The Aleph Blog – Page 49 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Learning from the Past, Part 4

Posted on 28 April 2015 by David Merkel

Welcome back to this irregular series where I go through the large blunders that I have committed in my investments. ?Let’s start with an unusual one: a telecommunications partnership.

In the late ’80s the US government allocated some telecom spectrum via a lottery process. ?I had some friends that participated in the first lottery, and received a decent amount of valuable spectrum. ?The only thing they had to do was have the engineering documents drawn up, which a third party consultant did. ?I said to myself that if it ever came around again, I would try to participate.

In the early ’90s, lo and behold, a second lottery with the same rules. ?I invested enough to gain a 30% interest in a partnership that would be going after the center of the US, ignoring the east and west coasts. ?I had seven partners with 10% interests, and they elected me to be the lead partner. ?So far, so good, right?

Well, seemingly. ?The thing is, why should the government allocate spectrum by lottery? ?Shouldn’t they sell it off to the highest bidder? ?After all, that’s what most people did with the spectrum they received in the first lottery. ?(I was planning on trying to create an operating company.) ?Shouldn’t the US government cut out the middlemen, and receive more for a valuable and somewhat limited asset?

Prompted by the telecommunication firms, who preferred having fewer and larger?auctions rather than buying from a bunch of disparate individuals, the US government acted in its own interests, and cancelled, even after all of the lottery participants plans had been approved.

In the end, we got back our fees from the government, but lost the money that we spent on engineering documents. ?After writing off the losses, it was a loss of 50%. ?That said, I also lost any profits from investing the money in stocks over the eight?years that the money was tied up. ?(The promoter that did the engineering documents went into hiding, having lost their shirts in the process, with a lot of annoyed people that bought their services.)

Small Cap Value Forever!

So what was I doing in equity investing in that era? ?Small cap value — little companies trading at bargain prices. ?Of all the managers that I interviewed when creating the multiple manager funds for my employer, I found the small cap value guys to be the most business-minded and interesting. ?A few of us at my firm would research out lesser known companies and?share the ideas. ?We had some fun with it. ?We would occasionally say to each other, “Small Cap Value Forever!”

Now, when the dot-com bubble came around, I was not tempted to play in that area of the market, but I fell into a lesser version of the same trap here. ?I started doing this just as small cap value’s period of outperformance was ending, and growth was taking over.

So how did I do? ?Not that bad… Small cap value lagged the S&P 500 by about 5%/year over the time I was focused on it, and I was able to beat the S&P 500 by a little bit. ?Not the greatest, but not the worst, either. ?In the process, I ran into a number of bizarre situations that taught me a lot, particularly with the smallest companies that I invested in.

In one case, I made the mistake of entering a market order to initiate a position. ?(Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was. ?The price promptly fell back to where it was prior to my purchase. ?Adding insult to injury, management ruined the place, and the price fell by over 80%. ?I looked at the situation, thought the assets were worth far more, and submitted a bid to an institutional investor to buy out his entire stake (and I would become a 5%+ holder of the company — I had to ask my compliance area if I could do that, and they were bemused at the odd request, and assented.) ?The investor did not take my bid, but held on, and the?management announced a buyout for the company at a level that would have given me a significant gain had I been able to buy the block of stock, but instead left me with a 80%+ loss on a small position, which wasn’t large enough to consider filing for appraisal rights.

Then there was one that went very well, but taught me the wrong lesson. ?A few weeks after I bought a stake in a small electronic parts company, Corcom, another company bought it for cash. ?At first I was happy with the quick and sizable win, but then I realized that I might have done better over time if the company hadn’t sold out.

That said, I noticed how wide the arbitrage spread was on the deal, and the annualized rate was 40%/year. ?I bought more and more of it, and eventually even used leverage to goose returns (this doesn’t sound like the older me, right? ?Right.) ?I made a lot of money in the process when the deal completed.

Here’s the wrong conclusion I drew: small deal arbitrage was lucrative and easy. ?I started doing that exclusively for two years during 1998-2000. ?During that time I learned:

It’s not easy. ?Small deal arbitrage investing is like investing in high yield bonds where the management teams have disproportionate opportunity to act against the interests of owners.
It’s not as lucrative as it looks, either. ?One deal gone wrong will eat the profits of ten that go right.
It takes a lot of time to find, analyze and compare new deals. ?I spent much more time on that than when I was doing value investing. ?I felt my time with my family was suffering.

More deals went bad than should have. ?My credit analysis on the deals was subpar. ?I particularly remember one where the buyer used an obscure clause to get out of the deal, and the company, Advanced Technical Products, took the acquirer to court and lost.

After the loss in court, I sold for a 70%+ loss, and then insult added to injury happened again… after 9/11, the products that they made for structural purposes came into high demand, and the stock shot up more than fifteen times. ?Had I held on, I would have quadrupled my original investment. ?(I smile and laugh a little as I write this.)

What did I learn?

This was the worst two years of all my investing, so I learned quite a bit:

Often your worst errors come trying to repeat a single abnormally large?success.
Stick to what you know best, which for me was value investing.
Don’t chase fads.
Analyze management teams of small companies very carefully. ?They can potentially get away with a lot more if there are no significant controlling investors.
Analyze your own investing to figure out what you are best at. ?I did such an analysis afterward, and saw value investing and industry analysis as key strengths.
Focus on risk control. ?Focus on risk control. ?Focus on risk control……
Do more analysis of unusual ways of investing before committing money.

On the bright side, this period set me for my best period of investing, which would be 2000-2010. ?The lessons and discipline learned would prove invaluable to me, and the companies that I served.

Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently

Posted on 25 April 2015 by David Merkel

Despite the large and seemingly meaty title, this will be a short piece. ?I class these types of investors together because most of them have long investment horizons. ?From an asset-liability management standpoint, that would mean they should invest similarly. ?That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true. ?In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so. ?So, why do they invest differently? ?Two reasons: internal risk management goals, and the desires of insurance?regulators to preserve industry solvency.

Let’s start with life insurers. ?Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges. ?The riskier the investment, the more capital the insurer has to put up against it. ?After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch. ?Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks. ?They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15?years. ?Back in?the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct. ?(Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds. ?Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets. ?Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor?that has to make future payments. ?They are free to invest as they like, and probably have the highest degree of variation in their assets as a group. ?There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.] ?You might think it would be smart to have the present value of 3-5?years of expenditures on hand in bonds, but that is not always the case. ?In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary. ?If you have thoughts on the matter, you can share them in the comments.

2000 More Points To Go; Look Elsewhere!

Posted on 24 April 2015 by David Merkel

15 years is a long time to wait for a 1%/yr return

The big news of the day is that the NASDAQ Composite hit a new high for the first time in 15 years. ?Nice, except as you note from the above graph, that if you adjusted for inflation, you still haven’t made a new high. ?By the time the NASDAQ Composite hits a new high, it will have to rack up at least another 2000 points, which is 40% or so away. ?Now if you add dividends back in since March 10th, 2000, you get to roughly a 1% return.

That’s a lot of pain for not much gain. ?That said, few if any rode out this storm in a fund like the NASDAQ composite. The pain would have been so great that most would have given up in 2002, and those that survived would have given up in 2008-9. ?We aren’t designed to take that much pain and hold on. ?I have a stronger financial pain tolerance than most, and I can’t think of a stock I hung on to past a 75% decline that ever came back in full. ?50%? ?Yes. ?75%? ?No.

I haven’t run the dollar-weighted return calculation for the QQQ, but I’ll try to run that calculation in a future blog post, and who knows, maybe I will run the calculation for John Hussman’s main fund at some future point also.

Look Elsewhere

Looking at the NASDAQ Composite is more a glimpse at the past rather than the future. ?But let me take two more glimpses at the past before I give you a guess at the future.

I remember March 10th, 2000, and the months around it. ?As the dot-com bubble expanded, what industry did the worst, and bounced back the hardest? ?Property/Casualty Insurance. ?I tell my story in detail in this post that I find amusing. ?To shorten this article, I can tell you that if you invested in undervalued industries in 2000-2001, you didn’t get hurt badly at all; you may even have made money like me. ?2002 was another matter — everything got smashed.

But many famous value investors never got to participate in that rally, because they got fired, or retired amid the furor of the dot-com bubble. ?This is yet another reason why it is so hard as an asset manager to hold onto promising assets that are out of favor… if your clients leave you because they?can’t take any more pain, you will be forced to liquidate because of them. ?If you are a big enough holder of those assets, the process may drive the price down further, adding insult to injury.

In my own case, I got derided by peers in early 2000 by owning a lot of property/casualty insurers, particularly my own company, The St. Paul (now part of the Travelers).

Here’s another glimpse: Sometime in 2005, I got introduced to a company called Industrias Bachoco [IBA]. ?It was a medium-sized chicken producer based in Celaya, Mexico. ?Today,?I believe?it is second to Tyson Foods in North America as far as chicken production goes.

It looked interesting and underfollowed, in an industry that I thought had good prospects, because in a world with a growing middle class, meat would be a?premium food product in demand. ?So I bought some, and mostly held on.

If you had bought IBA on March 10th, 2000, and held until today, you would have gotten a little more than a 17%/year return. ?4% of that came from dividends. ?Not quite a Peter Lynch 10-bagger from that point, but getting closer by the day.

Because I got there later, my returns haven’t been as good as that, but still well worth owning over the last ten years. ?I highlight IBA because I know it well, and it serves as a good example of a?winning?stock that few would have been likely to choose. ?Agriculture is not a sexy industry, whereas technology gets lots of admirers. ?But with an intelligent management team and conservative finances, IBA has done very well. ?Now, what will do well in the future?

This is why I tell you to look elsewhere for ideas, away from the crowds. ?Not that everything will do as well as IBA did, but where are the good assets that few are looking at?

Tough question. ?I’ll give you a few ideas, but then you have to work on it yourself.

1) Look at higher quality names in out-of-favor industries. ?The advantage of this approach is that your downside is likely to be limited, while the upside could be significant. ?I’ve seen it work many times. ?Note: avoid “buggy whip” industries where the decline is final; the internet is eating a lot of industries.

2) Look at companies outside the US that act in the best interests of outside, passive, minority investors like you and me. ?There is less competition there from analysts and clever US-focused investors. ?Note: spend extra time analyzing how they have used free cash flow in the past. ?Is management rational at allocating capital, or even clever?

3) Look at firms that can’t be taken over, where a control investor seems savvy, and acts in?the best interests of outside, passive, minority investors. ?Many won’t invest in those firms because they are less liquid, and a takeover is very unlikely.

4) Look at smaller firms pursuing a growing niche in an otherwise dull industry. ?Or smaller firms that have good finances, but have some taint that keeps investors from re-examining it.

5) Look through 13F filings for new names that look promising, before too many people learn about the company. ?Or, IPOs and spin-offs in industries that are dull.

6) Analyze stocks that are in the lowest quartile of performance over the last 3-5 years.

7) Or, go to Value Line, and look at the stocks with the highest appreciation potential, with an adequate safety rank.

Regardless, look forward from here, and look at assets that are cheap relative to future prospects that few others are looking at. ?There is little value in searching where everyone else does, such as the main stocks in the NASDAQ Composite.

Full Disclosure: long IBA and TRV for clients and me

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 2

Posted on 23 April 201523 April 2015 by David Merkel

You can catch part 1 here, where the first six reasons were:

Arrive at the wrong time
Leave at the wrong time
Chase the hot sector/industry
Ignore Valuations
Not think like a businessman, or treat it like a business
Not diversify enough

On to the last six reasons:

7)?Play around with pseudo-stocks

ETFs are simple. ?Perhaps they are too simple, allowing people to implement their investment views very rapidly, when have not done sufficient due diligence on the target of their investing.

As a quick example, consider the CurrencyShares series of ETFs. ?You know that if you use these, you are making an unsecured loan to JP Morgan, right? ?Well, you might be bright, but most people think these funds are collateralized.

ETFs are complex, particularly if you use any that are short or levered. ?They attempt to mirror the price move of a day, and typically underperform if held over longer periods. ?Again, you might know this, but most people don’t. ?Personally, I would ban them on public policy grounds.

Commodity ETFs and Bond ETFs have their own issues, as do ETNs with their credit risk, etc., etc. ?How many people actually look through the prospectus, or at least the information sheet provided by the fund? ?Precious few, I think.

If you use ETFs, stick to the good ones. (Article one, Article two)

8) Gamble

This one should be obvious. ?Most good investing focuses on avoiding losses, and compounding gains in a predictable manner. ?Taking chances, like speculating on the short-term direction of markets through puts and calls is a way to lose money predictably. ?(I leave out covered calls and married puts.) ?It is hard enough to get a good idea of where a stock is going in the long run. ?Getting it in the short run is much harder.

9) Ignore Balance Sheets and Cash Flow

Those who follow the fundamentals of most companies pay attention to the most manipulated of the three main financial statements — the income statement. ?Companies often try to make their earnings numbers, and compromise their accounting in the process.

Accrual entries depend on assumptions and can be tweaked to favor management’s view of profitability. ?Cash for the most part is a lot harder to fake, and most companies wouldn’t consider faking it, because few look there.

Looking at the change in net worth per share with dividends added back is often a better measure of financial progress than earnings per share. ?Beyond that, investing is not just about earnings, but about the margin of safety in the company. ?Many things look very cheap that have a significant risk of failure. ?Analyzing the balance sheet can keep you from many situations that will result in losses.

10) Try a little of this and a little of that ? No strategy / No edge

It takes a while to become good at a method of investing. ?Read about different methods and settle on one that fits the whole of your life. ?I gave up on certain methods because they took up too much time, and I had a family to tend to.

I rarely short assets, because to do it right would require large changes to the way I do risk control. ?(The same applies to options.) ?Good risk control is easy when the choice is between long assets and cash only. ?It gets a lot harder when you can short or go leveraged long, because you no longer have full control over what you are doing — the margin clerks will have some say over your assets.

Also, understand your circle of competence. ?What is your edge, and where does it apply? ?I avoid investing in biotechnology because I can’t tell a good idea from a bad one there, aside from estimating how long the company has before it needs to raise more capital. ?I do more with insurance than most do, because I intuitively understand how the companies work, and what a good insurance management team is like.

That doesn’t mean you can’t broaden your strategy or increase your circle of competence. ?But it does mean that you will have to study if you want to do it well. ?This is a business if you are going to make active bets in a big way. ?You will need to spend time equivalent or greater than that of a significant hobby.

11) Trade Aggressively

In general, you don’t make money when you trade. ?You make it while you wait. ?Most ideas in investing take time to work out, unless you are gambling on a short-term event, or speculating on a move in the stock price.

Most of the studies that I have done on investment in mutual funds of all sorts, including ETFs, show that buy-and-hold investors typically do better than the average investors in the mutual funds. ?On average, the losers are the ones who do the trading. ?That’s not to say there aren’t some clever traders out there. ?There are, but you are not likely to be one of them. ?Frequent trading, unless carefully controlled, is more likely to result in a lot of losses, and few gains, because fear causes many to panic in the short-run.

Even if successful, most aggressive traders get taxed more heavily than those with long-term gains. ?Most of my investment income qualifies for the lowest tax rates, and since I use big gains for charitable giving, my effective rates are lower still.

12) Short incautiously

This may affect the fewest number of my readers, but I have seen even professionals struggle with making money from shorting, particularly when they think an asset is worth nothing ultimately.

Shorting is a difficult way to make money, because your downside is unlimited, and your upside is limited to 100% if the asset goes to zero. ?Another way to say it is that your risk gets larger with shorting as the position moves against you. ?The risk gets smaller when long positions move against you.

if you must short, then treat it like a business and do it tactically.

Diversify shorts much more than longs.
Be tactical, and go for lots of little wins rather than a few big wins.
Set a time limit on your short positions at inception, and close out the positions no later than that.
Be aware that you are likely embedding factor bets on steroids, which can blow up in the wrong market environment. (E.g., short size, long value, short quality, short liquidity, short momentum, etc., would be common for a value oriented hedge fund)

Conclusion

Be aware of the foibles that exist in investing. ?There are many of them, as described in this article and the last one. ?If you want to profit over the long haul, act to avoid the traps that derail most retail investors. ?If you get knocked out of the game, and no longer invest as a result of a trap, you forgo all of the gains that you might have otherwise gotten with more diligence and patience.

On Negative Interest Rates

Posted on 21 April 201521 April 2015 by David Merkel

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted?to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets. ?I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life. ?I tried not to get my hopes up.

Lo, and behold! ?AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School. ?The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course. ?The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments. ?At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes. ?(Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton. ?That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.) ?At this point, the professor left, and a grad student came in to teach us about the pricing of bond options. ?At the end of his lesson, it was time for the class to have a break. ?I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous! ?Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t. ?But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen. ?You need your cash in the future for a given project. ?In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario! ?That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past. ?Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.? I trust you had a blessed Lord’s Day in the new building.?

Talking bonds today with my Econ class.? Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?? The Swiss and at least one other county sold 10 year notes with a negative yield.? Can you explain that?? No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

Low demand for loanable funds,?with low measured inflation, and
Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low. ?But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions. ?Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it. ?I’m taking most of my money out of the bank, and storing it at home.” ?Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it. ?Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger. ?If you don’t invest the money, where would you store it? ?Could you even get enough currency delivered to do it? ?if you had a vault large enough to store it, could you trust the guards? ?Why make yourself a target? ?If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be?units of account, and not stores of value. ?Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation. ?(Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.) ?The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS]. ?They did so because they had few other choices for transferring money to the future while still having inflation protection. ?Some people argued that they were locking in a loss. ?My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates. ?The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

Index Investing is not Inherently Socialistic

Posted on 18 April 201519 April 2015 by David Merkel

How does capital get allocated to the public stock markets? ?Through the following means:

Initial Public Offerings [IPOs]
Follow-on offerings of stock (including PIPEs, etc.)
Employees who give up wage income?in exchange for stock, or contingent stock (options)
Through rights offerings
Company-issued warrants and convertible preferred stock, bonds, and bank debt (rare)
Receiving equity in exchange for other claims in bankruptcy
Issuing stock to pay for the purchase of a private company
And other less common ways, such as promoted stocks giving cheap shares to vendors to pay for goods or services rendered. ?(spit, spit)

How does capital get allocated away from?the public stock markets? ?Through the following means:

Companies getting acquired with payment fully or partially in?cash. ?(including going private)
Buybacks, including tender offers
Dividends
Buying for cash?company-issued warrants and convertible preferred stock, bonds, and bank debt
Going dark transactions are arguable — the company is still public, but no longer has to publish data publicly.

I’m sure there are more for each of the above categories, but I think I got the big ones. ?But note what largely does not matter:

The stock price going up or down, and
who owns the stock

Now, I have previously commented on how the stock price does have an effect on the actual business of the company, even if the effects are of the second order:

My initial main point is this: capital allocation to?public companies does not in any large way depend on what happens in secondary market stock trading, but on what happens in the primary market, where shares are traded for cash or something else in place of cash. ?When that happens, businessmen make decisions as to whether the cash is worth giving up in exchange for the new shares, or shares getting retired in exchange for cash.

In the secondary market, companies do not directly get any additional capital from?all the trading that goes on. ?Also, in the long run, stocks don’t care who owns them. ?The prices of the stocks will eventually reflect the value of the underlying claims on the business, with a lot of noise in the process.

My second main point is this: as a result, indexing, or any other secondary market investment management strategy does not affect capital allocation much at all. ?Companies going into an?index for the first time typically have been public for some time, and do not issue new shares as a direct consequence of going into the index. ?The price may jump, but that does not affect capital allocation unless the company does decide to issue new shares to take advantage of captive index buyers who can’t sell, which doesn’t happen often.

The same is true in reverse for companies that get kicked out of an index: they?do not buy back?and retire shares as a direct consequence of going into the index. ?They may buy back shares when the price falls, but not because there aren’t indexers in the stock anymore.

So why did I write about this this evening? ?I get an email each week from Evergreen Gavekal, and generally, I recommend it. ?Generally it is pretty erudite, so if you want to get it, email them and ask for it.

In their most recent email, Charles Gave (a genuinely bright guy that I usually agree with) argues that indexing is inherently socialist because you lose discipline in capital allocation, and allocate to companies in proportion to their market capitalization, which is inherently pro-momentum, and favors large companies that have few good opportunities to deploy capital.

I agree that indexing is slightly pro-momentum as a strategy, and maybe, that you can do better if you remove the biggest companies out of your portfolio. ?Where I don’t agree is that indexing changes capital allocation to companies all that much, because no cash gets allocated to or from companies as a result of being in an index. ?As a result, indexing is not an inherently socialistic strategy, as Gave states.

Rather, it is a free-market strategy, because no one is constrained to do it, and it shrinks the economic take of the fund management industry, which is good for outside passive minority investors. ?Let clever active managers earn their relatively high fees, but for most people who can’t identify those managers, let them index.

If indexing did lead to misallocation of capital, we would expect to see non-indexed assets?outperform indexed over the long haul. ?In general, we don’t see that, and so I would argue the indexing is beneficial to the investing public.

I write this as one who makes all of his money off of active value investing, so I have no interest in promoting indexing for its own sake. ?I just agree with Buffett that most people should index?unless they know a clever active manager.

On Being A Forced Seller in a Panic

Posted on 17 April 201517 April 2015 by David Merkel

No one wants to be a forced seller in a panic. So how does anyone get into that situation? ?Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability. ?Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

For the big guys, I think that covers most of it. ?With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house. ?He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well. ?Then a?significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside. ?Then the shock hits. ?In the midst of the panic he faces one of the following:

The loss of his job (or severe trouble in his business)
Disability with no insurance
An uninsured casualty of some sort
Divorce
Health problems not covered by insurance
Death (and his wife has to pick up the pieces)
Etc.

Guess what? ?Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time. ?His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated. ?Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done? ?Here are a few ideas:

Hold a bigger buffer. ?Maybe toss in some high quality long bonds, as well as cash.
Reduce fixed commitments.
Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
Keep a rolling hedge of protective puts (costly)
Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one. ?As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars. ?The same is true for financial disasters. ?The planning is best done in the good times, like now. ?Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic. ?Eventually you have to trust in God, because no earthly security system is comprehensive.

From Stream to Shining Stream

Posted on 11 April 201512 April 2015 by David Merkel

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say? ?That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish. ?Few people develop a habit of saving when they are relatively young. ?Try to make it as automatic as possible. ?Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

Emergencies
Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding. ?The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, you don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or Research Affiliates. ?Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.

3) Value investing: Find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be?market timing, but be willing to take risk when things are at their worst. ?That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present. ?This applies to risky debt as well as stocks and hybrid instruments. ?The best returns come out of investing near the bottom of a?panic. ?Do your homework carefully here.

5) Avoid losses. ?Remember:

Margin of safety. ?Valuable asset well in excess of debts, rule of law, and a bargain price.
In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new?opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

You don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.

Also consider the risks you may face, and how your assets may fare. ?How are you exposed to risk?from:

Inflation
Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use. ?In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.

Be wise and?aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, you can’t rely on the markets or the policymakers to make income opportunities easy. ?Choose wisely.

On Human Fertility, Part 4

Posted on 2 April 2015 by David Merkel

I write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.425 births per woman that survives childbearing. That is down from 2.45 in 2013, 2.50 in 2011, and 2.90 in 2006. At this rate, the world will be at replacement rate (2.1), somewhere between 2025 and 2030. That?s a lot earlier than most expect, and it makes me suggest that global population will top out at 8.5 Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia is near replacement rate at 2.17, you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.62. Next is France at 2.08 (Arabs), New Zealand at 2.05, and the US at 2.01,?slightly below replacement. We still grow from immigration, as does France.

Most of the above is a quick update of my prior piece, which has some additional crunchy insights. ?This evening, I would like to highlight two articles that I saw recently — one on troubles with municipal pensions, and one on how some areas of China are dying. ?They are at root the same story, but with different levels of potency.

Let me start with the?amusing question where?Arnold Schwarzenegger asks Buffett via CNBC what can be done to solve the municipal defined benefit pension problem, which Becky Quick then asks Buffett. ?For the next 80 seconds, Buffett says it is a messy problem created by politicians that voted for high municipal pensions, because future generations would pay the bill, and not current taxpayers. ?The politicians that voted for them are long gone. ?Buffett offers no solutions, and I don’t blame him because all of the solutions are ugly. ?Here they are:

If state law allows, terminate the current plans and replace them with Defined Contribution plans, or reduce the rates of future accrual. ?If those can’t be done, create a new Defined Contribution plan for all new employees, who will no longer participate in the?Defined?Benefit plans. ?Even the last of these will be fiercely resisted by municipal unions.
Cancel the cost of living adjustment, if you can do so legally.
Raise taxes — I’m sure younger people will enjoy paying for past services of municipal employees.
Impose excise (or something like that) taxes on municipal pension payments, and rebate the money back to the plans.
Declare or threaten bankruptcy if you can legally do it, and try to extract concessions from the representatives of pensioners.
Amend the state constitution to change the status of pension benefits, including adding an?exception adding legality to adjust benefits after the fact. (ex post facto)

Don’t get me wrong. ?I don’t think the radical solutions could/would ever be done, and the National government would probably slap down any state that actually tried something draconian. ?Remember, states are practically administrative units of the national government. ?States’ rights is a nice phrase, but often very empty of power.

Here are some non-solutions:

Float pension bonds — just a form of leverage, substituting a fixed liability for a contingent liability, and assuming that you can earn more than the?rate paid on the pension bonds.
Invest more aggressively. ?Sorry, taking more risk won’t do it. ?Returns are only weakly related to risk, and often taking high risks leads to lower returns. ?The returns you are likely to get depend mostly on the entry prices you pay for the underlying cash flow streams in question.
Invest in alternative assets. ?Sorry, you are late to the game. ?Alternatives offer little more than conventional assets at present, and they carry high fees and illiquidity.
Adjust the discount rate, or salary increase rate assumption. ?That may make the current problem look smaller, but it doesn’t change the underlying benefits to be paid, or the returns the assets will earn. ?If anything, the assumptions are too aggressive now, and plan assets are unlikely to return much more than 4%/year over the next 10 years.

Buffett gave one cause for the problem, but there is one more — if the US population were growing rapidly, there would be a larger base of taxpayers to spread the taxes over. ?Diminished fertility feeds into the problems in the states, as well as other social insurance schemes, like Social Security and Medicare. ?You could loosen up immigration to the US, particularly for younger, wealthy, and or/skilled people, but that has its controversial aspects as well.

Here’s another way of phrasing it — it’s difficult to create workers out of thin air. ?Governments would like nothing better than to?have more working age people magically appear. ?It would solve the problem. ?Alas, those decisions were largely made 20-40 years ago also. ?There is even competition now for the best immigrants.

That brings me to the article on China. Rudong, a city in China where the one-child policy began, is now an elderly place with few younger people to take care of the elderly. ?Kind of sad, even if the problem was partially self-inflicted, and partially inflicted by conceited elites who thought they were doing a good thing.

A few?quotations from the article:

?China will see more places like Rudong very soon,? said Wang Feng, a professor of sociology at the University of California at Irvine. ?It?s a microcosm of the rapid demographic and economic transformation China has been experiencing the last decades. There will be more ghost villages and deserted or sleepy towns.?

also:

?China is quickly turning gray on an unprecedented scale in human history, and the Chinese government, even the whole Chinese society, is not prepared for it,? Yi said. ?In many places, including my hometown in western Hunan, it?s hard to find a young man in his 20s or 30s.?

and also:

What?s different in China is that the one-child policy accelerated the process, removing hundreds of millions of potential babies from the demographic pool. China?s old-age dependency ratio ? a measure of those age 65 or over per 100 of working age ? is set to triple by 2050, to 39.

The one-child policy created possibly the sharpest demographic shift in the world. ?It is largely irreversible; once women as a culture stop having children, they don’t start having more when benefits are offered or penalties are lowered. ?It would take a big change in mindset in order to get that to shift, like a religious change, or the aftermath of a big war.

The Christians are growing in China, and many of them would have larger families, but even if Christianity?gets a lot bigger, and the Party tolerates it, that won’t come fast enough to deal with the problems of the next 30 years, but it could help with the problems after that.

In closing, there is enough pity to go around. ?Pity for the elderly that will not get taken care of to the degree that they would like. ?Pity for those younger who cannot afford the time or monetary costs of taking care of the elderly.

I think the only solution to any of this would be shared sacrifice, where everyone gets hurt somewhat. ?My question would be what places in the world have the requisite maturity to?achieve such a solution. ?Optimistically, the answer would be many, but only after a lot of sturm und drang.

Opinions on the Market, Redux

Posted on 31 March 2015 by David Merkel

https://www.youtube.com/watch?v=xWrkWLyhGHE&t=13m11s

Here’s the second half of my most recent interview with Erin Ade at RT Boom/Bust. [First half located here.] We discussed:

Stock buybacks, particularly the buyback that GM is doing
Valuations of the stock market and bonds
Effect of the strong dollar on corporate earnings in the US
Effect of lower crude oil prices on capital spending
Investing in Europe, good or bad?

Seven minutes roar by when you are on video, and though taped, there is only one shot, so you have to get it right. ?On the whole, I felt the questions were good, and I was able to give reasonable answers. ?One nice thing about Erin, she doesn’t interrupt you, and she allows for a few rabbit trails.