Value Investing – Page 71

Book Review: Investing By The Numbers

Posted on 23 August 2008 by David Merkel

I’m going to be reviewing a few books on quantitative investing.? Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.? For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.? Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.? It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.? Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.? I have one of the few signed copies.? When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.? He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.? What do I mean by liability driven investing?? Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.? Instead, it has many models to share from different situations in the market.? There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.? Many strategies are competing for scarce returns.? Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
Why do value methods tend to work?
How do you avoid traps in calculating models?
How do investors with different goals and expectations affect the market?? What happens when you get too many momentum investors?? Too many growth investors?
Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
If the market tends toward equilibrium, the forces guiding it are weak.
Behavioral finance as a means of bridging investment theory and reality.
Market microstructure: how do we minimize total trading cost?? Minimize taxes?
How is the P/B-ROE model derived?
How to model market anomalies?
When do different valuation methods pay off well?
How does international diversification help?? (Bold in 1999, but a bit dated now.)
How to manage foreign currency risk in an equity portfolio?
How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.? This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

Current Industry Ranks

Posted on 21 August 2008 by David Merkel

Just a quick post to give a mid-quarter view of my main industry rotation model.? The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).? I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.? That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.

Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).? I spend most of my time in the green zone, looking at industries where I think pricing power will return.? For me, the red zone is more useful for sale decisions.? When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.

The Value of Being Approximately Right

Posted on 15 August 2008 by David Merkel

Buffett said something to the effect of: “I would rather be approximately right than precisely wrong.”? Everyone should agree with that maxim, but in the business world, many processes don’t work that way.

Take auditing as an example.? I’ve only experienced it as an actuary working in financial reporting, and it amazed me to see the detail work that they went through of checking cash flows (which should be done — how else do we detect fraud?), but with little to no attention on reserving assumptions.? Spending time on the “bigger picture” questions is important, and shouldn’t be neglected.

Or, consider earnings spreadsheets that analysts do.? They can be valuable, but I find it more valuable to look at the broader industry picture to see if an industry as a whole has a favorable economic picture, or, might be close to a turning point.

Then again, I think more like a portfolio manager, and less like an analyst.? That makes me better for some tasks, and not others.? My boss at Provident Mutual taught me the you need to identify the main 2-3 drivers of future profitability, and focus on them, because they will drive 80-90% of the results.? (I call this Cioffi’s Rule.)? If you get the main factors right, you will make more money than most investors.

Sometimes, I get labeled a lightweight because I don’t dig deep on certain issues.? I’m just trying to stay focused on the important issues.? Now, on financial stocks today, I own a bunch of insurers that put me over market weight for financials, but I own no credit-sensitive companies.? Even high-quality names are under stress.? (Consider the rate American Express had to pay to borrow money recently.? And I thought MetLife had it bad.? Ah, to be a corporate bond manager again… there are bargains to be had if one has an adequate balance sheet.)

What we don’t know is a significant factor.? I need to see some significant failures before the financial sector will be interesting.? I’m not investing to be courageous.? I’m here to make money over the cycle on a risk-adjusted basis.? It’s not that I avoid risk, it’s that I avoid taking it when I don’t see that I am paid to take it.

Also, even though my portfolio is concentrated, with 35 almost-equally-weighted companies, I avoid going “socks-and-underwear” (as my Dad would say playing Sheepshead) on any single company.? Even on industries, I try to be measured in my overweight positions.? But the objective is to take risk when you are being paid to do it, and avoid it otherwise.? Focusing is a popular strategy, and those who do well at it do very well.? Those who fail at it fail big.? On average, the strategy of focusing doesn’t of itself add value.

My eight rules help me be approximately right.? That doesn’t mean that I don’t make mistakes.? I make mistakes, and sometimes they are big.? But, my mistakes haven’t been frequent and big.

Consider this as you invest.? Focus on the big factors that affect profitability, and look for positive industry trends that are underdiscounted, and negative industry trends that are overdiscounted.? And, in the process, only buy companies that you know will survive.? More money is lost buying marginal companies than is gained.? Remember the margin of safety concept.? Your first job is not to lose money, so choose wisely.

Full disclosure: long MET

Don’t Overpay, for Insurance M&A

Posted on 14 August 2008 by David Merkel

I’ve been mulling over whether I should write about insurance M&A.? Ugh, yes, I should say something.? What pushed me over the edge was a piecein the WSJ on the purchase of Philadelphia Consolidated.? When I first heard about the deal, I blinked, and said, “Foreign acquirer overpays to enter the US.”? Is Philly a good company?? It’s a great company, but it may not be so under foreign ownership.? And, the price was well in excess of what it would have taken to create/attract the talent for a new venture.? Paying 2.7x book is not a winner.

But, the have been other missteps as well recently.? Liberty Mutual buys Safeco and Ohio Casualty for 1.8x and 1.6x book.? High prices for the assets obtained, and Liberty Mutual can’t lever that much as a mutual company.? It feels like the current management is going for growth at all costs, and the only losers will be the participating policyholders, who will eventually get a lower dividend stream.

I’m also not into funky holding company structures, for example, where a mutual company sells off a piece of a subsidiary to be publicly traded.? In that sense, it was good of ALFA to buy in their stock subsidiary (2.0x book), and now Nationwide is doing it as well (1.6x book).? Someone buying Nationwide Financial Services at the IPO earned an 8.7% annualized returnto the buyout.? ALFA shareholders did better, but I am not sure how much better, because I can’t tell how many times the stock split.? Both beat the returns on the S&P 500.? (I won’t mention the details of how Provident Mutual took Nationwide to the cleaners when they sold themselves; that had an effect on the returns.)

But, think about it from the perspective of the participating policyholders, who nominally own the mutual insurance companies.? That was expensive capital that diluted the dividends that they would have received.? But, mutual policyholders are sleepy, and mutual company managements take advantage of them.

I will mention three more deals before I close.

Commerce Group sold itself to Mapfre SA (1.6x book).? Another foreign company overpaying for a US presence.? I like the deal, because Safety Insurance will out-compete Commerce/Mapfre.
Midland Companies was bought by Munich Re for 2.0x book.? Midland was well-run, but I don’t see the fit with Munich Re.
Castlepoint Holdings was bought by Tower Group at 1.0x book value.? Perhaps a little incestuous, because it was Tower Group’s main reinsurer, but Tower helped bring th IPO to market, and I can’t tell whether this is a bright or dumb idea.

Insurance accounting is opaque to outside experts, and sometimes even to those doing the figures inside the companies.? Management often see marketing or cost synergies in doing deals, but my experience says those aren’t common.? Also, diversification benefits have to be weighed against lack of focus.? It is very difficult to manage disparate business lines.

To those are getting bought out, or who have been bought out, I encourage you to be grateful for the gift that you have received.? For those who own the acquiring company, I must say that the return performance for acquiring companies has been poor.? Consider investing in companies pursuing organic growth, which is often a better idea.

Full Disclosure: long SAFT

Book Review: Super Stocks

Posted on 13 August 2008 by David Merkel

When I review books, I don’t just review new books.? I try to share with my readers the books that have helped me become a better thinker on investments.? Fortunately, in this case, the 1984 book Super Stocks was reprinted in 2007.? Perhaps that validates my opinion that this is a valuable book.

Ken Fisher focuses on the concept of Price to Sales [P/S] ratios as a means of analyzing cheapness in companies.? Cheapness, yes, but predicated on the concept that a new product, process improvements, or better management will make more profits from the sales, or improve sales volumes and perhaps profit margins.

Though the examples are from the early 80s, the writing is clear enough that one can get the idea of how it might apply today.? You would get the same feeling from Ben Graham’s classic The Intelligent Investor, where the examples were from the 50s and 60s, but the truths are timeless.

Why choose this book to review now?? Profit margins are artificially high, and will come down somewhat from here, even if they remain above average.? How can we find cheap stocks when profit margins are so high?? Use P/S, or Price-to-Book [P/B].

My own investing looks at a wide number of valuation figures, but across an economic cycle, I give more or less weight to each variable.? When things are bad, I give more weight to P/S and P/B.? During the recovery, I emphasize P/E on a forward basis.? When the bull market is in full swing, I let industry selection dominate, which gives me more market sensitivity. As another example, I play up EV/EBITDA when buyouts are becoming common, and drop it as a criterion when buyouts are not being funded.

So, unlike Peter Lynch, paying attention to the macroeconomic environment can positively affect your performance, if you do it intelligently.

Super Stocks is very consistent with my eight rules, particularly the rules:

Stick with higher quality companies for a given industry.
Purchase companies appropriately sized to serve their market niches.
Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Fisher spends a decent amount of time on balance sheets, market share, competitive advantage, and use of cash flow for future investment.? Though I don’t endorse everything in the book, like his price-to-research ratios, there are a lot of good concepts for the average investor to consider, and benefit from.

Full Disclosure: If you enter Amazon through any of the links on my site (mainly on the leftbar) and buy anything, I get a small commission.? This is my version of the tip jar, and it doesn’t increase your costs at all.

Margin of Safety

Posted on 11 August 2008 by David Merkel

In value investing, it is imperative that one considers the state of the industry invested in, the balance sheet of the company, and earnings quality.? These are basic concerns for any investor, and all of my failures in investing can be be linked to neglect of one of these three items.

Ben Graham used the phrase “margin of safety.”? Actuaries, even less poetic, use “provision for adverse deviation.”? In either case, the idea is investing in such a way that you won’t get badly hurt if you are wrong.? It handles risk at the security selection level — choose your companies carefully; make sure they are survivors.

Does the industry have pricing power?? Is it under pressure from rising costs?? (Credit losses are a cost for financials.)? Pricing power, and lack thereof, should be considered in valuation decisions.? Are things so bad that companies are going bankrupt?? Perhaps it is time to buy the strongest one in that industry, because it often takes defaults to make pricing power turn.? Fewer competitors means profit margins can rise.

Does the company have a lot of debt?? Is the tangible net worth small relative to the liabilities?? Be careful, because a small negative change in the economics of the business could kick the company over the edge.

Do the earnings come from cash earnings, or do accruals dominate the earnings?? Cash earnings are always higher quality than accrual earnings.? This is one reason why financials almost always trade at a discount, becausethey are a bag of accruals.? Also, with financials, the quality of the accrual entries affects valuations.? Asset managers will have higher valuations than long-tail P&C insurers.? Who knows whether the reserves are right or not?

All that said, it was with sad amusement when I heard on the radio this afternoon that Legg Mason had become the largest shareholder of Freddie Mac.? Is Bill Miller (or Private Capital) doubling down?? He will look like a genius or a fool after this, depending on the outcome.? I think it is foolish, and an willing to say that he doesn’t understand the credit risk in the current environment, and should get advice from someone who gets the current credit crisis better, like me, or Eric Hovde.

After all, at the present time, even the rating agencies are downgrading everything at Fannie and Freddie except the senior debt ratings.

Value investors often invest in financial stocks.? That is their undoing in the present market, as earnings and net worth get eaten by credit losses.? But to any value investor that does industry analysis, this was avoidable, because the risk of credit losses to the banks grew as the banks were willing to lend on terms that were loose.

As a value investor, I have been able to avoid the current crisis.? I avoided credit-sensitive financials, and have bought cheap names among industrial stocks.? But that was yesterday, what of tomorrow?? I don’t think the credit crisis is done, and so I urge a conservative posture at present.

Post 800

Posted on 8 August 2008 by David Merkel

Every 100 posts, as WordPress counts, I take a moment out to reflect on my life , my blog, the markets, and more.? My blog is usually a reflection of me as an investor and businessman, but it is not a reflection of me, the whole person.? This is my chance to speak my mind more broadly.? (By the way, it is amusing to be doing post 800 on 08/08/08.)

Hasn’t the market been volatile lately?? I feel like a yo-yo.? Ordinarily my sector rotation methods help my portfolio to be less volatile than the market, but at present my “beta” feels like 1.3.? Now, on the plus side, I am underweight energy for the first time in six years, starting in mid-July, and my energy exposure has a large refining component through Valero and ConocoPhilips. Beyond that, I am in the plus column again for 2008, though returns on Monday could reverse that with ease.

That’s the market.? Only invest what you can afford to lose.

Writing this blog interfaces with the print/online world in a variety of odd ways.? I talk to reporters fairly frequently, and give them a good amount of my time.? So, I want to thank my contacts at the CNN/Money, Fortune, Bloomberg, TheStreet.com, The Wall Street Journal, Business Week, and the Associated Press.? Other interested writers/reporters, e-mail me, and we can talk.

Ordinarily, when I write these posts, I cite those who have driven traffic my way, but right now, my internet connectivity is not cooperating with me.? Instead, I will mention the blogs that are not on my blogroll that I admire: World Beta, Felix Salmon, Information Arbitrage, and Interfluidity.

I remain most grateful to my readers.? I can’t respond to every e-mail, but I do read all of them.? Thanks for taking the time to read my writings.? I enjoy doing it because it gives something back to the broader investment community; retail investors don’t have many friends.

I leave you all with this.? I know my blog is eclectic; I cover a number of issues, and less well than some blogs that are more focused on single issues.? If you have ideas that you want me to write about, please e-mail me.

May the Lord bless you in your endeavors, and grant all of us wisdom in what I expect to be turbulent times in the markets.

Full disclosure: long VLO COP

The Fundamentals of Market Bottoms

Posted on 7 August 200820 June 2017 by David Merkel

A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion? ? yes, residential real estate was near its top.? My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.

As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, ?Real Estate?s Top Looms?:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.

8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.

10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

11) Value investors find no lack of promising ideas, only a lack of capital.

12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.

14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

Changes in Corporate Behavior

1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.

3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??

4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.

5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

8 ) High quality companies keep buying back stock, not aggresssively, but persistently.

Other Indicators

1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.

2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:

Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.

The Fundamentals of Market Bottoms, Part 3 (Final)

Posted on 7 August 20087 August 2008 by David Merkel

12) Value investors find no lack of promising ideas, only a lack of capital.

13) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

14) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.

15) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

Changes in Corporate Behavior

1) Primary IPOs don’t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.

5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

Other Indicators

2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn’t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don’t sense true panic among investors yet.? Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

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That’s all for this post.? After comments are in, I will reformat the piece as one post and republish it.

The Fundamentals of Market Bottoms, Part 2

Posted on 5 August 2008 by David Merkel

Before I get started for the evening, here is a copy of the Fed statements compared in PDF format, in case you couldn’t read it well on RSS.

Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, “Real Estate’s Top Looms“:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That’s why I think the hot coastal markets are bubblettes. My position hasn’t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don’t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven’t morphed into permabears.

8) Value managers tend to outperform growth managers at bottoms, though in today’s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the “adults” more often.? By adults, I mean those who say “You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.”? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The “chrome dome count” shows more older investors on the tube is another sign of a bottom.

10) High quality companies keep buying back stock, not aggresssively, but persistently.

11) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

I will try to complete this piece this week.? There should be one more part, and I will publish it all as one unit.