Value Investing – Page 64

Post 1000

Posted on 8 July 20098 July 2009 by David Merkel

Every 100 posts or so, I stop to talk to my readers more personally, thank them for reading me, reflect on where we have been, and where we might be headed.

From my heart, I thank you for reading me.? You have many things to do with your time, and you deign to read me.? Thanks.? In some ways, my blog is an acquired taste.? I cover many areas thinly, because I have a broad range of interests in finance, business and economics.? I’m sure that the average reader has to endure (or ignore) 50% of what I write, and that’s fine.

Where have we been

I am reminded of Psalm 66, verse 12 in the era we have been through: Thou hast caused men to ride over our heads; we went through fire and through water: but thou broughtest us out into a wealthy place. [KJV]? The wealthy place is not yet here.? This has been a chaotic time.? We have seen markets destroyed, and come back to life in more limited ways.? There has been a bounce-back from panic, but options are reduced compared to where we were when I started writing this blog.? Areas of over-leverage have been revealed, even in seemingly safe areas.? There is nothing certain in such an environment.? All of the old certainties get questioned, even if they survive.

Where we are now

Though I am a value investor, and a quantitative investor, I don’t write much about my stock picks, mainly because you don’t get much praise for it, and you get a lot of complaints when you are wrong.? I wrote a piece at RealMoney that reflected my frustration in writing there about my investments.? It was called: Investing Is About the Whole Portfolio.? Too many people are looking for stock picks, when they should be looking to learn thought processes.? With a stock pick, you don’t know what to do as markets change.? Learning the thought processes is more complex, but it prepares you in how to understand the market as it changes, albeit imperfectly.

I spend a lot of time on macroeconomic and fixed income issues.? Why?? The bond market is bigger than the stock market, and has a big effect on the stock market.? I keep toying with an idea that would replace Modern Portfolio Theory, with something that would use contingent claims theory to develop a consistent cost of capital model for enterprises.? Essentially, it says that in ordinary circumstances, the more risk one takes in the capital structure of a company, the higher the return required to invest.? Estimate the implied volatility of the assets, and then apply that to the liabilities and equity.

Another way of saying it is that we can learn more from the shape of the yield curve and credit spreads than by looking at backward-looking estimates of asset class returns.? I continue to be amazed at those that use historical averages for asset allocation.? Start with the yield curve.? That will give you a good estimate on bond returns.? When credit spreads are high, typically it is better to be in corporate bonds rather than stocks, but it does imply that stocks might be cheap relative to Treasury bonds.

Most of the time the markets as a group tell the same story.? It gets interesting where one is out of line from the others.? My current example is banks exposed to commercial real estate versus REIT stocks and bonds, and CMBS.? The banks are not reflecting the future losses, but the REITs and CMBS are reflecting the losses.? Chalk it up to accounting rules for the banks.

Where are we going?

Demographics is destiny, to some degree.? Countries that shrink, or have large pension/healthcare promises will have a hard time of it.

Defaults are rising in both the corporate and consumer sectors.? Anyone who thinks the financials are out of the woods is wrong.? Even as new housing sales rise, there are many defaulting on their mortgages because they can’t afford their mortgages, or think that they are stuck with too much payment for too little house.? Add onto that continuing problems with commercial mortgage defaults and corporate defaults.

The Dollar is a problem in search of a solution.? None of the solutions are any good, so changes get delayed until the pain can’t be stood anymore.? This could be decades or years — but the Dollar is in decline.

The world has more laborers, the same amount of capital, and declining resources.? Relatively, the price of labor should go down, and the price of resources up.? The value of capital will fluctuate in-between.

Where is this blog headed?

We are going in my own idiosyncratic direction.? That means when crises hit, I will be there.? Aside from that, I will talk about the issues that affect the markets more generally.? There will be book reviews.? The next two are from Justin Fox, and James Grant.

I have more models that I will trot out.? For example, I have a short-term investment model that I am developing, and I hope it will come out in the next six months.? I might also roll out my alternative to Modern Portfolio Theory, if I work it out (I am dubious that I will get there).? I also have a review of the people on the FOMC coming out.? There’s more… I always have a list of articles that I want to get to, but time is short.

Time is short.? My apologies to all who have written to me, but I have not responded to.? I can’t answer all of my e-mails.? I do read all of them, and I appreciate that you write to me.? I don’t read comments on other sites that repulish my works, so I urge you to write to me here if you want to bring something to my attention.

One last bit of thanks

I could have stayed behind the pay wall at RealMoney, but I wanted to interact with a broader audience.? Amid some criticism, the investment blogosphere is a very intelligent place, and more attuned to the real situation than most of the mainstream news media.? Give the New York Times, the Wall Street Journal, Bloomberg, and Reuters their due, but the world needs investment bloggers — we point out truths that are missed by many.? I am not speaking for me, but for the many that I respect in blogging.

And as for readers, I thank the following selection of institutions where I have readers:

Alexander & Alexander
AllianceBernstein L.P. (US)
AMAZON.COM (US)
American International Group
Bank of America (GB)
Banque Paribas (US)
Barclays Capital (GB)
Bharti Broadband (IN)
BLOOMBERG, LLP (US)
Bridgewater Associates
Cambridge MAN Customers (GB)
Charles Schwab & Co. (US)
CIBC World Markets (CA)
Citadel Investment Group
Citicorp Global Information
Credit Suisse Group
DBS VICKERS SECURITIES
Dean Witter Financial Services
DEUTSCHE BANK (US)
Dow Jones-Telerate (US)
Dresdner Kleinwort Wasserstein
Federal Home Loan Mortgage
Federal Reserve Board (US)
Fidelity Investments (US)
GOLDMAN SACHS COMPANY (US)
Google (US)
H&R Block (US)
Harvard University (US)
Hewlett-Packard Company (US)
HSBC Bank plc, UK (GB)
Intel Corporation (US)
INTERNAL REVENUE SERVICE (US)
Jefferies & Company (US)
Johns Hopkins University
JPMorgan Chase & Co. (US)
Knight Capital Group (US)
KOCH INDUSTRIES (US)
KPMG LLP (US)
LEHMAN BROTHERS (US)
MAN Financial (US)
Merrill Lynch and Company (US)
Michigan State Government (US)
Microsoft Corp (US)
MILLENIUM PARTNERS, L.P. (US)
Moody’s Investors Service (US)
Morgan Stanley Group (US)
Morningstar (US)
Mutual of Omaha Insurance
Nat West Bank Group (GB)
Nesbitt Burns (CA)
Nomura International plc
Northern Trust Company (US)
RBC CAPITAL MARKETS
Repubblica e Cantone Ticino
Royal Bank of Canada (CA)
Salomon (US)
Societe Generale (FR)
Speakeasy (US)
Stanford University (US)
STARBUCKS COFFEE COMPANY (US)
The St. Paul Travelers Companies
The Vanguard Group (US)
Thomson Financial Services (US)
UBS AG (US)
Union Bank of California (US)
United States Senate (US)
University of Chicago (US)
University of Virginia (US)
US Department of the Treasury
Watson Wyatt
WELLS FARGO BANK (US)
Yale University (US)

What a group.? I am honored.? Again, thanks for reading me, whoever you are, and whoever you work for.

Final note

I am still looking for a lead institutional investor for my equity fund, which is available in both a long only, and market-neutral form.? (I’ve beaten the S&P 500 8 out of the last 9 years.)? If any of my readers have a lead on any institutional investor who might want to invest $1 million or more in my fund, please e-mail me, and I will send you my pitchbook.? Whoever gets me my first institutional investor gets my undying gratitude.? Help me if you can.

Book Review: The Guru Investor

Posted on 17 June 200917 June 2009 by David Merkel

John Reese and I share something in common: we both once wrote for RealMoney.com.? Occasionally I would question him in? the CC about what he wrote, but I never got an answer back.? He was probably a busy man.

Well, now I get to review his book, and I have to say that I like it.? It won’t be one of my favorite investment books, but it embeds many good ideas that will be useful to average investors.? Here are some of the main advantages:

1) It points people toward strategies that are valuation-conscious.? Whether investing for growth or value, the best investors pay attention to valuation.

2) Valuation is not everything.? Earnings growth and price momentum also are valuable to follow.

3)? Quality of the balance sheet matters.

One of the things that I like to say to investors is find something that fits your character, your free time, and your time horizon.?? This book simplifies the strategies of ten clever investors.? Some require more time and effort, some less.? With ten good strategies to choose from, perhaps one will fit your situation well.

For the ten gurus, it describes them, their strategies, and how to implement them in a simplified way.? I knew a little about all of the gurus before reading the book, but I learned a little bit new about each one, except Buffett.? They made life choices that led them to their investment theories, and the book makes that connection.

Sell Discipline

The sell disciplines in the book are similar to mine — rebalancing, and adding stocks that the model likes better, and removing those that rank lower.? For fundamental investors, that’s a reasonable way of limiting risk, assuming that you review your thesis before adding new money.

Quibbles

1)? Earnings quality: leaving aside Piotorski, the rest of the gurus spend little time on earnings quality.? Particularly for value investors this component is critical for avoiding mistakes.

2)? What Reese puts forth is a simplified version of what most of these great investors do.? The actual process is more complex, and requires business judgment.? That said, his simplifed versions have done better than the market, in general.

3)? Performance calculations cut off in July 2008.? Now, he had to cut off somewhere, or he couldn’t publish.? Still, it would be interesting to know how the strategies did July 2008 through February 2009 — how did they do at risk control?

4) To be able to use this book effectively, you would need to have access to some reasonably sophisticated stock screening software.? The cheapest one that I know of would come from AAII, but you would also have to be an AAII member to buy it.? (If anyone knows a better one at a cheaper price, let me know.)

Who Would Benefit From this Book

This book would work best for people who want to follow valuation-conscious strategies, and not spend a ton of time at it, if they are willing to put in some time at the beginning setting up stock screens.

Summary

If after you have read this, you want to buy the book, you can buy it here — The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.

Full disclosure: I get a small commission from Amazon on anything that gets bought after entering Amazon through my site.? Your price doesn’t go up, and Amazon is always happy to have additional sales, even at a lower gross margin.

Fruits and Vegetables Versus Assets in Demand

Posted on 9 June 20099 June 2009 by David Merkel

There is a way in which fruits and vegetables and financial products are opposites: when quantities are high for fruits and vegetables, quality is high, and prices are low. With financial products, when issuance is high, quality is low, and pricing is expensive, leading to poor future returns from lower yields, and higher future defaults. I offer this for what it is worth, but is there something more to it, than the seeming oppositeness?? Why are they opposites?

Do you Want to be Proud, or do you Want to Make Money?

Posted on 4 June 2009 by David Merkel

Abnormal Returns, my favorite investing blog,? had a piece yesterday entitled: Being right is?overrated.? It was a good post, but I felt I needed to take the other side of the argument, because I have heard this argument too much recently.? Here is what I wrote:

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I?m going to take the other side of this one. This is a bear/choppy market argument. During a sustained bull market, being right makes lots of money.

When I choose stocks, I do all that I can to have the odds tipped in my favor ? industry analysis, earnings quality analysis, valuation analysis, balance sheet analysis, free cash flow use, and even a review of the anomalies like momentum, volatility, balance sheet growth, etc.

It?s not perfect, but I typically have 70% winners, and my winners are larger than my losers. Being right helps make money? does anyone doubt that? But hubris destroys.

Does that mean I give up my risk control disciplines? No. I get things wrong, and when I am wrong, I cut my losses. Every 20% move down requires a review ? if the thesis is intact, I buy enough to rebalance. If not, I sell.

Also, my methods continually improve my portfolio, selling things with less potential to buy things with greater potential.

-===-=-=-=-=-=-=-=?=

I?ll give you this ? I knew a fellow for whom every position was a holy crusade. The regret level was high. He always wanted to win, and win big. Risk control took a back seat. If his staff had not been correct with a high level of frequency, his asset management firm would have died. As it was, they were constantly dealing with shorts running against them, with the pain of increase, cover some, go flat. Usually it went first increase, increase a little more, then cover some, some more, some more, until the momentum broke, and they would scale out with modest losses. And, the opposite with longs going down, but they wouldn?t rebalance like I do; they would double the position.

Toward money management of this sort, I would say, ?Do you want to make money, or do you want to be proud?? Pride goeth before a fall (Pr 16:18). It?s fine to want to be right, and to aim for it, but it is wrong to not be modest, and realize that we will be wrong, and methods must be employed to limit losses when we are wrong.

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Humility is an asset in all of life — it is even more so when it comes to asset management.? Reckless, macho asset management tends to lose, while those that focus on “what could go wrong?” tend to win.? Ben Graham’s main idea was not cheapness, it was margin of safety — we need to focus on safety more, and cheapness less.

“Just Gimme the Answer, Will Ya?”

Posted on 3 June 2009 by David Merkel

Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.

Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:

“What’s my illiquid structured finance bond worth?”

Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.

“How will this equity portfolio behave versus the market?”

Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.

“This investment will eventually come back, right?”

No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.

“What’s the interest rate sensitivity of this illiquid structured finance bond?”

Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.

“What’s the right spread to Treasuries for this illiquid bond?”

Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.

What’s the right yield tradeoff between bonds of different credit quality classes?

Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.

“Just Gimme the Answer, Will Ya?!? I need an Answer!”

Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.

Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.

You mean there are no answers?

No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.

I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”

I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.

Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.

So what should I do?

Keep a reserve fund of safe assets.
Be skeptical of short, intermediate, and long-term results, but for different reasons.
Resist trends during normal times, but during times of extreme movement, let it run.
Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.

There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.

Fifteen Thoughts on Advantage in the Markets

Posted on 29 May 2009 by David Merkel

1) I made the point last week when I talked about my experiences in the pension division of Provident Mutual.? The investment choices of 90% of individuals follows recent performance.? This is another factor in why markets overshoot, and why mean-reversion is a weak tendency.? Thus when I see many leaving the stock market for absolute return, bonds, cash, commodities, it makes me incrementally more bullish, though I am slightly bearish at present.

2) Has this been a “suckers rally?”? That’s too severe, but there is some truth to it. Many of the large financials may be safe, but at a cost of higher taxes and inflation.? Also, the losses on commercial real estate have not been felt yet on the balance sheets of banks.? I think we will break the recent lows on the S&P 500 before this is all done.? Debt deflation and dilution continues on.? We have an overhang in residential housing that will require prices to go below equilibrium in order to clear.? Global growth is anemic, even if some of the emerging markets are doing well.

3) When writing for RealMoney, I was usually diffident about buybacks, because I liked to see strong balance sheets.? Now in this era, those that bought back a lot in the past are paying the price.? Buy high, dilute low is a recipe for big underperformance, and we are seeing it in financials now.? (The comments about pension design in the article are spot-on as well.)

4) Behavioral economics does justice to what man is really like, both individually and collectively.? We are prone to laziness, greed and fear.? There is a weak tendency for a minority of individuals to break free from the fads and fashions of men, and pursue profit exclusively.? Remember, thinking hurts, so people conserve on it, unless the reward for thinking exceeds the pain.

5) Quantitative managers have gotten whacked, and few more than Cliff Asness of AQR.? It doesn’t help that you are outspoken, or that you took time away to aid the CFA Institute.? When the business goes south, thereare no excuses that work.? In times like this, be quiet, analyze? failure, and stick to your knitting.

6)? Ken Fisher made an argument like this in his book The Wall Street Waltz.? Eddy’s argument is ordinarily right; buy during bad times.? The only time that is not true is when you are in a depression, and there is much more debt to be liquidated, and more jobs to be lost.

7)? From Quantifiable Edges, there is some evidence that the ratio of the Nasdaq Composite to the S&P 500 can be used as a timing indicator.? Nasdaq Composite outperformance presages more positive returns in the S&P.

8 )? I read the article on the “purified VIX” and other “purified” indicators, and I get it.? Adam is still correct that periods where the VIX and SPX move in the same direction tall you something about future SPX performance.? If both are up, then the trend for the SPX tends to be up.?? Vice-versa if both are down.

9) Regarding this article on David Rosenberg, I think the earnings? are too optimistic, but the P/E multiple is too pessimistic.? Things may be ugly for a while, but I can see an S&P 500 above 1000 in 2011.? (That may be inflation.)

This phrase is problematic “As for the multiple, Rosie believes the P/E should approximate a Baa bond yield, leading to an “appropriate” multiple of 12x.”? E/P on average should be equal to a Baa bond average less 4%, making a fair P/E at 20+.

10) Beta stinks.? You knew that.? Here’s more ammo for the gun.? I have doubted the CAPM for almost 30 years.? It’s only value is to confuse other wise intelligent comptetitors.

11) Is small cap value still relevant?? Is winning relevant?? Please ignore the studies that use betas that adjust for small cap, value, and momentum — using each of those is a management choice, and those of us that choose to be smart take credit for following research, not that research should discount our actions.

12) Yes, the Q-ratio works.? Don’t tell anyone about it, though.? Shh…

13) Dow 36,000.? Yes, in 2030.? Glassman and Hassett were sensationalists that pushed an idea of rationality too hard, suggesting that people could accept a near-zero risk premium to invest in stocks, versus treasury bonds.? Bad idea.? The E/P of stocks averages near the Baa bond yield less 4%.? Stocks need 4% earnings growth to compete with bonds on average.

14) Homes are for living in; they are only secondarily investments, if you know what you are doing.? Compared to TIPS, gains in homeowning, less expenses, are comparable.

15)? As this post points out, and I have said it before, “The vast majority of currency ETFs represent stakes in an interest-bearing?bank account denominated in a foreign currency. They derive all their?return from two sources: the cash yield of the foreign currency over the expense ratio of the fund and changes in the exchange rate against the dollar.”? Be careful with foreign currency funds; they often embed financial credit risk.

Return of Industry Ranks

Posted on 27 May 2009 by David Merkel

I didn’t talk much about it at the time, but I had a hard drive crash around February 1st of this year, and it wiped out my main industry rotation model, and many other things as well. My last backup of the model was eight months earlier — I resolved to become better at backing up my data.

To do that, I back up my main files using a free service from Microsoft, mesh.com, in a way they didn’t intend.? Mesh is a way of synchronizing files across computers painlessly.? Well, almost painlessly; it is a bit of a bandwidth hog.? I turn it on for fifteen minutes each day, and updated and new files are replicated in cyberspace.? If I accidentally destroy a file, I can restore it.

Back to my dilemma in February — if I didn’t have my main model, at least I had my secondary model.? The secondary model was derived from a set of pieces written here (one, two), about four months ago, about the time that the momentum anomaly began to become overused (and right prior to the hard drive crash — I need to rebuild that model as well — I know its main result, but my proof is gone).

Fortunately, the two models give fairly similar results, although the secondary model predicts monthly performance, and my main model, annual performance.? The choice becomes what mode to use the model in — value/mean-reversion mode (cool-green), or momentum mode (red-hot).? Typically, I work in value mode, but recently I have been taking ideas from both the red and green zones.

There are two ways to do industry rotation.? In the green zone, the question is “Where has hope been abandoned?”? Buy the financially strongest companies there, and when the cycle turns (it always does, except for buggy whip industries like newspapers), you will do well.? In the red zone, the question to ask is, where have trends been underdiscounted?? In that case, buy companies of reasonable strength that will benefit from the persistence of the trend.

I have highlighted a few areas that I would consider at the top of the graphic, where it reads “dig through.”? You may see other opportunities that I don’t.? Either way, be careful as you select industries to invest in.? Careful selection pays off.

Book Review: Quantitative Strategies for Achieving Alpha

Posted on 20 May 2009 by David Merkel

In order to do this book review, I have to compare the book to five others that I have reviewed.

I chose these five, because they deal with factors that affect stock performance.? With 1 and 4, you can learn a great deal about price momentum.? With 4, you learn how price momentum and mean reversion interact, and even get taste of why even fundamentalists should grab onto this.

Today’s book, Quantitative Strategies for Achieving Alpha, takes a mix of factors, including price momentum, and attempts to show how investors can achieve above average returns.? That is similar to what was posited in books 2 and 3 in rudimentary ways, and in book 5 in more sophisticated ways.? The book that is most similar to this book is What Works on Wall Street.? More on that later.

The author has seven “basics” that must be applied to all investments:

Profitability
Valuation
Cash Flow
Growth
Capital Allocation
Price Momentum
Red Flags

These are the building blocks of good investment strategies, and the best strategies use 2 or more of the “basics.”? This is consistent with the book What Works on Wall Street.? The most important “basics” are Profitability, Valuation, Cash Flow, and Price Momentum.? Good strategies will look at most of them.

Quibbles

The data period for the analyses was short — a mere 20 years 1987-2006.? As time has gone on, data collection has gotten richer, but the 20 year period chosen was one of a big bull market, and not necessarily representative of the next 20 years.
Data mining — when testing a wide number of similar hypotheses, data snooping is a problem.? If theory A works well, why not test theories A’, A+, A-, A*, etc?? That happens in this book, but it does not make the error of What Works on Wall Street, because it does not make claims that the best strategies from the sample period will be the best strategies for the future.
Also on data mining, in the price momentum section, analyses are done to see which momentum strategies did best over the sample period, and then those strategies are applied.? Someone starting out in 1987 would not have had the benefit of that knowledge.
Strategies that favor increasing debt worked well, but that is a relic of the Greenspan era, where overages of debt were never punished.
Cash flow was an important variable, and there were variables for capital allocation, but there was not much discussion of earnings quality by itself, which has significant predictive powers.

The book is data and statistics heavy, but not equation heavy.? If your eyes glaze over from numbers and statistics, this is not for you.

Wrong way to use the book

Look for the strategies that gave the highest excess returns, Sharpe ratios, etc.? Follow those strategies religiously.? If you do this, you will mimic the excesses of the period 1987-2006.? Those won’t recur in the same way 2009-2028.

Right way to use the book

Use the book to guide your strategies.? Look at how you currently analyze stocks, and see if you aren’t missing significant factors that could improve your performance.? Look to balance your strategies such that all of the main factors get some representation.

Also, the summaries of each chapter are simple, and give the main thrust for those who get tired.? Tortoriello does a good job boiling it down for those needing a summary.? He also does not overpromise; the book is free from overselling, in my opinion.

If you want to buy it you can buy it here: Quantitative Strategies for Achieving Alpha (McGraw-Hill Finance & Investing)

Remember, I read the books that I review.? Not all do.? Those entering Amazon through my site, and buying anything, I get a small commission, and their prices do not rise at all.? This is my version of the “tip jar.”

Selling Hartford, Buying Canadian National

Posted on 16 May 2009 by David Merkel

Since the last time I wrote about my portfolio, things have been volatile.? Here are my actions since then:

New Buys

National Western Life Insurance
Canadian National Railway

New Sells — Hartford Financial

Rebalancing Buys:

Assurant (brnging it up to a double-weight)
Dorel Industries

Rebalancing Sells:

Allstate (2)
Assurant
Companhia De Saneamento Basico
General Dynamics Crp
Genuine Parts
Hartford Finl Svcs Group Inc (3)
Industrias Bachoco SA (2)
Ishares Inc MSCI Brazil Index Fund
Noble Corporation
Safety Ins Group Inc
Shoe Carnival Inc
Vishay Intertech Inc (3)

Comments

After the plunge, and the run, I scaled out of Hartford three times, and then sold because of the high odds that they will take the TARP money.? Taking TARP money has led to underperformance in the past, and though it looks like cheap capital, it can be a very expensive set of handcuffs to cut off.

If Allstate takes the TARP money, I will sell them as well, and buy a certain P&C reinsurer.? I suspect that they won’t take it — only the desperate take TARP money.

I replaced Hartford with National Western Life.? Little company, and illiquid.? If you follow me here, limit orders only.? It is a basic life an annuity company.? No debt.? Trades for half of book value.? Currently profitable, but future profits are uncertain.? One controlling investor, R. L. Moody, and the rest of the shareholder’s list reads like a “Who’s Who” of small cap value investing.? I have not reviewed the accounting in detail, but when I reviewed it in detail six years ago, I thought the accounting was more conservative than most insurance companies.

With all of the cash building up from rebalancing sales, I needed to add another name with a strong balance sheet.? I chose Canadian National.? Unlike US railroads, they go coast-to-coast — less need for loading and unloading.? Second, the valuation is not much higher than peers.? Third, the balance sheet is stronger than all peers.? Not that I think that any of the major North American railroads is at risk of failure, but it is unlikely that Canadian National will come under significant stress.

That’s all for now.? So far, it’s been a good year for me.? I’m running with cash at my upper 20% limit, so I am looking for safe and cheap ideas that would not get hit that badly in another pullback.

Full disclosure: long NWLI CNI DIIB.PK? AIZ ALL SBS GD GPC IBA EWZ NE SAFT SCVL VSH

The Zero Short

Posted on 13 May 2009 by David Merkel

Wrong

Something for nothing.

Intellectual and financial achievement.

We showed those losers.

Hey, it’s free money!

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Possibly Right

Don’t play for the last nickel.? It may cost you a buck or more.

Shorting is not the opposite of being long, it is the opposite of being leveraged long.? You don’t control your trade in entire, and the margin desk, or fear of the margin desk can make you leave a trade prematurely.

Pride goeth before a fall.

Would you rather be right, make money, neither, or both?

Free money in the market exists until too many people start searching for it.

Whom God would destroy, He makes overconfident.

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Though I do risk control different than many people, risk control is behind much of what I do in managing money.? Avoid risks that I am not being paid to take, and take risk where I am getting fair compensation or better.

Now, I can think of several companies where I think the common is an eventual zero.? Fannie, Freddie, AIG, GM, and Ford (I am less certain about the last one).? My calls on GM and Ford were ones made long ago.? The same for Fannie and Freddie.? AIG is more recent.

Now, I rarely short, because my risk control methods are not designed to work with shorting.? But one thing I would almost never do is try to “zero short” — short a stock to zero.? As I have said before, seemingly free money brings out the worst in people, and makes them play more aggressively than they should.

Don’t underestimate the power of control.? There is an optionality there that is underappreciated.? With the right offer management can sell assets, change the capital structure, get a bailout, etc.

Don’t overestimate the uniqueness of the reasoning involved.? Zero shorts attract parties wanting to short to the bitter end; they think that zero is inevitable.? No risk here.? One decision.

I would look at the borrow.? Can I borrow a lot more stock easily, without paying a premium either directly, or indirectly through the cost of some derivative instrument? (options, swaps, etc…)? If I can, perhaps I don’t have to worry so much about losing control of the trade.? If not, it may be time to close out the trade (for a little while, then re-evaluate), or at least evaluate how high the price could go in a short squeeze.? As we have seen recently, some lousy companies in a short squeeze can double or triple.? Would I have enough capital to carry the trade under such adverse conditions?

At least I should estimate short-term upside versus downside for that position versus others in the portfolio.? After a successful short, it may not employ a lot of capital; perhaps I should close it out.

What’s that you say?? The borrow is plentiful, and I should short more?? After all, it is going to zero.? I would not do it because the upside/downside ratio is worse than when the? trade began.? Figuratively, playing for that last nickel could cost me several bucks.

What if the position moves against me and the borrow is plentiful?? Should I short more?? After all, it is going to zero.? Sigh.? Review the thesis.? I might look for someone who doesn’t always agree with me, and ask him what he thinks.? If the thesis does not change, I would short a little more once the momentum against the position has stopped.

One more note: I review pricing across the capital structure.? Where does the bank debt trade?? Where are Credit Default Swaps [CDS] trading?? Yields of senior unsecured notes across the maturities?? Junior debt, trust preferreds, hybrids, preferred stock, etc…? These are all relevant bits of data to tell whether the common stock will indeed zero out.? If the next most senior class of capital to the common is trading above 50% of par, I would do more research on my thesis.? If it is over 80% of par, the zero short is not a good idea.

Risk control wins in the long run.? To me shorting all the way to zero is a risky way to do business, and so I am very unlikely to do it.? There is a pride element involved, and all good investing relies on having control over your attitude.? If you decide to zero short, be very careful.? It is not as easy as it looks, even if in the end, it does go to zero.