Value Investing – Page 56

Critical Analysis of Buffett’s Annual Letter

Posted on 27 February 201128 February 2011 by David Merkel

I’ve written a lot about Buffett over the years.? I think this is the eighth shareholder letter that I have written about.? I have the unique perspective of being both an actuary and a value investor.? I get what Buffett is doing, though by no means am I his equal.? This is a commentary on his 2010 shareholder letter.

Buffett begins with the transformational merger of Burlington Northern.? I spoke well of this merger that many dissed in my piece, The Forever Fund.? Face it — where could you find such a big business that is inflation-protected, and with such a large moat?? No one could replicate BN at the price that Berky paid.? This acquisition reshaped Berky, making it far more of an industrial firm, albeit one financed with insurance float.

Measuring Performance

From page 2:

In Berkshire?s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.

The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn?t possible.

To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value ? book value ? when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books. (Later in this report, we?ll present a case study.) But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.

This is a wise way to measure performance, and many value-oriented insurance companies do this.? But Berky isn’t just an insurance company, and book value isn’t a perfect metric.? But change in book value plus dividends is a much better metric than earnings, so using that is a reasonable metric to evaluate Berky.? On that score Berky has done very well over the years, and I would argue that Buffett has done even better in his later years because it is increasingly difficult to deploy a large amount of money and still beat the averages.? Look at what I call “dollar alpha.”? The amount of outperformance is limited, but Buffett is absorbing a large portion of the alpha in the market.? (Of course aggregate alpha is zero, but if a large player continues to do well, that has a disproportionate effect on the rest of the market.)

Capital Management

Our flexibility in respect to capital allocation has accounted for much of our progress to date. We have been able to take money we earn from, say, See?s Candies or Business Wire (two of our best-run businesses, but also two offering limited reinvestment opportunities) and use it as part of the stake we needed to buy BNSF.

Buffett understands the difference between businesses that have reinvestment opportunities, and those that don’t.

Culture

Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.

To start with, the directors who represent you think and act like owners. They receive token compensation: no options, no restricted stock and, for that matter, virtually no cash. We do not provide them directors and officers liability insurance, a given at almost every other large public company. If they mess up with your money, they will lose their money as well. Leaving my holdings aside, directors and their families own Berkshire shares worth more than $3 billion. Our directors, therefore, monitor Berkshire?s actions and results with keen interest and an owner?s eye. You and I are lucky to have them as stewards.

This same owner-orientation prevails among our managers. In many cases, these are people who have sought out Berkshire as an acquirer for a business that they and their families have long owned. They came to us with an owner?s mindset, and we provide an environment that encourages them to retain it. Having managers who love their businesses is no small advantage.

Cultures self-propagate. Winston Churchill once said, ?You shape your houses and then they shape you.? That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior. (As one wag put it, ?You know you?re no longer CEO when you get in the back seat of your car and it doesn?t move.?) At Berkshire?s ?World Headquarters? our annual rent is $270,212. Moreover, the home-office investment in furniture, art, Coke dispenser, lunch room, high-tech equipment ? you name it ? totals $301,363. As long as Charlie and I treat your money as if it were our own, Berkshire?s managers are likely to be careful with it as well.

Berky is one of the few companies where they have the interests of the outside passive minority shareholder at heart.? The company runs thin; excess expenses are small to nonexistent.

Insurance

He gives his usual praise of Ajit Jain who I have met.? A genuinely bright guy, and friendly as well.

With Gen Re, he emphasizes pricing discipline — the willingness to walk away, and not write business.? This is the core of good insurance management.? Never intentionally write business for an underwriting loss.

Manufacturing, Service and Retailing Operations

He talks abut the improvement at NetJets, which had been quite a dog for Berky.? David Sokol had quite an impact there.? But beyond that, Berky has a wide number of businesses that do very well.

He also discusses the black box that is Marmon, that Berky owns a majority of, and will own the whole thing by 2014 at latest.? It is also doing well.

Regulated, Capital-Intensive Businesses

BNSF and MidAmerican Energy fill out this segment.? Buffett is more than logical to put them together, because their enterprises are subject to their regulators, but enough distant from insurers that they get a different classification.? Why?

Like insurance, you don’t have perfect freedom to redirect earnings as you wish.? Some earnings must be reinvested into maintenance, and with discretion, into growth.

What Matters Least at Berky

The public investments, large as they are, are a small part of what makes Berky run.? People pore over the investments that Berky makes, but the guts of Berky are not investing, but managing a conglomerate of businesses funded by cash flow from insurance.

Todd Combs

While at a prior employer, I came to know Todd Combs, and we traded a bunch of ideas in the insurance space.? He was a bright guy.? I have little doubt that he will do well for Berky.? I remain available for any additional mandate that Berky might? require.? (I giggle as I write this, because though I have done well, why should Warren want a shmoe like me?)? That said, I am willing to manage any assets of Berky at my bottom rate of 0.1%/year.

Derivatives

Buffett describes how he has use derivatives to his advantage.? Amid the criticisms, he has made money there as the stock markets of the world have recovered.

Life and Debt

Buffett explains how avoidance of debt is wise. And after that:

We agree with investment writer Ray DeVoe?s observation, ?More money has been lost reaching for yield than at the point of a gun.?

True, utterly true.? And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

Problems with Constant Compound Interest (5)

Posted on 23 February 2011 by David Merkel

This is a continuation of an irregular series which you can find here.? Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.? I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.? They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.? My three comments to them were:

Prohibitive for life insurers to hold equities
At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.? They looked in the rearview mirror and said that we were doing fabulous.? Why change success?

I was outvoted; I was a one-man minority.? There are a lot of people who would have loved to make that change in hindsight, but done is done.? I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.? We may be headed for significant inflation or deflation; it is difficult to tell which.? Bonds offer little competition to equities here.? Commodities and cash may be better, but I am reluctant to be too dogmatic.? If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

That we can use simple models to forecast future outcomes.
That average people are capable of avoiding fear and greed when it comes to investing.
That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
Over long periods of time, average investors can beat long Treasuries by more than 2%/year.? (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
That financial markets are expressions of what is going on in the real economy.
That the real economy tends toward stability
That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.? And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.? If a large portion of the population wants to convert assets into a stream of income — guess what?? They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.? As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.? What they say is true, but the same is true of other types of defined contribution and defined benefit plans.? When assets underperform, and/or investors make bad choices, guess what?? The pain has to be compensated for somehow:

401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.? Also same as 401(k)…
Private sector DB plans: employers may contribute more, or they may terminate them.
Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”? First, risk and return are virtually uncorrelated in practice.? Only when enough people realize that might risk and return become positively correlated.? Second, there are times to increase and decrease risk exposure.? Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.? The time to add to high risk assets is when no one wants to touch a high yield bond.? More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.? Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.? At present, investment opportunities are average-ish.? I would be wary of stretching for yield here, or raising my risk exposure in equities.? Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.? I have a simple formula for how much one could take from an endowment at maximum:

10 Year Treasury Yield
Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.? At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.? This attempts to marry withdrawals to alternative uses for capital in the market.? You may withdraw more when opportunities are high, and less when they are low.? (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.? Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.? In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.? (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)? The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.? We’ve spent years on the illusions generated by assuming high returns off of financial assets.? Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.? Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.

On the Percentage of Market Cap held by Domestic Stock ETFs

Posted on 12 February 201113 February 2011 by David Merkel

I don’t have all the resources that I would want in order to do complex analyses.? Give me the database, and the right software, and I can do amazing things.

Even with limited data, and cruddy software, I still have something interesting this evening.? On January 21st, I made measurements of domestic equity ETFs to try to analyze what percentage of domestic equities were held by ETFs.

In order to limit my efforts, I polled the largest 61 domestic stock ETFs, excluding funds that are leveraged or inverse.? (those don’t buy/sell the equities directly, but use derivatives.? Granted, the derivative seller has to hedge, but he very well may cross hedge, messing up the estimates.)? That accounted for 90% of the markets cap of ETFs.? I then took the actual stock holdings of the ETFs and aggregated them, and then compared those holdings to the market capitalizations of the underlying stocks themselves, ending with a percentage of each stock held by the top 90% of ETFs.

I then ran a regression of that variable on several other variables.

SUMMARY OUTPUT

Regression Statistics
Multiple R	0.655372491
R Square	0.429513102
Adjusted R Square	0.428951442
Standard Error	0.013189645
Observations	7,118.000000000

ANOVA
	df	SS	MS	F	Significance F
Regression	7.000000000	0.931250612	0.133035802	764.719743739	–
Residual	7,110.000000000	1.236903529	0.000173967
Total	7,117.000000000	2.168154141

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	0.002247578	0.000264739	8.489772940	0.000000000	0.001728610	0.002766546
shr insd	(0.000086814)	0.000017370	(4.997942180)	0.000000593	(0.000120865)	(0.000052764)
beta	0.001683951	0.000182311	9.236686447	0.000000000	0.001326567	0.002041335
shr inst	0.000292763	0.000005154	56.804885114	–	0.000282660	0.000302866
mktcap	(0.000000003)	0.000000018	(0.151538794)	0.879555010	(0.000000039)	0.000000033
3m avg volume	(0.000000002)	0.000000002	(1.282295801)	0.199780706	(0.000000006)	0.000000001
3m realized volatility	0.000076315	0.000005765	13.237614053	0.000000000	0.000065014	0.000087616
Float/Shs	0.000001184	0.000002810	0.421210862	0.673613846	(0.000004325)	0.000006693

In short, I learned that ETF holdings of stocks were:

Inversely proportional insider holdings
Proportional to the stock’s beta, realized volatility, and amount held by institutions, and
Seemingly not related to market cap, trading volume or float.

Even the intercept term has some value as it is near the actual average percentage of market cap held by the top 90% of ETFs, which was 2.15%.? Assuming the same proportion applies to the last 10% that would mean that domestic stock ETFs own 2.39% of domestic stocks.? That’s enough to affect pricing at the margin.

Now, that percentage held by the top 90% of domestic ETFs in any common stock was as high as 17.9%, and as low as zero.? In terms of percentage of market capitalization held by the top 90% of domestic ETFs, we hit zero at stock 2912.

Implications

Domestic stock ETFs tend to pick more volatile stocks.
Domestic stock ETFs tend to pick stocks held by major institutions.
Domestic stock ETFs tend to pick stocks less held by insiders.? (They tend to be more boring.)

My summary is that those who create ETFs, even the big successful ones, tend to follow trends.? By their nature, they are extrapolating from what worked in the past, but in the process of doing so, end up overchoosing some names, and in the process add to their volatility.

That’s all for now, I still don’t feel well.

Book Review: Never Buy Another Stock Again

Posted on 2 February 2011 by David Merkel

With this book review, I put a knife to my throat.? Alas, I have been investing in individual stocks for over 23 years, and have done well the whole way.? Is it time to abandon my craft?

No, and I think the author would agree.? He is making a relative argument but the title phrases it in absolute terms.? On average, the advantage of investing in stocks is smaller than commonly believed, and for investors that can’t keep their wits about them when all is going wrong, the results are worse still.

This book attempts to infuse common sense (ordinarily sorely lacking in investments) into readers who are retail investors.

One nice feature of the book is that the author recapitulates everything in each chapter in a closing section entitled “Boiling It Down.”

Another nice feature of the book is that the author went and interviewed clever asset managers to flesh out his own understanding of the topic.? That helped produce a much richer book.

Quibbles

I don’t go in for using stop losses.? I analyze risk, and there will be a tiny number that really hurt, but the cost of using stop losses is missing the frequent snapback rallies, which on average in my experience more than pay for the losses.

Also, in this environment, where everything is so correlated, because of ETFs, he recognizes the difficulty of achieving real diversification.? But in his asset allocation advice, it is as if he forgot this.? If I were rewriting his asset allocation chapter, I would have introduced the concept of the credit cycle, and why good asset allocators vary their positions based on the opportunity offered, rather than a more static view of asset allocation.

I also would have given a little more credit to value investing.? If you are going to be anything but a trader, you may as well focus on value.

But on the whole, this was a very good book, and these are quibbles.? He writes very well, far better than me.

Who would benefit from this book:

Most inexperienced to moderate investors would benefit from this book.? It would help them to avoid common mistakes in investing, as well as make them aware of modern problems in investing that classic texts would not have been aware.

If you want to, you can buy it here: Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity.

Full disclosure: This book was sent to me, because I asked for it, after the publishers offered me a copy.

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: The Little Book of Sideways Markets

Posted on 20 January 2011 by David Merkel

I appreciate the cleverness and rigor that Vitaliy Katsenelson brings to value investing.? Value investing needs its popularizers, and Katzeneson does a very good job in explaining how good investing is a search after quality, growth, and value.

I don’t view value investing quite the same way… my views of value investing are a hybrid of the continuing concern view of Katzenelson and Dreman, and the resource conversion view of Marty Whitman.? Both views are correct, but depend on the market situation to make either one work.

I like the author’s views a lot.? I get to the same place he does, but I don’t follow the exact same procedures.? If you need more data, refer to his prior book, and read it in detail, because it is more comprehensive.

Quibbles

The book is a small improvement over his last book Active Value Investing, with some of his blog essays tossed in.

Who would benefit from this book:

Almost any investor would benefit from this book, aside from those that have read his prior work, Active Value Investing.? That was one of the first books I reviewed here, and it is still a good one.

If you want to, you can buy it here: The Little Book of Sideways Markets.

Full disclosure: This book was sent to me, because I asked for it, after Vitaliy offered it to me.

Incentives Matter, or, Why I Didn’t Set up as a Hedge Fund

Posted on 5 January 20116 January 2011 by David Merkel

I didn’t set as a hedge fund for a reason.? First, I changed my mind from prior plans, and wanted to serve people below the top 1% of society, as well as those above, and institutions.? But there is another set of reasons that is more fundamental.

My view is that requiring a manager invest almost all of his spare assets in his strategies is a far more effective means of aligning interests than a performance fee, because it discourages taking undue risk.? It?s the same reason why Wall Street worked a lot better when the firms were all partnerships, and not offering performance incentives to employees.? I?m with Buffett on this one, which is why I set up my firm the way I did ? 80%+ of my liquid assets are in the strategy.? Buffett started with more of a hedge fund structure, and ended up running a corporation where most of his assets were invested.? That provides alignment of interests, while acting to limit the downside, which I think are the goals of most investors.

Beyond that, I think shorting is a difficult way to make money.? Double alpha sounds wonderful in theory, but is really difficult to do in practice.? Common risk control works for long investments — as investments rise, trimming them locks in gains and lowers risks.? As investments fall, their ability to hurt diminishes.? Downside is limited, and upside is unlimited.

With shorting, upside is limited and downside is unlimited.? I can’t tell you how frustrating it is in working for a hedge fund when a large short moves against you.? You might be right in the long run, but can you survive the short run?? As a short goes wrong its impact gets larger, versus when a short goes right, its impact diminishes.

This is why I think alpha-is-the-goal shorting is very difficult to do.? My suspicion is that the average hedge fund that tries it loses, which is why bear funds rarely attract assets, even over a decade as bad as the last one.? Also, hedge fund fee structures encourage undue risk taking.? I did not set up as a hedge fund partly out of my last hedge fund experience, where I saw that risk control is almost impossible to achieve on the short side in a concentrated portfolio.

Part of the problem rests in the concept of the? credit cycle.? The best time to be a short is when the negative phase of the credit cycle arrives.? Aside from that, you are wasting your time being a short.? But who can wait for that time?? The optimal portfolio would be long during the boom phase of the credit cycle, and short during the bust phase.? That is tough to do, but at least it helps to know what the goal should be.? For me as a long only manager, it means taking more risk when credit spreads are tightening, and less when they are falling apart.

I am not out to make a fortune for myself, just enough to support my family.? If more comes beyond that; that’s fine, but I am not aiming for that.? Money for me is not my main goal, rather, I will not be happy at all if my clients do not do well.? I abhor the idea of being a sponge off of the assets of others.? I want to earn my own way for clients.? Lord helping me, I will do that.

UPDATE: One more note.? I say “I eat my own cooking.”? Hedge funds might say (after the truth serum was administered): “We eat lots of our own cooking when we succeed, much less when we don’t.”

Incentives matter.? Do you want asymmetric (but still positive) goals for your managers, or do you want them to genuinely lose money if they fail?? The hedge fund structure offers a free-ish option to the managers — after all, much like mutual funds, they can start a new fund if the first one fails.? Eventually some fund will achieve a performance incentive.

Book Review: The Million Dollar Financial Advisor

Posted on 29 December 2010 by David Merkel

This is not a normal book for me.? I am not a natural marketer by any means.? I have read a lot of marketing books in my time, but I am not a natural marketer.? I am reluctant to put myself forward, and boast.

But marketing does not have to be that way.? What if you could maintain and attract clients by giving them consistent attention, contacting them once a month and being a friend to them?? Now, granted, you have to give them good service, but what a lot of people are looking for is someone that they trust, who is out for their best interests.

You don’t have to be the best.? Show clients that you care, and give them high quality service as a wealth manager, and the question of the best returns goes out the window.? Just don’t blow it and lose a lot of money in the process.

As I read this as an investment advisor, I realized this book was best suited for wealth managers, but I concluded that the main lesson was show your largest clients personal care; their trust in you will grow, and they will stick with you unless you really blow it.

Indeed, one hallmark in the book is taking a lower-risk approach with client assets — most wealth managements clients are not looking for their manager to hit the cover off the ball, they just want him to reliably hit singles over time.

What I take away from this as an asset manager is to take moderate risks that are prudent for clients, and keep in touch with clients.? Show them that you care about them, and business becomes more sticky.? Also, if you can do it, ask your clients for referrals.? Remember, the best advertising is via word of mouth.

I write this as one growing an asset management business.? For me what would work well is to sub-advise wealth managers because I am good at beating the equity market, but I will continue to manage the assets of small investors for best return.

Quibbles

As with most marketing books there is the usual amount of boasting.? This one is better, in that these people have been tested and now have stable practices.? Still, you have to endure the jargon…

Who would benefit from this book:

All young wealth managers would benefit from this book.? Beyond that, I think most small investment advisors could learn from this book.? Caring about your clients is a core value to any business, but often gets forgotten in investing.

If you want to, you can buy it here: The Million-Dollar Financial Advisor.

Full disclosure: I bought this book.

Active Share

Posted on 18 December 201019 December 2010 by David Merkel

I often have to deal with practical “small institution” problems, because of the church I belong to.? Here are two of them:

1) The pastors have a defined contribution plan.? There are two questions.? Are the funds the best that we can get?? Are the asset allocation options that draw from those funds properly calculated? (Two-thirds of the pastors use those.)

For the first question, we have a board member who works for a major fund consultant.? He will easily be able to answer the question.? As for the second question, I have analyzed how the offered funds have done over the last 20 years.? Those allocations have done well in the past.? The problem is, when did the consultant do the look backwards and set the percentages?

The tendency is that once the percentages are set, future performance tends to decline.? Select managers who have done better than they normally would, and watch them regress to the mean, or worse.

My view is select managers that have done well for reasons that are not common to the environment that they were in.? There are often trends that benefit certain managers, then once the trend goes, they are gone as well.? But who did well in spite of the trend?? Those are managers to look at.

2) Recently, four members of my congregation came to me and said, “Here’s the list of managers in my401(k), who should I invest with?”? and “Here’s the portfolio my husband left me (after death), what should I do?? I can never turn down a friend, and particularly not a widow.

This was interesting.? As I looked into the mutual funds, I relied less and less on the performance statistics, and Morningstar stars, but looked at the actual portfolios in concert with performance, and decided that those with unusual portfolios with reasonably good performance were better choices.? Why?? They aren’t following the market.

Today, I ran into a name for that concept: Active Share.? How much does a manager vary from the index?? If you’re going to be an active manager, you ought to vary from the index quite a bit.? That is what you should be paid to do.

“But wait,” says the fund marketer, “Beating the index is the best, but missing the index is the worst.? We survive best with performance that is out of the fourth quartile.? So hug the index as you make modest bets against the index.”

Those are the portfolios I want to avoid.? An article in the WSJ concurs.? Don’t pay active fees for index-like performance.

I feel that way about my own investing.? If I am not looking at stocks that are less considered than most, then what am I getting paid for?? I would rather fail unconventionally than succeed conventionally.

And yet I know that managers that have high active shares, though they may do well on average, get excluded by fund management consultants, because they are too unpredictable.

Look, I am trying to make money for clients.? Consultants are a necessary evil in that process.?? Clients would be better off without consultants, but that will never happen, because clients want to stay out of the fourth quartile.

My active share is large, and I have done well.? Does that mean that a lot of people will invest with me?? Probably not, because they are not willing to endure an odd portfolio that isn’t mainstream.? Well, that is their loss.

Book Review: What Investors Really Want

Posted on 18 December 2010 by David Merkel

Meir Statman wants to tell us about the human condition.? We make bad economic decisions regarding investments.? That comes mostly from having multiple desires regarding investing that are inconsistent.? What are our problems?

We look for free lunches.
We think he past is prologue.
We get hopeful.
We want to look like a winner for friends.
We follow the herd.
We are reckless with money not easily earned.
We save too little.
We want an option on riches, and a guarantee against poverty.
We are loss averse.
We are tax averse.
We want to be accepted into exclusive investments.
We want our investments to reflect our values.
We want fairness.
We want our progeny to thrive.
We don’t know what we are doing, can someone teach us?

The spirit of the book says to me that most people don’t have the vaguest idea on what to do with investments.? They invest for many reasons, many of which are not economic.

This is a reason why pension plans should strip the investment authority away from participants, and put it in the hands of trustees.? Face it, only 20% of people at most know how to invest.? Amateurs have a hard time? distinguishing between the long-run and the short-run.

My take is that one has to unemotional, Vulcan-like, in investing, in order to be successful.? Our feelings, whether of fear or greed, deceive us.? We must resist and suppress our feelings in order to be good investors.? And as for me, it took me 5-10 years to get there.? By the time I was done, I created a system that tied my hands when I would be tempted to make a rash decision.

Quibbles

Page 84 demonstrates how short-sighted people pay up for flexibility, paying credit card rates for extra cash. On pages 96-97, he managed to convince me by bad arguments that the old system of segregating capital and income is correct.? Truth, a market-base spend in rule would float with the 10-year Treasury yield, with adjustment for how optimistic we are about the stock market.? Unless the income taken from an endowment floats with the market, it is not possible to be fair across eras.

The book describes our problems in economic decision-making, but provides no cure.? The last chapter tries to make up for it, by suggesting that an intelligent mix of paternalism and libertarianism would be the best solution.

Yes, that would be the best solution, but the devil is in the details, and the author spells out few of them.

Who would benefit from this book:

Anyone wanting to understand why he makes bad economic decisions would benefit from this book.? That would include most of us, and me.? As you read it, think of how you would change your behavior for your good.? Personally, I have designed my buying and selling methods in the stock market to avoid these troubles, but it means I have to have no emotions in the market, and that is tough to do.

If you want to, you can buy it here: What Investors Really Want.

Full disclosure: This book was sent to me, because I asked for it.

Flavors of Insurance, Part XII (Summary — The End)

Posted on 17 December 2010 by David Merkel

The insurance industry is a diverse place, with many places to make and lose money. In order to remain on the winning side, I? recommend four basic principles, which were mentioned above:

1.????? Stick with conservative managements. You make money in insurance by not losing it.? Conservative underwriting and reserving allow managements to make economically rational decisions, rather than fruitless market share wars, or giving into sell side analysts with a fixation on top-line growth.

2.????? Focus on companies with sustainable competitive advantages. Insurance is a competitive business; companies that do not have an edge against their competition will likely earn subpar returns.

3.????? Consider companies that can (and do) earn a high ROE over a full underwriting cycle. Anyone can earn money when the market is hard, but who protects your investment when the market for insurance is soft?? Intelligent insurance managements adjust their competitive posture to the market environment.

4.????? Finally, buy them cheap, and sell them dear. Within the above three principles, focus on companies that are out of favor, and sell companies when their prices outstrip their fundamentals. This last principle is the most obvious, which is why it operates inside the contours of the first three principles.

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Bringing it to the Present

I still think these four principles are valid.? They aren’t flashy, and they take some thought, but they focus the analysis in an industry that is difficult to understand.

I try to focus on companies that are good operators; they manage their base of insurance businesses well, rather than those that are clever investors, because the ability to be clever investors over the long run is much harder than being a well-run insurer.

With that, I bring my “Flavors of Insurance” series to an end.? I hope you enjoyed it.? I always wanted to publish it, and if I hadn’t tripped across a very bad copy of it, and had my son Timothy correct the OCR version, this never would have seen the light of day.? So what I wrote 6-7 years ago can benefit a wide audience.? And remember, aside from the “Bringing it to the Present” parts, the original was written in one excruciating, draining day– a labor of love that was frustrated, but now realized.