Search Results for “portfolio rule” – Page 3

The Rules, Part XLII

Posted on 31 May 201320 June 2017 by David Merkel

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.? I’ve been through it.? He would not bite.

The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.

The Rules, Part XXXIX

Posted on 24 May 2013 by David Merkel

The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.? Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.? The same factors that lead to buying to an unfair level also cause selling to an unfair level.

Benchmarking and risk control through VAR only work when few market participants use them.? When most people use them, it becomes like the portfolio insurance debacle of 1987.? VAR becomes pro-cyclical at that point.

Sometimes I think the Society of Actuaries is really dumb.? The recent financial crisis demonstrated the superior power of long-term actuarial stress-testing versus short-term quant models for analyzing risk.? The actuarial profession has not taken advantage of this.? Now, maybe some investment bank could adopt an actuarial approach to risk, and they will be much safer.? But guess what?? They won’t do it because it will limit risk taking more than other investment banks.? Unless the short-term risk model is replaced industry-wide with a long-term risk model, in the short-run, the company with the short-term risk model will do better.

The reason why VAR does not effectively control risk is simple.? VAR is a short-term measure in most of its implementations.? It is a short-term measure of risk for short- and long-term assets.? Just as long-term assets should be financed with long-term liabilities, so should risk analyses be long-term for long-term assets.

This mirrors financing as well, because bubbles tend to occur when long-term assets are financed by short-term liabilities.? Risk gets ignored when long-term assets are evaluated by short-term price movements.

And, as noted above, these effects are exacerbated when a lot parties use them; a monocultural view of short-run risk will lead to booms and busts, much as portfolio insurance caused the crash in 1987.? If a lot of people trade in such a way as to minimize losses at a given level, that sets up a “tipping point” where the market will fall harder than anyone expects, should the market get near that point.

The idea that one can use a short-term measure of risk to measure long-term assets assumes that markets are infinitely deep, and that there are no games being played.? You have the capacity to dump/acquire the whole position at once with no frictional costs.? Ugh.? Today I set up a new client portfolio, and I was amazed at how much jumpiness there was, even on some mid-cap stocks.? Liquidity is always limited for idiosyncratic investments.

The upshot here is simple: with long term assets like stocks, bonds, housing, the risk analysis must be long term in nature or you will not measure risk properly, and you will exacerbate booms and busts.? It would be good to press for regulations on banks to make sure that all risk analyses are done to the greater length of the assets or the liabilities (and with any derivatives, on the underlying, not contract term).

The Rules, Part XXXVIII

Posted on 23 May 2013 by David Merkel

There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.

What errors do most money managers make today?

Chasing performance
Over-diversification
Benchmarking / Hugging the index
Over-trading
Relying too heavily on earnings growth
Analyzing the income statement only
Refusing to analyze industries
Buy newsy companies
Relying on the sell-side
Trusting management too much

Let me handle these one-by-one:

Chasing performance

In writing this, I am not against using momentum.? I am against regret.? Don?t buy something after you have missed most of the move, as if future stock price movement is magically up.? Unless you can identify why the stock is underappreciated after a strong move up, don?t touch it.

Over-diversification

Most managers hold too many stocks.? There is no way that a team of individuals can follow so many stocks.? Indeed, I am tested with 36 holdings in my portfolio, which is mirrored for clients.? Leaving aside tax reasons, it would be far better to manage fewer companies with more concentrated positions.? You will make sharper judgments, and earn better returns.

Benchmarking / Hugging the index

It is far better to ignore the indexes and invest in what you think will yield the best returns over the next 3-5 years.? Aim for a large active share, differing from the benchmark index.? Make some real nonconsensus investments.???? Show real moxie; don?t be like the crowd.

Yes, it may bring in more assets if you are never in the fourth quartile, but is that doing your best for clients?? More volatility in search of better overall returns is what investors need.? If they can?t bear short-term volatility, they should not be invested in stocks.

Over-trading

We don?t make money when we trade.? We make money while we wait.? Ideas take time to work out, and there are frequently disappointments that will recover.? If you are turning over your portfolio at faster than a 50% rate, you are not giving your companies adequate time to grow, turn around, etc.? For me, I have rules in place to keep from over-trading.

Relying too heavily on earnings growth

Earnings growth is far less predictable than most imagine.? Companies with high profit margins tend to attract competitors, substitutes, etc.

When growth companies miss estimates, the reaction is severe.? For value companies, far less so.? Disappointments happen; your portfolio strategy should reflect that.

Analyzing the income statement only

Every earnings report comes four, not just one, major accounting statements, and a bevy of footnotes.? In many regulated industries, there are other financial statements and metrics filed with the government that further flesh out the business.? Often an earnings figure is less than the highest quality because accrual entries are overstated.

Also, a business may be more or less valuable than the earnings indicate because of the relative ability to convert the resources of the company to higher and better uses, or the relative amount to reinvest in capex to maintain the earnings stream.

Finally, companies that employ a lot of leverage to achieve their earnings will not do well when financing is not available on favorable terms during a recession.

Refusing to analyze industries

There are two ways to ignore industry effects.? One is to be totally top-down, and let your view of macroeconomics guide portfolio management decisions.? Macroeconomics rarely translates into useful portfolio decisions in the short run.? Even when you are right, it may take years for it to play out, as in the global financial crisis ? the firm I was with at the time was five years early on when they thought the crisis would happen, which was almost as good as being wrong, though they were able to see it through to the end and profit.

Then there is being purely ?bottoms up,? and not gaining the broader context of the industry.? As a young investor that was a fault of mine.? As a result, I fell into a wide variety of ?value traps? where I didn?t see that the company was ?cheap for a reason.?

Buying newsy companies

Often managers think they have to have an investable opinion on companies that are in the news frequently.? I think most of those companies are overanalyzed, and as such, don?t offer a lot of investment potential unless one thinks the news coverage is wrong.? I actually like owning companies that don?t attract a lot of attention.? Management teams do better when they are not distracted by the spotlight.

Relying on the sell-side for analysis

Analysts and portfolio managers need to build up their own industry knowledge to the point where they are able to independently articulate how an industry makes money.? What are the key drivers to watch?? What management teams seem to be building value the best?? This is too important to outsource.

Trusting management too much

I think there is a healthy balance to be had in talking with management.? Once you have a decent understanding of how an industry works, talking with management teams can help reveal who are at the top of the game, and who aren?t.? Who is honest, and who bluffs?? This very long set of articles of mine goes through the details.

You can do a document-driven approach, read the relevant SEC filings and industry periodicals, and not talk with management ever ? you might lose some advantage doing that, but you won?t be tricked by a slick-talking management team.? Trusting management implicitly is the big problem to avoid.? They are paid to speak favorably regarding their own firm.

Summary

This isn?t an exhaustive list.? I?m sure my readers can think of more foibles.? I can think of more, but I have to end somewhere.? My view is that one does best in investing when you can think like a businessman, and exclude many of the distractions that large money managers fall into.

The Rules, Part XXXVII

Posted on 21 May 2013 by David Merkel

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”? So the saying goes for those that blindly follow momentum.? The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.? (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

In 1998-2000, tech and internet stocks were the only place to be.? Even my cousins invested in them and lost their shirts.? People looked at me as an idiot as I criticized the mania.? Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.? This was not, “Buy what you know,” but “Buy what you assume.”
In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.? A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.? Both trades went badly.? Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to? blow up, and the least levered to suffer considerable losses.
2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.? There were earlier shocks around 2002, and the late ’90s.? Those buying them in 2008 and crying foul neglected the lessons of history.? The underlying collateral possessed no significant diversification.? Put a bunch of junk debt in a trust, and guess what?? When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.? Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

The go-go years of the ’60s or the ’20s
The various times the REIT market has crashed
The various times that technology stocks have wiped out
And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.? But recently, there has been some discussion of a possible “safety bubble.”? The typical idea is that investors are paying up too much for:

Dividend-paying stocks
Low-volatility stocks
Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.? It is possible to have one?? Yes.? Is it likely?? No.? Are we in one now?? Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.? But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.? At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.? Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.? They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?? Tenuously, but yes.? Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.? In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market? history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.? When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.? Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.? You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.? You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.? I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.? But with stocks, I would simply say look forward.? Analyze:

Margin of safety
Valuation, absolute & relative
Return on equity
Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.? If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”? Just don’t? compromise margin of safety in the process.

The Rules, Part XXIX

Posted on 20 January 201220 January 2012 by David Merkel

Risk premiums should never be capitalized, they should only be taken into income as earned.

This may end up being another odd post of mine.? I’m going to start writing about bank regulation, but I will end up talking about monetary policy.

There are many people who hate the rating agencies. They hate them because they are a convenient target, and most people don’t understand what they do. Rating agencies provide opinions. Nothing more, nothing less.

Many people would like to get rid of the rating agencies. But it’s not that easy. Regulators outsource their credit rating function to the rating agencies because they don’t want to do that work.

There is a way to eliminate the rating agencies, and I have written about that before. But the idea is so radical, that the banks would rather have the rating agencies exist, than use my idea.

So what’s my idea? Simple. If you were setting up a portfolio, what would you assume would be the minimum that you could earn on the portfolio? My minimum would be buying Treasury bonds and earning interest on them.

So if I am looking at a portfolio of risky assets, I would split each asset into two. I would mirror the cash flow pattern of each asset, and construct an equivalent Treasury portfolio to mimic the cash flows. All of the cash flows above that amount from the risky asset are the risky cash flows. The amount of capital that banks hold as reserve against losses should be proportionate to the present value of risky cash flows.

Unlike my last piece on this, I am not saying that the whole present value of risky cash flows should be held as capital against losses. But the regulators should use this, if we are not using rating agencies, as a proxy for credit risk in bank asset portfolios.

Why is this a good measure of credit risk inside banks? The market for lending is fairly efficient. Debts that have more risk have higher interest rates.

This measure of risk benefits from the concept of simplicity. It can be applied everywhere. And, there is good theoretical justification for it. Any return that is upon the government bonds is subject to question.

But suppose we decided to use this as a major portion of our formula for regulating bank capital. What would happen to monetary policy?

Well, if the Fed tries to do something similar to ?operation twist” it would require banks to hold more capital against their positions, because the safe interest rate falls, it causes the risky portion of each loan to rise. As such, any sort of ?operation twist” would fail, because the rise in capital levels, would blunt any advantage from over Treasury interest rates.

From my vantage point, it would be a real plus to have monetary policy neutered in that way. The Fed, should it deserve to exist, should be concerned with the banking system and its solvency. It should not be concerned with the overall level of interest rates. If lowering interest rates lowers the judgment of solvency, then that would restrain the Fed from being too aggressive in lowering rates. And that would be good. The Fed has generally not succeeded with monetary policy. They have been too loose in the past, leading to the problems of the present.

And, as I have said before, we should not have unelected bureaucrats driving our economy, rather, we should have Congress do it because we can vote them out.

That’s all for now. Thanks for reading me. I appreciate all of my readers.

The Rules, Part XXVII, and, Seeming Cheapness vs Margin of Safety

Posted on 29 December 201129 December 2011 by David Merkel

The market takes action against firms that carry positions bigger than their funding base can handle.? Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.? After that happens, valuation-motivated sellers appear to offer more at those prices.? The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.? As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”? The short-term proclivities of investors usually have no effect on the long run value of companies.? Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.? One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.? And often, they invested in financials that looked cheap, but took too much credit risk.? Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.? Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.? Every time I read something by him or see a video with him, I think, “Bright guy.”? But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.? Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.? From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.? And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.? Are the assets and liabilities properly stated?? Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

Company size (the ability of management to make sure values are accurate or conservative declines with size)
Rapidity of the company’s growth
Length of the asset or liability
Uncertainty over when the asset will pay out, or when the liability will require cash
Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”? It is also a question of whether the company will have adequate financing to hold those assets in all environments.? For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”? All financial asset values are relative to the financing environment that they are in.? Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.? Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.? Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.? (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.? Do they try to grow rapidly?? That’s a danger sign.? There is always the tradeoff between quality, quantity, and price.? In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.? Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?? How much do they explain away one-time events?? Are they raising leverage to boost ROE, or are they trying to improve operations?? Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?? Even with good financial companies there are disappointments.? With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.? They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.? What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.? Even the others of his top 10 have not done well, and the fund as? a whole has suffered.? Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.? And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

A 9.9% return from inception to 5/31/2011 is hot stuff, and,
A 6.0% dollar-weighted return is very good as well.? Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”? Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.? The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.? It can be a negative self-reinforcing cycle for some time.? My one bit of advice would be: focus on margin of safety.? If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

The Rules, Part XIX

Posted on 23 October 201023 October 2010 by David Merkel

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

After doing my talk for the Society of Actuaries last Wednesday, I got inspired to write something about modern portfolio theory, the capital asset pricing model, the efficient markets hypothesis, etc.? This particular rule deals with two things:

The same event can have different risk for different individuals.? Risk is unique to each individual.? It cannot be summarized by a single statistic for comparative purposes across individuals.
In general, with a few exceptions, risk is inverse to price.? As the price gets higher, so does risk.? As the price gets lower, so does risk.? The major exception to this rule is when trends are underdiscounted, because estimates of intrinsic value are flawed.

Let’s deal with these issues one at a time.? Start with a simple question.? Why do academics want to have a single measure for risk?? It allows them to write papers, and it keeps the math simple.? That’s why we have concepts like beta and standard deviation of total return.? It’s why we have concepts like the Sharpe ratio and other ratios that purport to measure return versus risk.

If our total planning horizon was similar to the periods that these figures are calculated over, they might have some validity.? But most of the time are planning horizons are longer than the periods that these figures are calculated over.? Even worse, most of these statistics are not stable.? The value calculated today may likely have a statistically significant difference from the value calculated a year ago.

But what is worse still is the idea that by taking more risk you will get more return.? If anything, the empirical research that I’ve been reading, and the value investors that I have talked to, indicate that the less risk you take, the more you’ll make.? A good example of that would be Eric Falkenstein and his book Finding Alpha.? Minimum beta and minimum standard deviation portfolios tend to outperform the market.? Junk grade bonds tend to underperform investment-grade bonds.

If it hurts too much, don’t do what I’m about to say.? Think about Lenny Dykstra.? When he and I were writing at RealMoney.com at the same time, I would often ask him about what his method would be to control risk.? He never gave me a good answer; actually he never ever gave me an answer at all.

My concern was for small investors, dazzled by the celebrity, and the simple approach that he would take that seemingly yielded huge profits, would adopt the approach, and not know what to do when things went wrong.? For Dykstra, who seemingly had a lot of money, losing a little on a deep in the money call trade would not hurt him much.? But to an unfortunate average guy reading Dykstra’s work, a similar sized loss could be very painful.

That said, that greatest risk was in plain view, which Steve Smith, I, and a few others went after — Larry didn’t know what he was talking about.

Risk varies by differences in wealth; risk varies with age.? Risk varies with the level of fixed commitments you have in life.? To give you an example there, when I went to work for a hedge fund, the first thing I did was pay off my mortgage so that I would feel free to take big risks for the hedge fund.? It is far harder to take risk, the higher the level of fixed obligations that one must pay month after month.

To make it more practical, think of all the malarkey that has been spilled talking about ?animal spirits.?? I don’t believe that businessmen are irrational; many Keynesian economists are irrational, but no, not businessmen.? Businessmen will not take risks when they are overleveraged, or, when a broad base of their customers is overleveraged.

Risk is unique to everyone’s individual situation.? Any time you hear someone bring up risk factors that are generic, you can either ignore them, or, more charitably think that they have a proxy that might have something to do with risk, maybe.

Go back to Buffett’s dictum: far better to have a bumpy 15% return than a smooth 12% return.

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The second part of the rule says that risk models should reflect higher risk as prices rise and lower risks as prices fall.? The implicit idea behind this is that it is possible to calculate the intrinsic value of an asset.? Can I disagree with one of my own rules?? Well, since I do the writing here, I guess I get to make up the rules about the rules.

There are many assets that it is difficult calculate the intrinsic value thereof.? Examples would include commodities, growth stocks, and anything that is highly volatile.

Though I believe my rule is correct most the time, markets are subject to momentum effects.? Often when a stock is at its 52-week high, that’s a good time to buy, because people are slow to react to changes in information.? And, when stock is falling hard, and is at a 52-week low, that is often a good time to not buy the stock, because there are maybe bits of information about the stock, or its holders, that you don’t know.

In general, though, higher prices are more likely to be overpayment and lower prices are more likely to indicate bargains.? Why?? Because returns on equity tend to mean revert.? Companies with poor returns on equity tend to find ways to improve business.? Companies with high returns on equity tend to find increased competition.

Thus, as always, I counsel caution.? Don?t ignore momentum, but also don?t ignore valuation.? Ask yourself how much upside there could reasonably be, and how much downside.? Play where the downside is limited relative to the upside, because the key to investing is margin of safety.? Play to win, yes, but even more, play to survive, so that you can play longer.

Tickers for the Current Portfolio Reshaping

Posted on 28 August 201029 August 2010 by David Merkel

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

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

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

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

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

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

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

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

What factors exist in my scoring model:

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

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

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

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

The Rules, Part XV

Posted on 19 May 201020 June 2017 by David Merkel

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.? Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.? Do investors want ultrasafe investments?? Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.? The remainder should be rated AAA (Aaa if you speak Moody’s).? Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?? What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?? Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.? Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.? Well, guess what?? Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.? If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.? And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.? They do not have to worry that money will run away from them.? The promises that these entities make are long duration in nature.? They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.? Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.

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But what of my first point?? There are securitization trusts, and there are financial companies.? During a boom phase, the securitization trusts can finance assets cheaply.?? During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.? Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.? Having a real balance sheet with slack capital has value during a financial crisis.? Securitization trusts follow rules, and have no slack capital.? Losses are delivered to the juniormost security.

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Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.? In 2005, with a few exceptions, the life insurance industry stopped buying them.? AIG was a major exception.? The consensus was that the extra interest spread was not worth it.? Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.? When risky assets are held by those with weak balance sheets, it is a recipe for disaster.

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During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.? That allows the economy to grow faster for a time, but there is no free lunch.? Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.? Usually a tranche offering credit support will tend to lose all of its principal, or none.? (Leaving aside early amortization and the last tranche standing in the deal.)? For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.? But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.? First, originators weren’t retaining much of the risk, so they could be more aggressive.? Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.? Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).? What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.? Debt levels increased, and made the system less flexible.?? Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.

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Securitization has been a mixed blessing to investors.? It is brilliant during the boom phase, and exacerbates trouble during the bust phase.? And so it is.? As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.? Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.? It’s not a hard calculation to run.

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Off-topic end to this post.? I added Petrobras to my portfolio today.? Bought a little Ensco as well.? I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.? Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV

The Rules, Part XIII, subpart C

Posted on 4 May 201020 June 2017 by David Merkel

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

More with Less.? Almost all of us want to do more with less.? Save and invest less today, and make up for it by investing more aggressively.? We have been lured by the wrongheaded siren song that those who take more risk earn more on average.? Rather, it is true 1/3rd of the time, and in spectacular ways.? Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.? Few people are disposed to say, “On a current earnings yield basis, these investments yield little.? I should invest elsewhere,”? when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.? Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.? What good investments will persist?? What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.? Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.? Ignore the middle.

Less with More.? Doesn’t sound so appealing.? I agree.? As a bond manager, I avoided complexity where it was not rewarded.? I was more than willing to read complex prospectuses, but only when conditions offered value.? Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.? We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.? CDOs are inherently weak structures.? That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.? Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.? Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.? No one held guns to their heads.? The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.? (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.? It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.? I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.? It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.? Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.? You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”? Yield greed is one of the clearest examples of hogs getting slaughtered.? So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.? Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.? Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.? It will be ugly, with sovereigns likely offering risk as well.? At this point, I wish I could give simple answers for here is what to do.? What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.? What I will avoid is credit risk.