Value Investing – Page 57

Advice to a Friend

Posted on 10 December 2010 by David Merkel

Dear Mr. Merkel,

I was sorry to read about the demise of your firm a month ago.? I hope God prospers you in whatever path you pursue now.? I?m writing to you with a few investing questions because I know you actually can evaluate what I?ve done- and from a perspective that I think matches mine (buy dividend-paying value for the long-term), and I really would like to deliberately practice improving my evaluation of companies with testing & feedback.? If, however, my request falls under your own business plan- I understand completely.

4 years ago, I picked several energy stocks using only one metric: P/E ratio.? Since then, I found Graham?s writing on investing and your blog and started thinking that one-stick-measuring for something as complicated as a business is a dangerous game.? Using what?s available to me on Vanguard?s website (plus what I?ve learned from you and Graham), I have a slightly less incomplete model to measure a business.

I know you?re very busy, but if you ever have a chance, would you look at my scoring system and give me some small feedback?? I?m curious about a few specific things:

a) Have I left out any key aspects or ratios?? If so, what?? (and what should they be?)

b) Graham suggests going back years and years when looking at a business.? What is the point where you get such diminished returns that?s it not worth the effort to dig up the numbers?? 3 years? 5 years? 10 years?

c) Follow up to b: does your answer to that question change based on the aspect examined?? (ie: EPS should be?reviewed for the last 5 years but Cash only for the previous year)

d) In my scoring system, have I over- or under-weighted any of the categories?? Have I not been stringent enough in?awarding points?

Naturally, I have many more questions.??But I?ll greatly appreciate any feedback you give me on these.

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I get a lot of e-mail.? I wish I could freeze time, and respond to all of it.? I have been spending time recently clearing out the e-mail box.? I am down to seven flagged messages.

The above message is from a friend of mine, whose father is a close friend of mine.? The father taught me a lot.? He might be my top intellectual influence — he is certainly in the top 5.

I sympathize with my young friend here.? I was once an individual investor myself, and I tried a wide variety of ideas before I settled on my current strategy, which grew out of my value strategy in the mid-90s, when I was much younger.

Before I answer his questions, I will say that for two decades I spent one hour per day at minimum (excluding Sundays) improving my skills.? Investing well takes training.? Simple solutions are rare.? The alternative name for this blog was “The Investment Omnivore,” because I have studied so many things in investing, from so many different angles.

Now for advice to my friend:

You have six criteria, it seems. I will handle them in the order of your spreadsheet.

1) You analyze versus 1 and 3-year price action.? With 3-year price action mean reversion is likely, but with one year price action, momentum tends to persist.? Change the direction of your scoring system on 1 year price performance, because investors tend to lag fundamental improvement in the short-run.? Momentum tends to persist over a year or two.

2) With dividends and earnings per share, your scoring is logical, though there is this difficulty — stocks react to changes in expectations, not data on the announcement date, though surprises change expectations.

3) I use the current ratio as a disqualifier.? I don’t use it for scoring, but for whether it is worthwhile to consider a given company.

4) The same is true for Cash-to-Total-Debt.? Low ratios would disqualify a company, but high ratios would not get points in my opinion.

5) And also for total debt to equity.? I should tell you that one has to consider these matters on an industry by industry basis.? Stable industries can bear more debt.

6) Then you have cheapness — price to book, earnings and cashflow.? With financials and utilities, I use P/E times P/B as a criterion, as Graham did.? With Industrials I use Price-to-Sales.? With Industrials I also look at price to cashflow and free cashflow.

So, my advice for you is this: the key idea of value investing is margin of safety.? The first task of a value investor is to assure safety.? This means using balance sheet statistics that you cut the universe in two — worthy of consideration, and out of the question.

After that, we look at valuation and analyze those companies that are acceptable to find those that offer the best values.? I give more credit to companies that have better growth prospects, but that is a soft criterion.

And after that, price momentum and mean-reversion.? Momentum works in the short run, and mean reversion in the intermediate-term.

Though you might think I am critical of your efforts here, please understand that in the mid-90s I was much like you, struggling with the concepts of value, and trying to come up with a coherent thesis.? I am impressed with your work and not dismissive.

This is a trail that I rode when I was young.? With additional study, you can do better as well.

And I say this to all readers, because there are many who follow simple ideas that fail.? I urge those who read me to read broadly in investing, and pursue the broad ideas that seem to work.

Flavors of Insurance, Part I

Posted on 4 December 2010 by David Merkel

I view the insurance industry as a loosely related group of sub-industries, where knowing something about one sub-industry tells little about any other sub-industry. Even within each sub-industry, companies can be very different from each other. This article will attempt to go through the vast wasteland that is the insurance industry, and attempt to point out some of the more interesting aspects of it.

There are three major risk factors with insurers: the underwriting cycle, investment returns, and expense control.

The Underwriting Cycle

The property/casualty insurance industry, like all mature industries, is a cyclical business. Cyclical businesses revolve around pricing, which involves the relative degree of capacity available in the industry.

The P/C industry derives its capacity to write business from the amount of surplus available to support business. This creates a four-phase cycle for the industry.

1.????? When surplus is abundant, rate-cutting is prevalent, and generally poorer-quality business gets written in an effort to retain market share. Terms and conditions for insurance are loose. During this period, the prices of P/C companies fall relatively hard, as prospective estimates of profitability fall.

2.????? After enough poor quality business gets written, and premium rates decrease meaningfully, high quality companies exit lines of business, or buy reinsurance, and low quality companies begin to look impaired. At these times, the stock prices of high quality firms fall a little, and low quality firms fall more.

3.????? As the results of bad business become evident, reserves get raised, sometimes drastically, and surplus declines. When surplus is deficient, premium rates rise, and the stocks of companies that have survived the cycle rise dramatically. The best business from both a profit and risk control standpoint, gets written in this phase of the cycle Terms and conditions for insurance are tight.

4.????? When surplus becomes adequate, premium growth rate slows, and stock prices rise slowly, at roughly the rate of retained earnings. This continues until surplus is abundant.

Catastrophes, when they happen, temporarily reduce surplus, and improve pricing. The companies least affected by the cat rally, and those most affected, tend to fall, or rise little. Major catastrophes can cause the cycle to bottom, or extend the positive side of the cycle, because surplus is diminished.

The rating agencies tend to cut ratings near phase 2, and raise them near phase 4. Diminished ratings decrease the amount of business that an insurer can write, and further limit the willingness of prospective purchasers of insurance, particularly long-tailed coverages, who want to be sure that the company that they buy insurance from will be around to pay claims.

Investment Returns

Strong investment returns increase surplus. In a bull market, some companies become more aggressive about writing business so that they can earn money from investments. This is particularly true of companies that sell coverages that result in long-tailed liabilities. Strong investment returns prolong phases 1 and 4 of the cycle. Investment returns were so strong throughout the 1990s that insurers often compromised underwriting standards, leading to much of the troubles that occurred in the industry from late 2000 to early 2003. Not only were investment returns low or negative, but the results of prior poor underwriting were realized through reserve adjustments that diminished surplus.

Expense Control

Every time a premium gets calculated, there is an estimate embedded in the premium for expense. Expenses typically take three forms: policy acquisition, claims adjustment, and operational. There is a tendency for expenses to drift higher when investment returns are strong, and when the market is softening due to greater competition.

Now I will discuss each sub-industry separately. Included in each discussion is a description of products, risks, and industry performance over the last ten years. The graphs show the performance of each sub-industry over the last ten years, derived from my own proprietary indexes. At the end, I give my outlook for each sub-industry.

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Bringing it to the Present

This series was written seven years ago in an all-nighter for my new boss.? The piece never saw the light of day, which annoyed me, though I liked my boss, and I never complained about it.

As I publish the ten-or-so pieces of it, because it was long, at the end of each installment, I will try to update the insurance subindustries to the present.? But it would be useful for anyone reading this to look at my presentation to the Southeastern Actuaries Conference on the Amazing Decade for Insurance Stocks.? Aside from that, I have lost the graphs of the original presentation.? My apologies.

Insurance is an amazing business.? Insurers make promises.? Many of the promises are uncertain with respect to amount and/or timing.? That makes the accounting complex.? This is one of the reasons why examining the qualitative aspects of an insurance company to understand how a management team makes decisions is so valuable.

Anyway, more to come here, and I hope you all enjoy this series.

Changes for David — IV

Posted on 3 December 2010 by David Merkel

My goal is to open for business at the beginning of January 2011.? I could have started earlier, but I didn’t feel that giving clients an additional bit of tax data was worth the early start.? In general, I have spent the extra time trying to make sure that I get things right at the start.

Here is my remaining to do list:

Decide on Custodian/Clearing Broker ? Any thoughts from Dailey?
Compliance Strategy, Including Web Compliance Strategy, CFA Document Retention
Procedures for suitability ? CFA notes, Investment Policy Statement
E&O Insurance
Marketing ? and deal w/e-mail, Linked-in day, other contacts, Press Release
Strategy for Illiquid names ? DIIBF, PCCC, IBA, NWLI

Deciding on the custodian/clearing broker is the biggest item, and affects #4 as well.? I am leaning toward Interactive Brokers, because I like their cost structure for small accounts, and they offer a lot of tools to be able to trade cleverly, particularly in an era of high frequency traders.

The downside is that they aren’t good on the service side, which means that I will have to compensate, and be the friendly front end for my clients.

Proxy Voting Policy

I modified the proxy voting policy of one of my readers, and I thank him for his help.? I disagree with him on a few issues, so I don’t want to name him or explain where we differ.? Instead, here is my proxy voting policy, and I solicit your comments.

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Aleph Investments, LLC Proxy Voting Procedures

The Chief Investment Officer shall responsible for voting all shareholder proxies. It will be the Chief Investment Officer?s responsibility to ensure that all proxies are voted in a timely manner. Proxies shall be voted in the best interests of shareholders, with an emphasis on voting against any management proposals that act in general to insulate companies from the discipline of the market or accountability to shareholders.

Specific Policies:

A. Corporate Governance

1. Unless exceptional circumstances exist Aleph Investments will vote against proposals that make it more difficult to replace Board members, including proposals to:

a. Stagger the Board;
b. Overweight management on Board;
c. Introduce cumulative voting;
d. Introduce unequal voting rights;
e. Create supermajority voting;
f. Establish pre-emptive rights.

Aleph Investments will vote in favor of any proposals to reverse the above.

Generally, Aleph Investments will withhold its vote for directors who hold little or no stock in the company and have been on the Board for three years or longer, or for new directors who appear to be primarily political or show appointments who do not appear to possess skills or knowledge that is relevant to the company’s business.? Aleph Investments also favors separating the roles of Chairman and CEO, and not having the CEO on the nominating committee.

For companies that have not given us an adequate rate of return (subjectively determined), we will vote down all questions and positions proposed by management, including the auditor.

B. Takeover Defense and Related Actions.

Aleph Investments generally will vote against proposals that make it more difficult for a Company to be taken over by outsiders, and in favor of proposals to do the opposite. The reason for this is that we believe that corporate management should be subject at all times to the incentives and punishments of the market, not insulated from them.

C. Compensation Plans.

Aleph Investments generally will vote against most large incentive pay proposals, with the exception of those that are meant to apply to ordinary employees.? Most of the time, management teams are paid well enough; it should be enough incentive for to have moderate incentives, and know that if you can?t deliver, you will be replaced, just like the rest of us.? Once management teams get too well off, they tend to underperform.? Also, we prefer management compensation to be tied to things management/workers can work on, like net operating income or change in book value, rather than stock valuations, which they can?t affect much.

In addition, Aleph Investments will vote against any compensation that would act to reward management as a result of a takeover attempt, whether successful or not, such as revaluing purchase price of stock options, golden parachutes or handcuffs, etc.

D. Capital Structure.

Aleph Investments generally will vote against proposals to move the company to another state less favorable to shareholders interests, or to restructure classes of stock in such a way as to benefit one class of shareholders at the expense of another, such as dual classes (A and B shares) of stock.

E. Noneconomic Proposals

Aleph investments will generally vote against noneconomic proposals.? We expect firms to follow the law in the places in which they operate, and to observe general ethics beyond that.? We don?t want firms to follow the ethics of tiny minorities who submit proxy proposals.

F. Size of Board

Aleph Investments will vote against any proposals that act to increase the size of the board beyond
12 – 15 members. We believe generally that large boards have a more difficult time with major changes and other important decisions, and that responsibility is more easily avoided and diffused among too many members.

G. Appointment of Outside Directors.

Aleph Investments will vote against any proposal to allow the CEO to appoint outside directors, and in favor of any proposal to eliminate this ability. The Board’s outside directors should not owe their position or allegiance to a member of management, but to the shareholders and/or independent board members alone. For the same reason, we may vote against any outside Board member who has business dealings with a company on whose Board he sits. Allowable exceptions may be venture capitalists who helped bring a company public, and have a great deal of industry knowledge; senior management of companies in industry sectors served by the company, and who may have valuable insight to contribute regarding industry competitive and business factors; and similar factors that may contribute to the knowledge level of the board members.

H. Multiple Director Positions

Aleph Investments will generally vote against any Board member who is also a Director of four or more different companies. Multiple directorships are time-consuming, especially for senior management of other businesses who have other full-time jobs. We find it difficult to believe that in such cases the Director can adequately fulfill his or her responsibilities to the shareholders.

I. Incentive Stock Award Programs:

Aleph Investments will vote against incentive stock awards that act to concentrate significant amounts of stock in the hands of upper management. While we understand the need to incentivize management by placing a significant amount of upper management and director compensation and net worth at risk in the stock market, this needs to be meaningful only at a personal level. It should not necessary to set aside a significant proportion of shareholder capital for a limited number of upper management personnel in order to incentivize them.

Aleph Investments will support proposals that force executives to put their own money on the line in company stock in exchange for other incentives.? We are putting our money on the line, so should managers.

J. Conflicts of Interest.

Due to the nature of our business and its small size, it is unlikely that conflicts of interest will arise in voting the proxies of public companies, because Aleph Investments, LLC does not do investment banking, or manage or advise public companies.

Full disclosure: long DIIBF, PCCC, IBA, NWLI

Industry Ranks December 2010

Posted on 2 December 20102 December 2010 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 wth more potential over the next 1-5 years.

I like technology names here, some utilities, and healthcare-related names, 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.

I?m looking for undervalued and stable industries.? Human resources ? sure, more part time workers.? Healthcare information?? A growing field, even with the new ?health bill.?? Same for Biotech.

Even in a double dip, phone calls will still be made, and the internet will still be accessed.

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 more highly cyclical than I have seen in quite a while.? I will be very happy hanging out in dull stocks for a while.

This report I will continue to publish after my firm commences operations at the start of 2011.? But I will delete my portfolios at Stockpickr.com, and will only report trades after all of my clients have their orders filled.? More to come on all of that.

On Investment Modeling, Part 4

Posted on 24 November 201024 November 2010 by David Merkel

I thought part 3 would be the end, but I ended up with one huge and good comment from a friend.? A real friend, not a Facebook friend.? I will respond to it in pieces.

Good article and series. A few comments and/or questions for you. First, there is no doubt that both value and momentum work. And while I happen to personally be a big believer in (certain) trend-following approaches, the way in which Covel interacts with people is childish at best. There is room for professional discourse and disagreement, but he has little interest in being professional about anything?at least in the blogosphere/twitterverse world. So, keep at it?be a gentleman and let the other chips fall where they may. Now, a few other areas:

I try to stay polite.? Sometimes I fail, but thankfully, it is not common.

1. First, I?d be interested to have you elaborate a bit further (or point me to a different post) on your views of the Carhart factors. In my mind, there is no doubt that they are betas?but at the same time, there is also no doubt that those betas can and should be used (carefully) as alpha factors as well. Much as my brain has been trained to think about them as simply betas, I?m more than willing to think about them in both ways. They aren?t mutually exclusive, are they?

I have no other post on this.? This series was meant to bring this idea buried in me to the surface.

I think the thing that set me off here is the value factor.? Value is regarded as a risk factor, when if you own enough stocks with the value factor, you will outperform over the intermediate term.? The same applies to momentum, it is a risk factor, but it tends to outperform.? The same can be said for size, small is usually a winner because of neglect.? Beta tends to be negatively correlated with outperformance.

If the factors were neutral, having zero expectation of future performance, they would be betas.? But that is not true even of “beta.”? Thus, most of the time one can make money by tilting to the moneymaking sides of these factors.

Recently, there was an analysis of Berkshire Hathaway for the last decade, showing Buffett had no alpha.? But if you looked at Berky versus the index, Berky beat it by 6%/year.? Buffett asks whether companies are cheap.? If he buys a company because it is specially cheap, or because its associated “risk” factors are cheap, that should be measured as skill, not taking risk.

If we add enough “risk” factors to the analysis, most alphas disappear.? But the ability of managers to buy when a risk factor is cheap does not go away, as does their ability to be “late followers” and lose money as so many retail investors do.

2. Second, and importantly, I don?t believe that every investment strategy can be boiled down to a fairly simple mathematical/quantitative approximation. Therefore, not every strategy can be tested in a purely academic sort of fashion. Take Covel?s trend-following, for instance. There are obviously many ways to do trend-following, but few are so simple as to easily do an historical test. It?s NOT simply momentum (as you well know!), and while momentum and trend-following certainly have some correlation, it would be a disservice to the TF crowd to view one as a proxy for the other. The buy and sell rules, timing of entry points, level of stop loss, etc. are hugely crucial to the success of the strategy.

You are right here, mostly.? What we test are only the quantifiable aspects of the strategy.? We don’t test, we cant test nuances.? Nuances will get lost in the noise.? We are out to test the first approximation of a strategy, not the strategy itself.

Most managers have an initial screen that winnows down the universe of stocks that they will then use their abilities to analyze.? Managers think that only a subset of stocks are worth their time, because that pool is likely to outperform, now let’s get the best of those.

In this sense, we are not testing the fullness of a manager’s processes, but only his initial quantitative screen.? Processes beyond that are alpha, whether positive or negative.

As one who has sat through many dog-and-pony shows (and you, friend, more than me), most managers fall into buckets off of their screens.? What is their investable universe?? We test that.? We can’t test the fine gradations beyond that — the law of small numbers interferes.

But what I will argue regarding trend following is that there is some measure of momentum that explains over 70% of the results of a wide number of trend followers, much as Buffett could point to the “Superinvestors” and claim that they were all one tribe, though the details differed considerably, much as Covel has done with trend following.? The first approximation of the group element is the important part tested.? Maybe we need to use principal component analysis to tease it out, but we do need to simplify the broad parts of the strategy for testing.? We can test the broad stuff.? Beyond that we are stuck.

3. So with #2 as an assumption, the only way to analyze TF is as a group of investors. Is there survivorship bias? Yes, but you have that with value guys, too. Is it enormously dependent on sticking with the system, even when it?s not working? Yes. Is there a good sample of auditable accounts out there? No?not so far as I?m aware. I think the issue that Covel has is that the majority of the best investment returns people have ever put up are from the momentum/TF crowd. However, one should very clearly separate investing from trading. The trading crowd has the ability to put up ginormous returns, but at what cost? Huge volatility, gigantic turnover, etc. that most people are not willing to live with.

Let Covel and his friends try to raise money from the institutional investment community.? We may admit that momentum works, but not the ability to consistently make money off of price/volume action when managing a large amount of money.? If they do have that skill, we need to explore it, and let the behavioral investors analyze it so that we get a first approximation, a factor, to explain it.

Survivorship bias? You bet that is there.? That is why we test mechanized first approximations to a strategy, not the strategy itself.? We test tribes, we don’t test families, much less individuals.

So in the end, as you?ve said before, it comes down to finding a system/approach that has shown the ability to work well for others and sticking with it through the tough times. No approach to investing/trading will be absolutely perfect every month, and most people lack the discipline to actually make it work over time. They switch from system to system, at the most inopportune times.

Thanks for the good work?keep it up!

You would know better than most that though I am generally a value investor, my own strategies are different because I use industries as my primary screen in investing.? And it is nonlinear — I look at those that are running, and those that are dying, but not the middle.? I consider macro factors that many do not, whether I am right or not.

I am one of those managers that would be hard to measure, if one wanted to measure things precisely; I don’t screen, as most managers do.? But I consider value, momentum, and mean-reversion effects to be givens, while I try to analyze what industries and companies will do well.

And that is a reason why I have not fared well with fund management consultants.? Like Covel, I do not fit their paradigm.? Unlike Covel, I would like to fit their paradigm.

But no, I am happy for the present to attract individual investors who want to outperform on a risk adjusted basis over a 5-year? period.? That is my forte, and I will pursue it with investors as my firm goes live at the beginning of 2011.

On Investment Modeling, Part 3

Posted on 20 November 201022 November 2010 by David Merkel

This is the last piece intended in this series, but I know that I will get a some abuse for it.? One small request to those who agree with me on this issue: if I get flames as a result of this piece, and you disagree with the flames, please comment in my favor.? Thanks.

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Warren Buffett once wrote a piece that is in one the editions of Ben Graham’s The Intelligent Investor, called The Superinvestors of Graham-and-Doddsville.? Buffett chooses nine investors that learned from Ben Graham, including himself, and shows how they outperformed the market averages over many years.

Very nice.? Another win for value investing.? I live in Graham-and-Doddsville for the most part, and have admiration for my neighbors.? No envy here.? I do well enough.

But, even though Buffett knew these investors long ago, and they were all students of Ben Graham, what I don’t know is whether Buffett culled only the best of Graham’s students for his essay.? I think the best of Buffett; I generally think he is an honest guy, but I don’t know for sure.? I write this as a convinced value investor.

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Far better to try to do a general study.? The trouble is that it is difficult to segment the market into value investors, and everyone else.? The category is squishy.? Even if we could define the category well, we would have a hard time aggregating all of the data from all of the brokerage accounts.

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So, what are we left with?? We boil down strategies into their quantitative essences, and measure the performance of the quantitative strategy versus the index.? The result is bloodless, and accurate to the first degree, in analyzing an investment strategy.

This is what the academics do.? Though I disagree with the Carhart factors, because I view them as alphas and not as betas, the basic idea of testing a strategy over the whole of the market is valid, if they take into account a full accounting for transaction costs.

See if the strategy is valid from the first approximation of turning it into a mathematical formula.? For value investing, it has worked.? Value factors have outperformed.? I love being a value investor, and I have been better than most of my competitors.

But that is not enough.? Price momentum factors have also outperformed.? Which brings me to my final point: Michael Covel hand-picked many successful trend followers in the his book, Trend Following.? He had more freedom to pick trend investors than Buffett did to pick value investors.? I give Michael Covel a choice:

Are you willing to recognize that value investing works, even as momentum investing works?
Or, do you end up a narrow-minded man who only sees one way to make? money in the markets?

Though I am mainly a value investor, I do not abhor momentum investing.? I incorporate it where I can.

But when Michael Covel chose other trend followers to demonstrate the value of his theory, he was less restrictive than Buffett was, and Buffett’s method was less than scientific.

I am not trying to pick a fight with Michael Covel.? On October 1st, we had a “discussion” over Twitter that he started, and I finished, where we discussed this topic.? Anyone who can re-assemble the full details of the topic please e-mail me, and I will post it.

I tried to be a gentleman, but Covel interpreted me as being a wimp.? I hate that.? A gentle answer discourages wrath, and that is what I aimed for, but he did not perceive it.

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Much as I am not crazy about academics in finance, the way that they analyze strategies is the only fair way of analysis, because it allows for no discretion.

There are two choices for doing an economic analysis in finance:

Segment investors, and analyze their performance
Describe the distinct strategies of investors in easy quantitative terms, and show how they perform versus the index.

There are a large number of studies that show that price momentum is a winning strategy.? I agree with those, and let Michael Covel agree with me.? I am not looking for a debate, but an agreement.

With that, I leave it in the hands of my readers.? Why not incorporate both value and momentum into your investing?

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Update: here is a transcript of the discussion with @Covel:

Covel: @AlephBlog You get grief because you don’t understand the subject and ignore the performance.

Merkel: @Covel As you wish sir.

Covel: @AlephBlog http://www.michaelcovel.com/2009/04/25/david-merkel-defending-a-wrong-view-to-the-bitter-end/

Merkel: @Covel I don’t bear grudges, do you?

Covel: @AlephBlog Is this seriously how you debate? Everything is an emotional counter?

Merkel: @Covel No, I still stand by what I wrote.? There are five parts, and you would do well to read them carefully.? My opinion is expressed.

Covel: @AlephBlog If you were serious about the subject you would examine the blind spots in your argument. You don’t and wise people see why.

Merkel: @Covel I responded in detail to your statements; you did not. Your use of “ad hominem” argumentation was without basis. Compare me w/Cramer?

Merkel: @Covel Look, I am fair. Please write a piece that shows pt-by-pt where I am wrong, or affirm that your last piece was that. I will +

Merkel: @Covel re-examine my “prejudices” and write a follow-up.? But, are you willing to be as fair? It’s your ball, run with it.

Covel: @AlephBlog If you are truly intellectually curious write a cogent argument for trend following performance. Don’t be lazy like your review.

Merkel: @Covel I have written many times on the value of using price momentum in investing.? I mentioned that in my reviews a number of times.

Merkel: @Covel Try this, then: http://alephblog.com/2009/01/21/a-different-look-at-industry-momentum/

Covel: @AlephBlog No banana. Explain the decades of trend following performance generated by the traders mentioned in my book. Let’s see it.

Merkel: @Covel In any strategy, those who do the best survive and get known. Using hindsight, they get picked to show that the strategy works.

Merkel: @Covel Buffett used the same argument for value investing in his essay The Superinvestors of Graham and Doddsville http://bit.ly/9IKsDf

Merkel: @Covel My answer to you is that cherry-picking is not analysis. Please do a study of all trend followers to prove your argument.

Merkel: @Covel Comprehensive article on the value of momentum and mean-reversion. http://bit.ly/cCzx2p This is what I think is careful research.

Covel: @AlephBlog Who are failures? Name them. Describe why they failed. Let’s see it. Don’t hide behind “Covel it’s only survivors!”

@edwardrooster @alephblog His argument is idiotic. He is trying to say thousands of trades over decades is luck. That is foolish.

Merkel: @Covel Selection of high performing investors does not prove that a method works. I am not saying anyone’s performance is luck. Momo works.

Covel: @AlephBlog I am out. Even if you read my book, there is no comprehension. Typical bias. Wrong, but unable to accept. You must protect self.

Merkel: @Covel Happy trails. Come back when you want to talk reasonably.? If you get to Baltimore, lunch is on me.

On Investment Modeling, Part 2

Posted on 18 November 2010 by David Merkel

Before I begin tonight’s piece, one small thing that I want to point out from my last piece was that though my models were a few years ahead of the life insurance industry, the two most important things that I did were:

Not optimize for best return, even if risk adjusted.? I gave extra weight to avoiding the downside.
Added in the details.? My models were entirely home-grown, and took advantage of my programming abilities to come to a sharper result.? I am not a good theoretical mathematician, but I am good at using math to solve practical problems.

The idea is model completely, and don’t ignore scenarios that could not happen.? My interest rate model had scenarios that mimicked what we actually got, though what we got was not a high probability.

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One of the themes that I came away with from the Denver conference last week was look through the windshield, not the rearview mirror.? But much of the investment industry, and retail investors are destined to? look through the rearview mirror.? I, as an actuary, have been unfairly accused of driving life insurance companies through the rearview mirror, look at this and say that we can look through the windshield, but we have to be more than the common shlubs who are the majority of the market.

To do that we have to adopt an independent disposition, and not care about raising funds, but only earning returns for clients.? If we build it, they will come.? In one sense, it is like someone who has a beautiful singing voice, but who avoids pride, and admires his voice as if it were someone else’s voice. (Apologies/Credit to C. S. Lewis)

The main point here is to look through the windshield, and exercise intelligent independent judgment.? Analyze the situation, and figure out where there is an advantage as a businessman.? The tools of modern portfolio theory will be useless here, so ignore them.? They only sharpen/obscure our understanding of the past/present by calculating parameters that are not stable or predictive.

The only positive thing about Modern Portfolio Theory is that it sidelines a bunch of bright guys who would otherwise be competitors in the markets.? Sun Tzu would admire this tactic — getting a large portion of the opposition to become peaceniks because the expected value of the war is zero or negative.? It’s as if an economic Tokyo Rose is broadcasting that competition in financial markets is futile — in aggregate, everyone will get average performance, so why fight to get better performance?? It’s futile; give up; go home.

I would simply say there is always a decent amount of lazy investors in the market. Smart investors can get better returns through paying careful attention to what seems to offer the best returns on a forward-looking basis.

Part of looking through the windshield is avoiding noneconomic constraints.

1) Do I care where a company is located? Yes. I want a place where the rule of law is honored.? As many have commented at my blog, does that include the US?? Yes, for now.? Global diversification is important.? That said, it will be interesting to see what will happen to investments should we see tariffs, foreign exchange controls, and expropriation.? At least in you own home country you only have to deal with the “devil you know.”

2) Do I care whether a company has a large or small market capitalization?? Not now.? Even if my asset management firm grows, I will adjust my strategy to include attractive small caps at lower target percentages.? If my buying begins to affect the stock price, I will take smaller positions.

3) Do I care if a stock is “a growth stock” or a “value stock?”? No, I care more about industry and firm prospects relative to price.? I will pay up on occasion.? Still, mostly I try to buy them cheap, and it biases me toward “value stocks.”

4) Do I care about whether a stock is volatile or not?? Yes.? Stock price volatility is a sign of low creditworthiness, and usually I only buy higher quality stocks.

5) Do I care about price momentum?? Yes.? Typically, I buy companies that have strong current momentum, or poor momentum over 3-5 years.? Is it what I focus on?? No.

6) Do I care if I have an “undiversified” portfolio?? No.? I want to be in the right place at the right time on average.? Mimicking the index is a recipe for mediocrity.

7) Do I care if I am holding cash?? Yes.? I’d rather be in stocks, but will build up cash if I have to.? Cash moderates volatility in a concentrated portfolio, and allows for opportunistic purchases.

8 ) Do I care if I underperform?? You bet.? It burns a hole in my gut.? But it doesn’t make me change my methods.? It will make me sharpen my analyses.

A large part of the idea is to focus on risks, not risk.? Academics focus on univariate risk, with its simplistic math — beta, standard deviation, skewness, and all of the half-measures and ratios that stem from them.? I can’t model my methods in full, but I look at the risks in particular for each of my investments.? Every investment has to justify its existence in my portfolio independently.? I don’t do correlations; they are not reliable.

I also don’t go in for the four Carhart risk factors — beta, size, value/growth, and price momentum.? I don’t think of them as “betas,” but as “alphas.”? These are factors that can be taken advantage of when they are cheap or rich.? They are not risk factors, they are simply factors.

In closing, there has been a shift in the environment from inflation to deflation.? How does that affect investment choices?? My guess: buy well-financed companies with a low price to tangible book.? Stagflation?? In the ’70s the answer was low P/E with pricing power.

The closing segment of this series will focus on how to do statistically valid studies of investment performance.? I know at least one person who may be annoyed by what I say, but it is important to try to be fair in investment analysis, lest we lead others astray.

On Force-Placed Homeowners Insurance and the Effect on Investors

Posted on 11 November 2010 by David Merkel

I had a number of people ask me today, so tonight I am writing about the American Banker article on Force-placed homeowners insurance, and its impact on Assurant, which was down 11% on the 10th.? To give an example, one fellow asked:

David, care to comment on the Assurant (AIZ) news? American Banker magazine is alleging ?kickbacks? to banks that agree to place ?expensive? creditor-placed property insurance on homes. Would you be a buyer here?

Yes, I would be a buyer here, but my rules prevent me from buying here, because the price did not hit my lower rebalance point, even at the lows of the day.

A word about Assurant, from my point of view: Assurant is one of the few insurance firms that if they asked me to come work for them, I would make adjustments that I would not make for other companies.? They are one of the few insurance firms that I think treats their employees right, and does risk control right.? They also choose their markets carefully, and understands what their “sweet spot” is with respect to what businesses their corporate culture will do well at.

After I read the two articles at American Banker, I wrote the following as a letter to the editor:

Your articles on forced-place homeowners insurance left out several significant bits of information:

Most forced-place homeowners policies are only in effect for several months.? Why?

Because people have an incentive to go and get a regular policy after that.? And most do.

These policies also only come into force because a homeowner is neglectful in maintaining the insurance that is required to have as a stipulation of his loan.

Typically, the insured gets warned in advance that the policy will be force placed.? He has time to make other arrangements.

Any homeowner can avoid forced-place insurance.? All they have to do is keep current on their insurance policy, which they have to do as a term of their loan.

As for any sort of long backdating, that’s an abuse that needs to be corrected.? But as for the other competitive dynamics of this industry, it would be impossible for a forced-place insurer to do business without compensating the mortgage servicer, whether through commissions, which should be disclosed, or via reinsurance treaties.? Similar practices exist in other areas of insurance, including warranties and private mortgage insurance, both of which do not disclose the commissions.

In the interests of full disclosure, I am a shareholder of Assurant.

Sincerely,

David J Merkel

The author wrote me back, reminding me that he had met me at the Fordham University Too Big To Fail bank conference.? I hit myself on the head, remembering that I had really liked his approach to the markets.? He said:

Your note came closer to addressing a key issue than any insurer or bank ever did ? and I spent a week asking them. So I figured I?d ask if you wanted to address this question:

— are commissions regular in other fields where the entity receiving it is buying the insurance on behalf of a third party who has not requested it? (It sounded from your e-mail like your answer is ?yes,? but a bit more detail would be helpful.

— Next, what would you say to the allegation that servicers have no incentive to pick the cheapest insurance ? and in fact are incentivized to send business to insurers that pad their rates to account for commissions? This was the key element of the story, and I never found a bank or insurer or trade group that would address it.

So I wrote back the following:

I agree that it gets murky when you have undisclosed commissions.? When I worked for Provident Mutual, in their pension division, we had a rule for pension consultants – you can have undisclosed commissions, so long as you disclose that you are getting a commission, or disclosed commissions, but not both.? Some of our competitors would allow for both.? Legal, but shady, definitely.

Private mortgage insurance has the same practice of reinsurers owned by the banks, which get the majority of the profits, because they control the communications of the transaction.? The insurer is the “back office,” for lack of a better term.? The insureds have no idea that the lender is benefitting from the PMI, I’m pretty certain.

With warranties, buyers are not told that the retailer is getting a large amount of the premium.? The typical breakdown is something like an even split between retailer, loss costs, insurer expense, and insurer profit.

Insurance brokerage was another area where undisclosed commissions to brokers led to a scandal 6-7 years ago.? The big guys discontinued the practice, the little guys didn’t, and the laws were never changed.? It’s still legal, and at least one of the big brokers has returned to the practice — can’t remember which one.

This highlights how these deals come to be, in any complex (multiparty) insurance arrangement.? The one who controls communications gets the lions share of the value of the transaction.? Even though forced-place is an oligopoly, the servicers have the advantage, and they take little to none of the risk, typically.

Assurant may have some advantage here, because they are the biggest, and their systems do actively troll for policies going out of force.? I have talked with management several times about the business, and how they warn potential insureds that their existing policy has gone out of force, etc.? They claim to follow all existing laws and regulations, but in a big firm, when many things are automated, who can tell for sure.

So, when I read your piece, I agree with a lot of it.? The trouble is that the average person in such a crisis does not think straight because he is in a crisis that he can’t get out of, and everyone is pinging him for money that he doesn’t have.? Most could mitigate the forced place, and get a cheaper policy in force, but they don’t even have the money for that.? Everything goes against people who are on the brink of bankruptcy, and I feel sorry for them.? Trouble is, as a nation, we encouraged

people to take on too much mortgage debt, and now we are dealing with the aftermath.

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Please pass the above onto your editor, so that he knows that I am not one-sided on this issue.? If he wants, I could reformulate a longer letter that embeds more of the complexity of multiparty insurance deals.??Most financial scandals require three or more parties to be effective.

I did not comment on the lack of incentive to choose the cheapest insurance, because I missed it.? That is one of the perversities of multiple party arrangements.? When you sign an agreement that allows someone to make choices for you if you fail in your obligations, and bill it back to you, or bill it back to the one that will pay if you default, you have essentially said, “If I default, you are free to harm me in some limited way.”

The author responded to me:

Thanks. This is well thought out. I sent your e-mail to our web folks, and expect they?ll follow up. For what it?s worth, I thought your original letter was solid.

The only quibble I?d have is that I guess when it comes down to it, the borrower isn?t actually the entity that I think is usually getting harmed. The investor/GSE is.

That?s sort of the point I wanted to make with the lead of the sidebar (Don?t know if you saw that one: http://www.americanbanker.com/issues/175_216/losses-from-forced-place-insurance-1028475-1.html)

While the borrowers do get a notice of the commission sometimes, the investors have no say in any of this ? but are paying for the commission at the time of foreclosure. When it comes down to it, most force-placed policies aren?t a choice ? they?re bought on homes owned by people who can?t/won?t pay their mortgage, making the information about force-placed costs and commissions useless.

So it seems to me that no amount of disclosure to the borrower could fix that problem. Even if the commissions are being disclosed, they?re being disclosed to a party who is no longer in the game.

The author is entirely correct here, and I hit myself on the head and go “duh” as a result.? There is a hole in the securitization agreements, because if the borrowers go into foreclosure and won’t pay, it comes out of the hide of the junior certificateholders of the securitization.? With GSE loans, that means the taxpayer takes a hit.

From one of the articles:

“It is clear that [the Real Estate Settlement Procedures Act] prohibits fee splitting and unearned fees for services that are not performed,” said Brian Sullivan, spokesman for the Department of Housing and Urban Development. Foreclosure defense and legal aid attorneys say force-placed insurance is found on most of the severely delinquent loans in this country. If so, the cost to investors may well be in the billions of dollars.

“This is clearly not in the investors’ interest,” said Amherst Securities analyst Laurie Goodman, who in May noted the potential for misconduct with Bank of America’s force-placed-insurer subsidiary, Balboa Insurance Group. “Servicers are getting a huge chunk of money from force-placed insurance, and investors pay for it by higher loss severity at the liquidation of the loan.”

This will be hard to enforce in a court of law, but the insurers are doing the work and bearing the risk; those receiving riskless profits are the servicers.? From my view, banks and servicers will be on the hook for bad decisions here.? The insurers have no discretion.

Now, my perception of Assurant is that they are on the more ethical side of their industry here.? But, this is only a belief, and not a fact.? I am willing to accept contrary data, and I welcome the thoughts of those who know things that I don’t.

Down another 7% percent, I will buy more shares of Assurant, but for those that don’t own it, this is a good entry point.? Assurant is a very diversified insurance company, more than any other that I know of.? Their P&C division will not die, and the other divisions are not affected.

PS — It is really difficult to lose money on stocks where the P/E is below 10, and the P/B is below 1.

Full disclosure: long AIZ (it is a double-weight in my portfolio)

Comment on: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

Posted on 6 November 20109 November 2010 by David Merkel

I have the fun of speaking at the Burridge Center Conference at the University of Colorado at Boulder this week on Friday.? The CFA Society of Colorado is co-sponsoring it.? As a guide, they have asked my panel to comment on this piece? by James Montier of GMO: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt.? I’m going to comment on each of the ten questions, and show where I agree and disagree.

Lesson 1: Markets aren?t efficient.

“As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python?s Dead Parrot. No matter how many times you point out that it is dead, believers insist it is just resting.”

I partially disagree.? The EMH is valid as a limiting concept. The markets tend toward efficiency, but there are many disturbances in the market, and some of them are quite big.

The EMH properly understood only means that it is intensely difficult to beat the market, nothing more.? Market prices reveal the current expectations of the market as a knife edge — sharp but thin.? They might be the best estimate of values for the moment, but offer no infallible guide to the future. The crisis tells us nothing about the EMH.

Lesson 2: Relative performance is a dangerous game.

Definitely true.? Those chasing relative performance tend to destabilize markets to the degree that their time horizons are short.? Focusing on short term relative performance leads to an over-emphasis on momentum, and when too many focus on momentum, the markets tend to go nuts — overshooting and falling dramatically, until enough momentum players exit.

Lesson 3: The time is never different.

It’s never different, or it’s always different — which one you choose is a matter of semantics.? The main thing to remember is that human nature never changes.? In aggregate, we don’t learn from market behavior.? We follow trends — we arrive late to the party, and leave the hangover near the nadir.

Most professionals and nonprofessionals tend to chase performance — see lesson 2.? That is a large part of the boom-bust cycle, which no amount of government intervention can repeal.

Here’s some advice: read books on economic history, and avoid current books on how to beat the market.? Learning economic history will help inoculate an investor against greed and panic, and will help the investor understand the guts of the speculation cycle.

Lesson 4: Valuation matters.

You bet it matters.? Excellent long term results stem from buying cheap, among other factors, like margin of safety, earnings quality, and having a sense of the credit cycle, and industry pricing cycles.

Bubble language such as “This time is different,” often appears near the end of booms.? The truth is: it’s never different, or, it’s always different.? Human nature in individual and aggregate, does not change.? Watching valuation is a major way of avoiding getting whipped at extremes, and encourages willingness to invest in the depths of panic.

Lesson 5: Wait for the fat pitch

Also agreed.? One thing that I have focused on in my money management ideas, is to avoid thinking short-term.? There are too many hedge funds, day traders, swing traders, and high-frequency traders out there for me to compete against.? Even mutual funds turn over their positions too rapidly.

I aim to hold investments for three years, but I am not wedded to a time period.? If an investment still looks attractive after five years, compared to the other investments that I hold, I will keep it.? If I find a more? attractive investment than my median idea, I will buy it, and fund it with the proceeds from one of my investments scoring worse than my median idea.

Lesson 6: Sentiment Matters

Yes, sentiment matters, at least until too many people follow it.? I do this in an informal way by following the credit cycle — when risky yields are tight, only own safe stocks.? Volatile stocks rely on sentiment — it is almost a tautology.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

Any investment can be overlevered, and die.? Think of Fannie and Freddie.? They ran on thin capital bases for years, thinking that they could never lose.? So long as housing prices continued to rise, they were right.? And for many, the idea of housing prices falling in aggregate was ridiculous.? Those who suggested that it would happen, like me, were roundly derided.

Yes, leverage can make a good investment bad.

Lesson 8: Over-quantification hides a real risk.

Just because you can quantify it does not mean you understand it.? The Society of Actuaries has a vapid motto quoting John Ruskin: The work of science is to substitute facts for appearances and demonstrations for impressions. Easy to say; hard to do.? Scientists are biased? like everyone else.

Mathematics applied to economics or finance serves to show where assumptions are inaccurate.? Mathematical risk controls are less important than changing the culture of a firm, and setting in place checks and balances.? Toss out VAR, and reduce incentives that would motivate people to take inordinate risks — instead, hire idealists that love the work because they would do it even if they weren’t paid.? That’s how I feel about investing; I just love the game, and wouldn’t want to do anything else.

Lesson 9: Macro matters.

Much as I admire Marty Whitman (and Peter Lynch), I am with Montier and Graham regarding the value of Macro.? Whitman, Pzena, Miller and some others rightfully got their heads handed to them when they neglected the key doctrine of value investing , which is “margin of safety.”? Most of my great mistakes have come from similar neglect.

Particularly when times are unusual, macro factors drive stocks.? But, how well can we predict that?? I’ve done okay over the years, but I am skeptical on being able to do that all of the time.

Lesson 10: Look for sources of cheap insurance.

Again, easy to say, hard to do.? I would like an infinite stream of patsies to soften the blow if I make bad decisions.? In the middle of the 2000s, I felt that shorting credit was nearly a free option, but will there always be bulls making stupid decisions during the bull phase of the market?

On second thought, yes, that should always be true, so where you find cheap insurance, like CDS 2003-2007, buy it.

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So, after all that, aside from point one, I agree with Montier almost entirely.? What a great article he wrote, and what a great article to stimulate the panel that I am on.

The Path of Least Resistance

Posted on 30 October 201031 October 2010 by David Merkel

As with anything in economic forecasting, what I am about to say is at best an educated guess.? Given the present environment, where is the global economy likely to go?

Any analysis like this has to contend with political factors that drive the major imbalances of the global economy.? Here are the imbalances as I see them:

China insists on keeping its currency cheap in order to promote employment at home.
The US does not care about deficits or currency debasement, as it seeks Keynesian remedies to its economic crises.? (Little realizing that they are making things worse…)
The Eurozone protects profligate euro-fringe nations, at the possible cost of destroying the Eurozone as a whole.

If China will not allow its currency to strengthen, well then, the path of least resistance is for the US to debase its currency, leading the world in a cycle of competitive debasement/inflation.? Since many nations want to be net exporters, US Dollar weakness is responded to through debasement, or purchase of US Dollar assets.

Putting it simply, the path of least resistance is inflation.? Reduce the value of nominal debts in real terms.? Eliminate underwater debts by raising the nominal prices of the collateral.

Now, surplus nations like China and Germany will resist this, but I suspect they will be dragged to this, kicking and screaming.

We are in the process of trying the alternative approach to solving the Great Depression via inflation, which will have a different set of problems than the foolishness of FDR.? The problem is too much debt, which needs to be changed into equity, but government tinkering discourages compromises.

Rather than the deflation that characterized the Great Depression, inflation may be what drives the future.? The question could be “how much?”

But all that said, there are other possibilities.? We could raise taxes and pay off the debt.? We could default on the debt.? Neither of these are favored by current politics, but they could happen.

So as you invest, consider an inflationary bias.? I think it is the likely wave of the future.