The Trend Is Not Your Friend: Part II

reminiscences of a stock operator pdf

I had two more good questions in response to my piece Why I Resist Trends.  Here we go:

I think you have some idea which ones are the best by the discount to intrinsic value. If you were running a business (which you are when you are investing) and you had 10 projects with lets say a minimum return of 5% but a spread of 20% to 5% wouldn’t you first invest in the 20% return project and fund each project in descending order of return. By equally weighing aren’t you equally investing in the 5% and 20% projects? If you were a CEO shouldn’t the shareholders fire you? I know the markets have more volatility than projects due to the behavioral aspects of investing but in my view equally weighting is more important when you do not know much about your investment and less important when you do. I think you know a lot about the companies you invest in. Why not try an experiment. Either in real time or historically take a look at what would have happened overtime if you would have weighed you selections by discount from intrinsic value. I think you will be pleasantly surprised. I and John Maynard Keynes have been pleasantly surprised.

I do this in a limited way.  In the corporate bond market we have the technical term “cheap.”  We also have the more unusual technical term “stupid cheap” for bonds that are very undervalued.

When I have a stock that is “stupid cheap” I make it a double weight, if it passes margin of safety and other criteria.  On one rare occasion I had a triple weight.

But I meant what I said  in Portfolio Rule Seven — “Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best.”  I have been surprised on multiple occasions as to what would do best.  Investing is not as simple as assessing likely return.  We have to assess downside risks, and possibilities that some things might go better than the baseline scenario.

I don’t use a dividend discount model, or anything like it.  I don’t think you can get that precise with the likely return on a stock.  My investing is based on the idea of getting very good ideas, as opposed to getting the best ideas.  I don’t think one can get the best ideas on any reliable basis.  But can you find assets with a better than average chance of success?  My experience has been that I can do that.

So, I am happy running a largely (but not entirely) equal-weight portfolio.  It is an admission of humility, which tends to get rewarded in investing.  Bold approaches fail more frequently than they succeed.

By the way, though Keynes was eventually successful, he cratered a couple times.  I have never cratered on a portfolio level, because of my focus on margin of safety.

On to the next question:

What are the tests you use to check if accounting is fair?

Start with my portfolio rule 5, here’s a quick summary:

Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

  1. For nonfinancials, review the difference between cash flow from operations and earnings.  Companies where cash flow from operations does not grow and  earnings grows are red flags.  Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.  The latter portion of that rule can be applied to financials.

  2. For nonfinancials, review net operating accruals.  Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.    The values of assets on the balance sheet are squishier than most believe.  The accruals there are not entirely trustworthy in general.

  3. Review taxable income versus GAAP income.  Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.  b) management is clever in manipulating GAAP earnings.  It is the job of the analyst to figure out which it is.

  4. Review my article “Cram and Jam.”  Does management show greater earnings than the increase in book value plus dividends?  Bad sign, usually.  Also, does management buy back stock aggressively — again, that’s a bad sign.

Then add in my portfolio rule 6, here’s a quick summary:

Cash flow is the lifeblood of business.  In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

  • I want to avoid companies that do big scale acquisitions.  Large acquisitions tend to waste money.

  • I also want to avoid companies that do acquisitions that are totally unrelated to their existing business.  Those also waste money.

  • I want to avoid companies that buy back stock at all costs.  They waste money by paying more for the stock than the company is worth.

  • This was common in the 50s and 60s but not common today, but who can tell what the future will hold?  I want to avoid companies that pay dividends that they cannot support.

Portfolio rule 6 does not deal with accounting per se, but management behavior with free cash flow.  Rules 5 and 6 reveal large aspects of the management character — how conservative are they?  How honest are they?  Do they use corporate resources wisely?

On Ethics in Business and Investing

I would add in one more thing on ethics of the management team — be wary of a company that frequently plays things up to the line ethically and legally, or is always engaged in a wide number of lawsuits relative to its size.

I know, we live in a litigious society — even good companies will get sued.  But they won’t get sued so much.  I realize also that some laws and regulations are difficult to observe, and interpretations may vary.  But companies that are always in trouble with their regulator usually have a flaw in management.

A management team that plats it “fast and loose” with suppliers, labor, regulators, etc., will eventually do the same to shareholders.  Doing what is right is good for its own reasons, but for investors, it is also a protection.  A management that cheats is in a certain sense less profitable than they seems to be, and eventually that reality will manifest.

All for now, and to all my readers, I hope you had a great Thanksgiving.

By David Merkel, CFA of alephblog

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About the Author

David Merkel
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 RealMoney.com. 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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