Category: Value Investing

How to Manage a Portfolio

How to Manage a Portfolio

Posted on by David Merkel

Given the title above, I feel embarrassed to write, because the topic is too basic. I write because too few managers think clearly on the topic. The following analysis applies to long only funds and hedge funds; it also applies to equity and bond funds. The impetus to write this note arrived because the Fidelity Magellan Fund is reopening because cash inflows will make the life of the portfolio manager easier… not that he will get many inflows for now.

My view is that it should not be hard to manage a shrinking portfolio. It is much harder to manage a rapidly growing portfolio. (I have experienced that, and that is a topic for another day.) Here is the key concept: the portfolio manager must rank his portfolio by expected returns, adjusted for risk. This applies to both the longs and shorts. If there are cash inflows to a portfolio, assets should be allocated to the highest returning assets. If cash outflows, assets should be liquidated from the situations with the lowest expected returns. It is that simple, and I did that when I was a corporate bond manager. It worked well.

The reason why it will not be implemented at many asset management shops is that it takes work to do it, and we all avoid work if we can. But maintaining lists of long and short ideas ranked by likely risk-adjusted returns will yield better decision making, if one will do it.

What of the January Effect?

What of the January Effect?

Posted on by David Merkel

I’m not feeling well this evening, so this will be a short post dealing with one simple issue.? (If I have strength, I may do one more.)

The January Effect is one of the best known calendar anomalies.? Stocks and high yield bonds tend to do well after the first day of the new year. This happens because these assets get oversold as some investors sell losing positions for tax reasons.? This tends to be more powerful for stocks that have done poorly over the past year, and for small companies, and value stocks.? This year it seemingly hasn’t happened.? Why?

First, all anomalies exist within a broader market environment.? When enough market players jump onto an anomaly, the anomaly outperforms in the short run, but peters out, because all interested parties have bought in.? If that were true of the January Effect, we would see the gains made in December, rather than January.? That’s not what happened this year.? (Anomalies tend to do best when they are ignored.)

Second, in a market where small value stocks may be overvalued, the January Effect could disappear for a year while small value stock valuations adjust back to normal, or below that.? That might be true this year.

We are in the winter season, not just for the calendar, but for small stocks and value investing. ? I feel the winter chill in all that I do at present, and no, I am not talking about the lack of insulation in my hovel.? I have the winter wind in my face now (much as I remember walking home from high school in Milwaukee), and yet I know that this is the time that my best purchases are likely to be made.? I have to focus on my core disciplines, and buy good long-term cash flow streams cheaply.

Before I close, I would say that a new favorite blog of mine is the CXO Advisory Group blog.? For quantitative investors, there is a wealth of knowledge there.

Industry Ranks and Additional Stocks

Industry Ranks and Additional Stocks

Posted on by David Merkel

If I did not use a mechanical method for ranking replacement candidate stocks against my portfolio, I would not let so many stocks go onto my potential replacement list. Today I updated my industry model, and here it is:

Industry Groups January 2008

(If you have any difficulty downloading that, let me know. I’ve been having trouble with that.)

From that, I ran a bunch of screens, adding in some technology industries that have been hit of late. Here are the additional tickers that will be added to my candidates list: AMIE ASYT BBBY BC BELM BGFV BIG BNHN BRLC BWS CAB CBR CHRS CHUX CMRG CRH CTR CWTR DBRN DECK DFS DSPG DSW ESEA EXM EXP FHN FINL FRPT FSS GASS HGG HLYS HTCH HZO IDTI IKN IM IMOS JAS JNS KSWS KWD LF LIZ LNY LSI MIPS MRT NSIT NSTC NTY ODP OPMR OVTI OXM PERY PLAB POOL RCRC RENT ROCK RSC RT RUTH SAIA SHOO SIG SMRT SNA SNX SONC SSI TJX TOPS TUES VLTR VOXX ZQK

Now, the mechanical ranking system is supposed to be a simple way of prioritizing value stocks, and typically it does pretty well in directing my attention to the stocks that I should analyze, not necessarily the ones I should buy. That’s true of any screening method, no matter how simple or complex. You always find some companies that look really good initially, but got there because of data errors, accounting mis-characterizations, or a business situation that was vastly different when the accounting snapshot was taken.

Now, after all of this work, I’m only trading 3-4 stocks into and out of my portfolio of roughly 35 stocks. But the idea is to end up with a portfolio with better offensive and defensive characteristics, such that the relative performance will be good, and should the market turn, I will be in the industries and companies with a lot of potential to outperform.

Time for the Next Portfolio Reshaping

Time for the Next Portfolio Reshaping

Posted on by David Merkel

I will admit, I don’t feel much like doing my portfolio reshaping now, even though it is a part of my management discipline, because the portfolio has been kicked around.? Not much worse than the rest of the market, though, and there are some stocks that look interesting that could be worth considerably more three years out.? As you look through my tickers list for candidates for addition, you’ll see a few commonalities:

  • Energy (still)
  • Industrials (still)
  • Retail (now, that’s new)
  • Insurers (many still cheap, particularly some stronger operators, also title names)
  • Technology (different for me)
  • ?A few odd real estate names (not likely, but there are some places where values are protected)

So, the process begins.? Within a few days, I’ll run my industry model, and do a few screens off of it, adding a few more tickers.? Beyond that, I invite you to send me ideas as well.? Last time, ideas suggested by readers made up two of the four new names that I bought.? So, send them in, and thanks as always for reading me.

The replacement candidate tickers:?? AA ABK ACIW AEO AES AIG AIT ALL APA APL ARM ARO ARW ASGN ATU ATW AVCA AVZA AZ BAC BCS BER BGP BKE BKS BRO BRY CACC CAE CAKE CALL CAMD CBL CCRT CHS CNQ CNX COF COST CQP CRI CRK CRZO CSCO CSG CSGS CSL CTLM DDS DFG DITC DLB DNR DRI DTLK DVN EAT EEP EFII EMC ENWV ESST ESV EXAR EXTR FLEX FNF FNM FRE FSII GCA GLW GPC GS GSIT GSK GW HAS HCC HCSG HD HIG HILL HMC HOC HOG HOLX HPQ IDTC INAP INFN INSP INT INTC IRE ISSI JCG JCP JEC JRT JWN KEM KFT KSS LINE LM LOOK LRW LUV LYG MAN MAS MDC MHK MHP MHS MMC MNST MTSC MTW MU MUR MVC MW MWA NOV? NSH NSR OII OMX ORI OXY PCZ PDC PDE PDII PDS PHLY PNCL PNRA POL PROS PTEN PVSW RAMR RAVN RGA RIG RNIN RNWK SCMR SGP SIMG SKS SKSWS SKX SLXP SNY SPN SSTI SSW STC STI SU SWK T TECH TECUA TEX TGI TLGD TMTA TM TNB TOT TRID TRLG TSO TWB UFS UNP URBN USG VFC VMC VNR VPHM WAG WCG WDC WHQ WLL WSM WSTL WU WWW XL XTEX XTO

PS — Though I don’t feel like doing it, I didn’t feel like doing it in the Fall of 2002 either,and some of my best picks came then.? So, discipline before feelings.

Momentum, Schmomentum

Momentum, Schmomentum

Posted on by David Merkel

My biggest insecurity when it comes to my investing comes from the concept of momentum.? For the past 7+ years, I’ve been leaning against the wind, buying companies with bad momentum, and for the most part, it worked.? In general, falling stocks have bounced back.? Over the last six months it has not seemed to work so well.? Now, I had a period that was much worse in the middle of 2002.? I even scraped excess money together to invest in late September of 2002.? I am less confident here.

I have a number of ideas that work with respect to momentum:

  • In the short run, momentum persists.
  • In the intermediate-term, momentum reverts.
  • Sharp moves tend to mean revert, slow moves tend to persist.

My own proprietary oscillator indicates that we are very close to a short-term bounce point.? The recent move down has been too rapid, and sellers should be tired.? One more hard down day, and a bounce should occur.

Back to my own portfolio management.? Since I am a value investor, I have leaned toward longer holding periods, which implies to me that I should be playing for the intermediate-term reversal of momentum phenomenon.? But the short-term momentum anomaly is probably stronger.? Consider these two pieces from Crossing Wall Street.? Eddy illustrates the point well.

So, as I head into my next portfolio reshaping, I am scratching my head, and wondering how I should use momentum in my investing.? Suggestions are welcome.

On Benchmarking

On Benchmarking

Posted on by David Merkel

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”? Ergo, the commenters are always right, at least in terms of what they want to read about.? So, tonight I write about benchmarking.? (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.? The idea behind a benchmark is one of three things:

  1. A description of the non-controllable aspects of what a manager does.? It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
  2. A description of the non-controllable aspects of what an investor wants for a single asset class or style.? It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
  3. A description of what an investor wants, in a total asset allocation framework.? It reflects the risk-return tradeoff of the investor.? The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.? The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.? Should he buy it?? Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.? Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.? (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.? Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.? The greater the frequency of measurement, the more index-like performance becomes.? The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.? Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.? Give them the money, and check back in five years.? (The list is illustrative, I can think of more…)

What does that mean for me, though?? The first thing is that I am not for everybody.? I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.? Over a long period of time, I believe that I will beat those benchmarks.? Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.? I think I will beat those broad benchmarks for several reasons:

  • Value tends to win in the long haul.
  • By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
  • By not limiting picks to the US, I can find chedaper stocks that might outperform.
  • By rebalancing, I pick up incremental returns.
  • Industry analysis aids in finding companies that can outperform.
  • Avoiding companies with accounting issues allows for fewer big losses.
  • Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
  • I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.? In the short-term, I live with underperformance.? Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.? Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM

If This Is Failure, I Like It

If This Is Failure, I Like It

Posted on by David Merkel

I thought I did worse this quarter, but I ended up trailing the S&P 500 by less than 50 basis points. That meant that I trailed the S&P 500 for the first year in eight by somewhat less than 1%. So goes the streak.

On the bright side, it happened in a period where growth was trouncing value, and large capitalization stocks were trouncing the small.? My investing style is value-oriented, and all-cap, so I will always be smaller than the S&P.? I did better than value indexes, and better than small caps.? Is this examination of factors an excuse?? I don’t know.? The wind was at my back for the last seven years, and it is in my face now.? What I do know is that I’ve had my share of bad decisions, and I will try to rectify them in 2008.? The next reshaping is coming up soon, and I am gathering my tickers and industries.

But winning big and failing small should be good for anyone. With that, I wish you a Happy New Year.? Let’s make some serious money in 2008, DV.

The Beauty of Broken Moats

The Beauty of Broken Moats

Posted on by David Merkel

When I wrote this post on Berkshire Hathaway, the main point I was going for was that the price of Berky was not unreasonable if one attributed value to what Berky could do in a crisis. When I trotted out the Ambac scenario, the idea was to illustrate how Buffett could if he wanted to, take advantage of a situation where values are depressed because the moats of competitors have been broken. (Think of what he did in manufactured housing finance after all the competitors were nearly destroyed. He bought the one healthy remaining company inexpensively.)

Now, had I been more thorough, I also would have pointed to pieces referencing Buffett and his experience with Gen Re Financial Products. The thing is, Buffett doesn’t like to be an external money manager or lender (for the most part), and
does not like structured finance exposure (even in its infancy, a la Salomon Brothers), he does recognize where there can be a clean, core business with defensible boundaries (a moat), where he can earn above average returns over time — insuring municipal bonds.

One key decision that any businessman must come to when entering a new field is build versus buy. Buy can be more attractive when there might be synergies between the acquirer and the target, or if the purchase price is sufficiently low. Build can be more attractive when the necessity of having something new that is unaffiliated with the old order is more attractive (no legacy liabilities), and where your competitors are viewed as being compromised, whether in balance sheet terms, or ethically. For the latter, think of the revenue lost by major insurance brokers after the Spitzer investigations. New players ate into the business models by avoiding conflicts of interest.

So, the announcement of Berkshire Hathaway Assurance Corp [BHAC] is no surprise here. Warren sees an opportunity, and he will pursue it.

Now here are three weaknesses of doing it this way. Buffett is not going to be the low cost provider, in a business where basis points matter as to who gets the business, and who does not. This strategy implies that he suspects that the major bond insurers have problems more severe than have been discounted by the equity and debt markets, and that their AAA bond ratings will remain under threat for some time. Second, it assumes that the managements of his competitors won’t take some action that significantly dilutes their equity in order to retain the solvency of their franchises, benefitting their own bondholders, those guaranteed by their firms, and management themselves (assuming they aren’t ousted). So far, the infusions to the financial guarantors have been significant, but not significant enough to remove doubt. The purpose of a AAA rating is that it is beyond doubt.

Third, a new startup will have higher fixed costs to amortize over the new business written. Mr. Buffett wants to charge more. Well, he will need to charge more, though perhaps that disadvantage is minimized because his competition faces higher costs in a different way from financial stress:

  • Distraction of management over structured finance exposure
  • Distraction with the rating agencies
  • Distraction over shoring up the capital structure
  • A much higher cost of capital than was previously available
  • Shareholder lawsuits (coming)

But, if I were in the seat of the competitors, I would tell my municipal divisions to ignore the problems of the company as a whole, and keep writing good business at pricing levels below that of BHAC. That will contribute to the value of the firm, and, the ratings agencies know that the marginal amount of capital needed to write that business against a mature block is almost zero. So keep writing, and protect the franchise.

Finally, it looks like this subsidiary is separately capitalized, and not guaranteed by Berky. It likely gets a AAA on its own, with only implicit support from the holding company. This gives Buffett the option to write a lot of business by providing more capital as needed, preserving flexibility at the holding company, while limiting downside if that subsidiary should ever run into trouble (very unlikely, given their business plan).Tickers mentioned: BRK/A, BRK/B, ABK

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

Posted on by David Merkel

Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend.? At that time, I tried to point out (at RealMoney) that buybacks are not costless:

  • They reduce financial flexibility.
  • They lower credit ratings and can raise overall financing costs, if overdone.
  • They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
  • They often don’t get completed, leading to some disappointment later, after the initial hurrah.
  • They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments.? In a sense, shares are shifted from shareholders to management.? Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets.? Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
  • A higher regular dividend could be more effective in some cases
  • Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon?? That’s what a large buyback implies.

But after reading a glob of articles criticizing buybacks, it makes me want to take the opposite side of the trade.? (Where were these writers during the bull phase?)? Buybacks can instill capital discipline, as regular dividends do.? A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.

The best buybacks are valuation-sensitive.? The company has an estimate of its private market value, and the buyback only goes on while at or below that value.? When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.

Much of my thinking here boils down to how good the management team is.? A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it.? A high quality management team can run with more excess capital.? In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable? them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.

There is no simple answer here.? Buybacks can be smart or dumb, depending on management talent, what external opportunities exist, and where the private market value of the company is.? We can entrust Berky and Assurant with excess capital; it will get used well eventually.? Other companies, well, there are some that should keep the capital tight, because the management teams are not good strategic thinkers.

For the less competent management teams, (and, no, you don’t know who you are, that’s part of being less competent), you can look at the problem this way: either you shrink your company through buybacks, or activists will come and try to force you to do it, ejecting you in the process.? That may not sound fair, but hey, this is the public equity markets.? Sink or swim.

Full disclosure: long AIZ, and a critical admirer of Buffett.? Ticker mentioned: BRK/A

The Nature of a Nervous Bull

The Nature of a Nervous Bull

Posted on by David Merkel

Cast your bread upon the waters,
For you will find it after many days.
2 Give a serving to seven, and also to eight,
For you do not know what evil will be on the earth.
3 If the clouds are full of rain,
They empty themselves upon the earth;
And if a tree falls to the south or the north,
In the place where the tree falls, there it shall lie.
4 He who observes the wind will not sow,
And he who regards the clouds will not reap.
5 As you do not know what is the way of the wind,[a]
Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.
6 In the morning sow your seed,
And in the evening do not withhold your hand;
For you do not know which will prosper,
Either this or that,
Or whether both alike will be good. [Eccelesiates 11:1-6, NKJV, copyright Thomas Nelson]

The point of Ecclesiastes 11:1-6 is that the farmer in Spring, much as he might be hungry, and want to eat his seed corn, instead has to cast his seed into the muddy soil, perhaps planting 7 or 8 crops, because he doesn?t know what the future may bring. If he looks at the sky, wondering if it will rain enough, or whether the winds might ruin the crops, he will never get a crop in Summer or Fall.

That?s the way that I view investing. You always have to have something going on. You can?t leave the market entirely, because it?s really tough to tell what the market might give you. Typically, across my entire set of investments I run with about 70% equity investments, and the rest cash, bonds, and the little hovel that I live in. Private equity is a modest chunk of my equity holdings, so public equities are about 60% of what I own. Domestic public equities are about 45%.

I don?t think of that as particularly bullish or bearish. Even with public equities trading at high price-to-sales ratios, my portfolio doesn?t trade at high ratios of sales, cash flow, earnings, or book value. Together with industry selection, modest valuations provide some support against bear markets.

My tendency will be if the market moves lower from here to layer in slowly using my rebalancing discipline. That?s what I did in my worst period 6/2002-9/2002, and the stocks that I held at the end were ideally positioned for the turn in the market.

So, I never get very bullish, or bearish. I see the troubles in the markets, and I avoid most problem areas, such as in housing-related areas, but I continue to plug along, doing what I do best — trying to pick good stocks and industries (and occasionally, countries.)

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