — I sometimes say, ” I am a good investor because I learned from my Mom, and I am a good businessman because I learned from my Dad.”? My Dad did excellent work for clients, and was never sued once in 35 years of work.? His reputation of doing quality work at a moderate price preceded him, and allowed him to survive in bad economic environments.? I hope that I can be as good.

Valuation & Momentum — The Impossible Dream

Posted on 16 April 201116 April 2011 by David Merkel

This piece is a brief and final update to the piece The Holy Grail Projects, which I have since renamed “The Impossible Dream” projects.? I have solved both of them, and with far less effort than I would have anticipated.? There is a way to gain superior bond performance, with one factor, at least as far as the past is concerned, but with higher volatility.

For equities, two simple factors are required, but they beat the market by 2%/year with 70% of the equity volatility over 130 years.

Personally, I find these two results surprising, particularly in the short time that I received them.? That said, I only passed over the data once for each project, which gives me more confidence in the results.

If you have interest in this, e-mail me.? In general, I have not favored tactical asset allocation in the past, but these measures have given me some confidence.

PS — from my days at Provident Mutual in the 90s, what I have replicated is similar? to what one firm I interviewed showed us who had the best track record.? I was really impressed with them and that gives me more confidence.