Improve the Position


By David Merkel of Aleph Blog

It’s hard to take a loss.  But taking losses is necessary to avoid even larger losses.

This is prompted by Barry Ritholtz tweeting to me a piece he wrote 3 months ago called, Take The Loss.  Good piece, worth a read.

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What I suggest to you today is that there is a better way to manage portfolios.  Ignore the cost basis — the price at which you bought it.  Instead, focus on improving the economic value of your portfolio.

It is hard, really, really hard to choose the best assets.  I  can’t do it. It is easier to choose assets that are better than the ones you currently own.

This assumes that you have a reasonable way of estimating the value of assets.  When I was a corporate bond manager, it was easy, because I had a large number of rules to help me estimate the proper yield tradeoffs, perhaps more than most managers had at the time.

  • Discount vs Par vs Premium bonds
  • Differing maturities
  • Special covenants
  • Deal size
  • Secured, senior unsecured, junior unsecured, trust preferred, preferred stock
  • Implied credit betas of different industries (take more/less risk when you want to)
  • Spread tradeoffs needed for capital requirements and likely default/capital losses
  • Holding company vs operating subsidiary
  • Public bond vs 144A vs private placement

There are probably more, but they aren’t coming to me now.  It is generally easier to estimate the tradeoffs with fixed cash flow streams with a maturity than unlimited life instruments where any cash flow back to you is uncertain.

Thus equities are squishier, where you have to compare valuation, industry trends, use of free cash flow, company quality, etc., to determine what is more valuable.  This is a much harder game, but one that can be played with discipline to good effects.

It is a lot easier to do swaps in equity portfolios than to to try to create the current optimal portfolio.  It is much easier to make comparative judgments (these are better) than absolute judgments (these are the best).

Other things equal, can you:

  • Improve the cheapness of your portfolio?
  • Improve the quality of your portfolio (unless you are in a period where leverage is expanding dramatically, and the opposite will pay off for a time)?  This applies both to balance sheet and accounting quality in earnings.
  • Improve your industry allocations?
  • Own management teams that use cash flow more effectively, and are more shareholder oriented?

Always trade for what is better, and ignore the price where you bought the assets.  It doesn’t matter what you paid; that is a historical artifact.  Trade for better securities regularly, subject to transaction costs and other limits.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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