Value Investing – Page 59

Earnings Estimates as a Control Mechanism, Flawed as they are

Posted on 6 October 2010 by David Merkel

Why does the stock market pay so much attention to earnings estimates?? Don’t earnings estimates embody the worst type of analysis of stocks on Wall Street?

There is some truth to the thought above.? After all, earnings estimates eliminate all one-time charges.? Now, that makes sense in the short run, but not in the long run.? In the short run we want to estimate the growth in value of the business on a continuing basis.? Thus, we eliminate one-time events.? In the long run we must see how a management team has grown the total value of the Corporation.? To do that, we must factor in all of the one-time events as well as the regular earnings in order to see how they have managed Corporation over time.? Would that one-time events were really one-time events.? And, would that one-time events averaged out to zero.? But truth, one-time events are on average highly negative.? And so, companies with a lot of one-time events typically have lousy earnings quality, and deserve a lower price earnings multiple as a result.

So if there is that much trouble with how we measure earnings as far as earnings estimates go, why do we use earnings estimates?? Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.? Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.? The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

So long as the earnings estimates are relied on a fair measure of likely future earnings of the company, they become an influence on the current price stock.? For example:

If earnings estimates rise rapidly, so will stock prices.
If actual earnings comes in above estimates the stock price will have one-time rise.
And vice versa for when estimates fall , and when actual earnings are less than the estimate.

Now if earnings estimates were done right, together with growth estimates, by angels did not men, they would serve as cornerstones for estimating the value of corporations.? But our ability to see the future even collectively is poor.? Many things happen that we do not expect, whether from the government or the central bank or wars, you name it.

But even with all those flaws, earnings estimates provided useful function in being a feedback mechanism so that the market knows how to react in general, when earnings are released.

New Problem

But when beating earnings estimates become the be all and end all of the corporate management, we run into trouble.? Knowing that the estimate drives the stock price, makes some corporations fuddle the accounting.? They adjust revenue recognition, they differ recognition of expenses, enter into useless mergers and acquisitions, etc. Most accounting chicanery problems would not exist if beating the earnings estimates was not so important.

So what do we as investors do?? We look at the release of actual earnings with skepticism.? We carefully consider the adjustment of net earnings to operating earnings and asked whether the adjustments are truly reasonable or not.? We also don’t give full credibility to earnings estimates as if they were a sure thing.? Further, we review revenue recognition policies, and all other means to easily adjust operating earnings so we are not deceived by corporate managements.

And, if I can be so radical, we begin ignoring earnings and focus on growth tangible book value per share.? We look at growth cash flow per share net of maintenance capital expenditure.? We do all we can estimate free cash flow, and yet, take a step back and ask how the free cash flow is being used.

Free cash flow is not valuable if it’s being used to buy back stock at a high multiple.? It’s not valuable if it’s being used to do a scale acquisition.? Both of these are forms of dilution to common shareholders.

The key question is this: is the management building the net worth per share of the company?? That’s a lot harder question asking if the current earnings beat the estimate, but if this were easy, they would’ve brought someone else in to do it, not you or me.

PS ? I leave aside the issue of intangibles here.? Usually intangibles are worthless.? But some are quite valuable, like the name Coca-Cola, or distribution network that is not easily replicated, or research and development is unique to the Corporation has not yet developed into a product.? All that said, for an intangible to have value, it must produce additional cash flow in the cash flow statement under operations, that do not reflect in the earnings statement.

Portfolio Rule Three

Posted on 2 October 20103 October 2010 by David Merkel

One side benefit of deciding to start up Aleph Investments, LLC, is that it is forcing me to write out articles on my rules.? When I was writing for RealMoney.com, I wrote a number of articles about my eight rules, but I only wrote about four out of the eight rules.

Before I write about rule number three this evening, I would like to bring you up to date on what I am doing with Aleph Investments, LLC.? This past week I incorporated the business, and in this coming week.? I will be registering as an investment advisor.? I will be managing equity money, on both a long only and hedged basis.? I have yet to choose a custodian and clearing broker, but I am working on this.? Given the state that I am domiciled in, Maryland, there may be delays but I suspect I’ll be up and running by late November or early December.

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Let me give you a little history of how the eight rules came to be.? In 2000, I had an e-mail discussion with Kenneth Fisher.? I explained to him what I had been doing with small-cap value, and how I had done well with it in the 90s.? He told me to forget everything that I’ve learned, especially the CFA syllabus, and look for the things that I can do better than anyone else.? We exchanged about five or so e-mails; I appreciate the time he spent on me.

So I sat back and thought about what investments had worked best for me in the past.? I noticed that when I got the call right on cyclical industries, the results were spectacular.? I also noticed that I lost most when investing in companies that didn’t have good balance sheets, no matter how “cheap” they were in terms of valuation.

I came to the conclusion that size and value/growth were not the major determinants of my investing success. ?Instead, industry selection played a large role in what went right and wrong with my investment decisions.? So, I decided to formalize that.? I would rotate industries with a value bias.? But that would have other impacts on how I invested.? One of those impacts is rule number three.

I formalized the first seven of the rules in 2002, when the strategy was two years old and seemingly performing quite well.? I began doing what rule number eight states sometime in 2004, and reluctantly added it to the seven rules sometime in 2006.

With that, on to rule number three:

Stick with higher quality companies for a given industry.

There are three simple reasons for why rule number three works:

First, companies with lower debt levels within a given industry tend to be more profitable than companies with higher debt levels that industry, contrary to what the Modigliani-Miller theorems state.
Second, many investors, both retail and professional, have a bias toward what we might call “lottery ticket stocks.”? Many people swing for the fences in the stocks that they buy and accept high risks in order to achieve a high return.? On average, this strategy does not work.? In general, buying high beta, high volatility stocks is a recipe for disaster and buying low beta, low volatility stocks tends to earn money better than the market averages.
Third, if you are rotating industries, there are two ways to do it.? These two ways are not mutually exclusive, you can have part of your portfolio in one strategy and part of your portfolio in the other.? Method one is to look for trends that are clearly going on, but that the market has not fully discounted.? In this case, one can buy companies with excellent or good balance sheets because the trend will carry you along.? Method two is to look for industries that are sick but not dead.? In that case, you only select companies with excellent balance sheets.? This is how it works: if the industry remains sick, weaker competitors will be destroyed, capacity will exit, and pricing power will return to the survivors.? If the industry?s pricing power suddenly improves, then all of the companies industry will do well.? The one with the excellent balance sheet will outperform the market as a whole.? That the ones with poor balance sheets do even better is not a concern.? The idea is to avoid losing money; don’t take the risk by buying the “lottery ticket stock.”

For what it is worth, this same idea not only works with stocks but it works with bonds as well.? If you read the book Finding Alpha, the author has an extensive discussion on why high quality bonds outperform low-quality bonds over the long haul.? In general, corporate bond investors underestimate the costs of default risk.? BBB bonds do best, followed by AAA bonds, and then other investment grade bonds.? After that, the lower the rating of the bond the worse they do.

The same is true of stocks, which is why it pays to look at where the market is in its liquidity cycle.? In November of 2008 through March of 2009, it made a lot of sense to buy junk bonds, and I did so for my church building fund.? Though I didn’t say it at the time and did not act on it, it was also in hindsight the right time to buy junk stocks.? Oh well, that’s water under the bridge.? I tend not to take the risk of buying junk stocks because I don’t want to lose money.? I did well enough by adding to more cyclical names that had strong balance sheets.

Two notes before I close: first, industries tend to have preferred habitats.? In other words, typically the difference between the company with the best balance sheet the industry and the company with the worst balance sheet industry is not all that great.? Why is that?? If you’re in the same industry, typically you have similar levels of fixed costs versus variable costs, and you face the same levels of variability in sales.? These two factors together will lead an industry to a preferred level of financial leverage.? But even though the difference might not be that much between the company with the best balance sheet and the worst balance sheet within the industry, when pricing power is weak that small difference is significant.

Second, I am a proponent of “good enough” investing.? What I am saying here is that it is very difficult to achieve optimal results, and that if you try too hard to achieve optimal results, it is likely that you will do worse than good enough results.? The demands of perfection kill.? Size your goals to what is humanly possible.? My methods allow me to sleep at night.? My methods allow me to step away from my computer, and spend time analyzing what really might matter.? I can go visit clients and not worry that something is going to blow up on me.

This is not laziness on my part.? It is my view that most investors can do well enough in investing at low to moderate levels of risk.? But at high levels of risk, you have to get too many things right too much of the time in order to succeed.

That’s all for now.? Back next week when I write about rule number four.

Portfolio Rule Two

Posted on 25 September 201026 September 2010 by David Merkel

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

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If you have read me for a while, you have heard of my eight rules of stock investing.? Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.? I thought it was a good idea, so this is the second of what is likely to be eight episodes.? Here?s portfolio rule two:

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

The first principle of value investing is having an adequate margin of safety.? Make sure that your downside is clipped, if things go wrong.? But that’s not today’s topic, I will cover it later in this series.

The second principle of value investing is buying the investment cheap to its intrinsic value.? That is an easy phrase to utter, but complicated to implement.? There is no one single simple metric that serves as a guideline for evaluating cheapness as a value investor.

Ideally, one would create an integrated free cash flow and cost of capital model, one like Michael Mauboussin did in his book Expectations Investing.? That is the correct general model to use; the only problem is that it is impossible for individuals or even small investment shops to implement.

So, when evaluating companies, rather than using a complex model for free cash flow and cost of capital, it makes more sense given limited time, to look at the most critical partial sensitivities of the true model.? What do I mean there?

I go back to what the best boss I ever had sent me regarding modeling: “80 to 90% of the valuable model can be encapsulated in the top 2-3 factors of the model.? What that implies to me regarding analysis of valuation is that simple ratios do still have punch.? But the challenge is selecting the ratios that are the most appropriate for companies in a given industry.

Here is the most basic thing I have learned so far about what valuation ratios to use: with financial companies use price-to-book, and with all other companies use price-to-sales.? How did I come up with this insight?? I spent a lot of time using one of Bloomberg’s functions [GE] and I found the tightest correlation of price movement to each of those variables.

But the intuition that I have received from that is not the end of the story.? Let’s stop for a moment and think about what various valuation ratios mean.

The classic ratio is the price to earnings multiple.? It makes a lot of intuitive sense because we want to know how much we are earning per dollar spent on the stock.? Earnings, and its cousin operating earnings, are the lowest figures on the income statement.? They are also the most manipulated numbers on the income statement.? But there are other ratios on the income statement, less manipulated, that exist higher up on the income statement, or over on the cash flow statement.

Operating income/earnings is a means of trying to look at the profitability the business before interest, taxes and nonrecurring elements.? Many analysts think that this is a better measure of earnings on a continuing basis than ordinary earnings, because it eliminates a lot of noise.? But you can go higher up on the income statement and move to price to sales.? Particularly in an environment like this where sales growth is so scarce, the price to sales ratio plays a larger role.? Exactly how cheap can a stock get on price to sales ratio basis?? Where would its valuation be stretched?

Away from that, on the cash flow statement, we have EBITDA, cash from operations and free cash flow.? EBITDA is earnings before interest, taxation, depreciation and amortization.? Cash from operations is simple to understand.? How much cash is the business generating?? So long as that does not involve the buildup of additional liabilities, or need for additional capital expenditure, that can be a useful figure for analysis.? The same is true of EBITDA.? Free cash flow goes further and subtracts maintenance capital expenditure.

Operating earnings and free cash flow are proxies for trying to understand what the income generating capacity of the business is on a normalized basis.

But then there are balance sheet measures like price-to-book and price to tangible book.? The idea is to ask how much assets are allocable to the equity investors.? In financial companies, where the cash flow statement is pretty meaningless, attempting to estimate the value of the firm, using book or tangible book has some power.? Why?? Because financial firms are in the business of shepherding scarce capital in order to produce returns.? Since capital is typically a constraint for earnings price-to-book is a useful measure for analyzing the valuation of the financial company.

The same is largely true of sales for industrial companies, sales are relatively hard to fake.? Now don’t get me wrong here, sales have been faked in many companies.? It helps to study revenue recognition policies, and it also helps to consider the buildup in accruals for accounts receivable.? Yes, sales can be faked, but cash from sales is very hard to fake.

One more metric worthy of consideration is enterprise value to EBITDA.? This metric is useful during times when there are a lot of mergers and acquisitions going on.? This metric measures in a crude way the amount of free cash flow that the assets of the business throw off.? It is the way many acquirers would look at a business.

Another way to think of it is, is the business more valuable in the hands of the current management, or the hands of new management?? If it is more valuable in the hands of new management, enterprise value to EBITDA is the better metric.? If the current management makes it more valuable, then price to sales is the better measure.

Now there are two more ideas that must be considered here: cost of capital, and reversion to mean.? In one sense we want to look at earnings, or free cash flow in excess of the cost capital employed.? The way I handled this is not to estimate the cost of capital but to look at the credit ratings, leverage on the balance sheet, volatility of the stock price, and volatility of earnings in order to get a feel for the riskiness of the company.

Mean-reversion is involved in value investing, in the sense that return on equity for firms tends to mean-revert over time.? What that implies is that it makes sense to pay attention to valuation, because firms in bad shape often clean up their act and get better, and firms in exceptionally good shape find their excess earnings competed away by other firms.? And that’s why value investing tends to work: companies with cheap valuations improve, and multiples expand.? Companies with high multiples tend to contract, because it is difficult to maintain superior growth over the long haul.

Book Review: The Elements of Investing

Posted on 21 September 2010 by David Merkel

This is a basic book.? A very, very basic book.? Did I mention this is a basic book?? Well, it is a basic book.

Sorry about that.? When you read a lot of sophisticated stuff on investing regularly, and then read The Elements of Investing, you know that you have to take a step back and re-think investing for everyone.

Written by Burton G. Malkiel & Charles D. Ellis, two notable investment writers favoring low cost indexing, and with a forward from David Swensen, you know that it will be a traditional buy-and-hold analysis.? (Though there is something funny here.? The authors criticize using the complex asset classes that Swensen uses, and Swensen criticizes buying individual stocks, which the authors use in small measure.)

The book has five sections:

Saving
Indexing
Diversify
Avoid Blunders
Keep it Simple

The section on saving is excellent, and offers many ways that people can cut their spending without ruining their lives.

The indexing section is fine, though it overstates the inability of investors to beat the indexes.? Yes, the market can’t beat the market as a whole, but dedicated investors following value and momentum can beat the market, until too many copy those unpopular strategies.

Diversification is wise.? But there are limits.? If one is going to be active, be active, and ignore the index.? Otherwise, be passive and index.? What’s that, you say: “If I miss by too much, I will lose a lot of assets.”? Sorry, but that is the price of being an active manager.? If you are going to do it make the most of it; don’t hug the index.? But the wag will say, “just avoid being in the bottom quartile.? You only get fired in the bottom quartile, so hug the index.”? The behaviors that benefit managers are not the same ones that benefit clients.

They recommend rebalancing, which I do as well.? They also recommend value investing in moderation.

I am totally in agreement with the chapter on avoiding blunders.? You win by not losing, and compound it over time to really build value.

The section on keeping it simple focuses on asset allocation, tailoring investment returns to individual situations, and is pretty basic.? I found little objectionable here, but I would spend some time analyzing when asset classes are cheap or dear.

They have an appendix on saving on taxes which is valuable, but if I had been in their shoes, I would have described additional strategies to lower tax liabilities off of both capital gains and losses.

Quibbles

They treat international investing as a free lunch, which it is not due to confiscation, currency risks, war, plague, famine, financial failure, etc.? The last forty years have been special, because of peace in developed economies.? That may not be true in the future.? I invest internationally, but only 25% of assets at most, and only in places where I trust the rule of law.

Who would benefit from these books:

This is the perfect book for your dumb brother-in-law (or similar) who has excess cash flow, and always seems to lose money on his investments.? Given the section on saving, it could also be valuable for your spendthrift brother who is constantly complaining about being in debt.

This is a very basic book.? Give it to the clueless; it cetainly won’t hurt them, and it might help them a lot.

If you want to, you can buy it here:?The Elements of Investing.

Full disclosure: Without asking, I was e-mailed a copy of the book.? Personally, if I were the publisher, I would send a physical copy.? Not that I am going to post it for free use, but I know that many will.

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.

Portfolio Rule One

Posted on 18 September 201019 September 2010 by David Merkel

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

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If you have read me for a while, you have heard of my eight rules of stock investing.? Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.? I thought it was a good idea, so this is the first of what is likely to be eight episodes.? Here’s portfolio rule one:

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

I always get a little look of surprise the first time that I mention my main idea to consultants or other equity managers. I sometimes say, “Some managers are top down, others are bottom up — I am middle out.”? The idea is that I don’t rely on a view of the economy to drive my investing, nor do I just look for cheap stocks, wherever I might find them.? Instead, I look for industries that are hated, either absolutely or relatively.

In my view, paying attention to industry fundamentals is always superior to viewing the economy as a whole, because:

The industry cycles as compared to the overall economic cycle are not exact comparisons, both with respect to timing and amount.
Among other reasons, demand outside the US can be decidedly different than demand inside the US.
New entrants and company failures and acquisitions can affect the industry economics more than the general economy.
Major innovations like the Internet can turn stable cash flow generators like newspapers and parts of the telephone industry into permanent losers.

If I were allowed to turn back the clock, and teach those who allocate equity assets how it really works, I would have told them to ignore value and growth, large and small.? I would replace those with industries.? Industries tend toward value and growth, large and small, but the aggregation hides a lot of valuable information.? But the consultant community is a sucker for simple explanations that explain little of a more complex reality.

Think about it, ideally, when to you want to buy shares in an industry?? When the hatred is thick.? Valuations are crushed to the degree that they can’t go much lower.? And at such a point, the risk lover buys the dodgiest company in the industry — high fixed costs, bad balance sheet.? Clever, but what if the recovery takes too long, and it goes broke?? Such a strategy makes a short-term bet.? Those with a longer time horizon, and reasonable expectations, buy the high quality company.? If the downturn prolongs, more competitors will fail, and they will pick up pricing power.? If the downturn ends quickly, and pricing power returns, the high-quality company will still do very well relative to the market as a whole, though a lower quality name that might have died under other circumstances will do much better.

The second-best place to buy are industries in the midst of improving pricing power that will persist, but many think it will not persist.? In that case, since there is only a low threat of companies going into financial stress, buying cheap companies of moderate quality will result in very good gains.? The risk is that I am wrong in my estimate of continuing pricing power, but if I am wrong, the cheap name typically won’t do that badly, and I can trade away for the small gain, or not much of a loss.

All of this means spending time watching industry economics, looking for places that will outperform market expectations.? This isn’t always easy, but there aren’t so many players asking those questions, compared to those doing top down or bottom up investing, and so I have a better chance of profit, in my opinion.

PS — For those with access to RealMoney, some of my best articles on portfolio management are listed here.

Micro + Soft = Small + Squishy

Posted on 14 September 201014 September 2010 by David Merkel

When Microsoft decided to do its special dividend in 2004, I was interviewed by TheStreet.com.? I commented here:

In addition, the stock may avoid falling a full $3 because many investors believe the cash is better in their wallet and not in Microsoft’s. “Some people might say, ‘Well, good, that means Microsoft can’t waste the money on an acquisition that might not be so good,'” said David Merkel, a senior investment analyst with Hovde Capital and columnist for RealMoney.com. “So it might actually make Microsoft’s stock price go up a little bit.” (Merkel’s firm does not hold Microsoft shares.)

“Cash is worth more in my hand [than the company’s hands] almost always,” Merkel added.

And then at the same time here:

“In a case like Microsoft, where management has committed to returning cash to shareholders, you can value that cash at face value,” said David Merkel, a senior analyst with Hovde Capital and columnist for RealMoney.com. He believes the only time to deduct a company’s cash on a dollar-for-dollar basis is when there is a definite liquidity event, such as Microsoft’s special dividend, that truly gives investors control of the cash.

In the early 1980s, cash had that dollar-for-dollar value because so many corporate raiders were putting the cash on their balance sheets for use in buying other companies.

But in today’s world, a more likely use of cash might be buying back stock — a step Microsoft is taking in addition to its special dividend. But announcing a buyback plan is no guarantee a company will buy the shares, Merkel noted. Hence, he would only deduct 90 cents for every $1 of cash from a stock’s price to value a stock because of uncertainty as to whether management will use that cash as it says.

Another situation in which you might not give a company full credit for its cash is if you don’t fully trust management, perhaps because it has a bad track record with acquisitions or expanding into new markets, Merkel said.

My view was that Microsoft was a mature business that needed to return cash to its shareholders.? The more, the better; cash in the hands of management was leading to poor acquisitions and overpriced buybacks.

Now consider the returns on MSFT stock from August 2004 through August 2010:

Less than 1%/year does not make it, particularly when the stock is basically a wasting trust.? I don’t have interest in the company, because they have consistently bought back shares at high prices — near $34/share over the last four years, considering issuance to employees.

Also, Microsoft may look cheap on an earnings basis after deducting cash, but much of the cash is not free to be dividended.? Microsoft would have to pay taxes to repatriate the money.? (Can’t they find a clever transfer-pricing accountant?)? Why pay more than six times tangible book for a company that is not growing its earnings rapidly, and misuses its free cash on buybacks and acquisitions?

So when I hear that Microsoft will borrow money to fund dividends and a buyback, I say, “Why pay money for financial engineering?? Better you should look for genuine organic growth.”? There is nothing good to be found in Microsoft, look elsewhere for value among tech companies.

Dave, What Should I Do?

Posted on 8 September 201011 September 2010 by David Merkel

I get requests from local friends fairly regularly for aid in understanding their finances.? While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.? Her response was, “So what else is new?”? Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.? As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.? Her father was well-off, but humble, and I am well-off, and I try to be humble.? You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.? I will take no money, but I won’t hold your hand and guide you either.? I will give you very basic advice, and it is up to you to learn and implement it.”? I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.? Another son-in-law, given to incaution, is advising putting everything into gold and silver.? What to do?

She has adequate assets to support her through the rest of her life.? Her husband was responsible.? I asked her if she needed more income, and she said no.? I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.? She didn’t see the need, and I told her that was fine.? She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.? But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.? Her husband was a great guy; an inspiration to me in many ways.? He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.? What to do?? I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.? I suggested purging certain funds that were likely mismanaged.? I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.? Funds are from TIAA-CREF.? We decided on a 50-50 stock-bond mix three years ago.? Recently we rebalanced to add more equities.? He was disappointed that his portfolio had moved backward.? I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.? My stylized view of it stems from comments that I got at church.? In 1999, my friends were people into equities, as I was holding back.?? In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.? I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.? By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.? We all become worse capital allocators when there is no safe place to put excess funds.? It tempts people to stupid decisions.? If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.? Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.? If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.? They have no sense of looking through the windshield, rather they ask what has worked, and do that.? Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.? The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.? The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.? Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.? The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.? They can only deliver what the real economy does.? Stocks only do well over the long run if profits do well. Valuations come and go.? Bonds make money off the stated interest (coupon) rate less default losses.? Valuations come and go.? Real estate is worth the stream of services that the land and improvements can deliver.? Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.? But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.? The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

Illustrating an investment plan for a family
Setting the discount rate for a defined benefit pension plan
Setting the spending rate on an endowment
or even, setting assumptions for the Social Security trust funds.

Recent Portfolio Actions

Posted on 1 September 2010 by David Merkel

New Buys:

5/19/2010????? Petrobras
7/9/2010??????? Goldman Sachs Group Inc
8/31/2010????? American Electric Power
8/31/2010????? Corn Products International
8/31/2010????? Zhongpin
8/31/2010????? PC Connection
8/31/2010????? Stancorp Financial

New Sales:

8/31/2010????? Goldman Sachs Group Inc
8/31/2010????? Dominion Energy
8/31/2010????? PPL Inc.
8/31/2010????? Sempra Power
8/31/2010????? Safeway Inc.

Rebalancing Buys:

5/19/2010????? Ensco International Inc
6/1/2010??????? Noble Corporation
6/29/2010????? Computer Sciences Corp
6/30/2010????? Industrias Bachoco
6/30/2010????? Northrop Grumman
6/8/2010??????? Safeway Inc
7/6/2010??????? National Presto
8/12/2010????? Constellation Energy Group

Rebalancing Sales:

8/2/2010??????? Noble Corporation

Thoughts

1)? I try not to trade too much.? For those that are new to my writings, rebalancing buys and sells are meant to bring the positions back to target weight after they have moved 20% away from the target weight.? As it is, for three months, I have not made a lot of trades.

2) I reduced utility exposure, it seems to have gotten relatively expensive amid the yield craze.? I have added cheap, well-financed names in a number of areas.

3) Assurant and National Western are double weights.? The rest of the portfolio is equal-weighted aside from that.? Note that National Western is quite illiquid.? Do not place market orders to buy or sell.

4) I flipped my momentum factor from small negative to moderate positive.? I have concluded that in a touchy macro environment like this, it is wise to consider return momentum.

5) I still don?t trust the financial sector aside from insurers here.

6) I had some runners-up in my analyses: AXS EDS TRH DFG

7 ) Some thoughts on the 8/31 buys:

PC Connection is a net-net, illiquid, but makes money.? Unusual to have a company that trades for less than its net assets, and makes money.? THIS IS ILLIQUID.? NO MARKET ORDERS.
Stancorp Financial is a well-run insurer trading at a discount.? Issues: Commercial mortgage exposure high, and disability may prove problematic during recessionary conditions.
American Electric Power was cheaper than the utilities it replaced.
Zhongpin sells pork in China.? Seems cheap, and has a decent amount of growth potential.? The financials look clean, but I am still reviewing it.
Corn Products seems cheap, and its products are needed globally.

8 ) I have roughly 11% in cash.? If I find a really good idea, I might bring that down to 8%.? At present, my stocks are nearer to the high end of their rebalancing bands, so I am more likely to be doing a little selling than buying of my existing stocks in the short-run.

9)? Here was the last update.? Comments welcome.

Full disclosure (here is the whole portfolio): COP SBS DIIBF IBA VLO NTE SAFT RGA ESV ALL PRE PEP GPC LNT AIZ ADM CVX NE ORCL NWLI CB CSC NOC NPK SCG TOT SENEA CEG PBR AEP HOGS PCCC SFG CPO

Tickers for the Current Portfolio Reshaping

Posted on 28 August 201029 August 2010 by David Merkel

I haven’t written about my portfolio management methods in a while.? I’ll be writing on this a few more times over the next week or so.? The eighth rule of my investing is:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

First I have to get new ideas.? I have two sources for that:

My industry rank study.? Within those industries chosen, I run a screen that uses financial strength, valuation, and growth potential to highlight promising names.? Of the 34 current names in the portfolio, the screen chose 10 of them, out of 79 suggested names.
Trolling around on the web and talking to friends.? When I hear a promising idea, I print it out or write it down, and put it in a pile to wait for the next reshaping.? This helps me to forget who suggested it and why, so that I am forced evaluate it independently.? If I don’t fully understand it, I will not know when to buy more or sell it.? That generated 40 additional names.

Anyway, here are the tickers for the?replacement candidates:

ABFS ACM AEP AFL AMGN APA APC APOL ATPG AXS BCE BDX BHI BRY BT CAG CALM CAM CDI CL CLX CNQ CPO CVS DFG DLM DO EGN ENR ESLT FDP FISV FLIR FRX FST FTO GD GLRE GMXR HAL HOGS HRL HSII IP JBL KELYA KEX KFT KHDHF LLL LNC LPX MDT MDU MET MMM MOG/A MOT MRO MUR MWV NBR NEMNLC NOV NVDA OCR OII OSG PCCC PG PRU PXD PXP RAH RDS/A RE REP RIG RNR RTN SJM SPR SU SUN SXT TDW TDY TEG THS TK TLM TMK TMO TRH TRP TSO TTI UNM V VZ WAG WAT WMT WPP WY YUM

I will run my quantitative model on these companies versus the current companies in the portfolio, and kick out companies I now own that score poorly and buy some the score well.? This procedure is not absolute; there are often bits of data? that the quantitative factors ignore.? But when all is said and done, I buy companies that I think are better than those that I am selling.

This also forces me to review the whole portfolio, and be dispassionate about what gets sold.? It also forces me to take things slow, and not make hasty decisions.

What factors exist in my scoring model:

Valuation – Earnings, Book, Sales
Momentum
Earnings Quality
Sentiment indicators — neglect, volatility, etc.

I change the weights over time.? I ask myself, “What is working now?” and, “What has or hasn’t been working for too long?”? What working now should get extra weight, while leaning away from ideas that are too popular, and leaning toward those that are unfairly tarred as dead.

But this is only an aid and a guide.? If I put something into the portfolio, it has to pass my qualitative reasoning tests, which admittedly are subjective, but encompass my reasoning as a businessman.

In short, that is what I do.? I hope to give you an update in a few days to explain how this practically worked out in this reshaping.? If you have other tickers that you think I should consider please let me know in the comments, and I will toss them into the mix.? Thanks.

Industry Ranks August 2010

Posted on 26 August 201026 August 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 still like energy names here, some utilities, and reinsurers, particularly those that are strongly capitalized.? I?m not concerned about hurricanes for the strongly capitalized (it’s not likely to be a strong season anyway; if it hasn’t been strong yet, it likely will not be); they will be around to benefit from the increase in pricing power after any set of hurricanes.

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, toiletries will still be purchased.? Phone calls will still be made, and the internet will still be accessed.? Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

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.