Why Stocks Go Up and Down: Book Review

This is a good book to help the inexperienced learn about investing.  It begins by teaching the rudiments of accounting through the adventures of a man and his company who have built a better mousetrap.

Why stocks go up and down

He starts the business on his own, but needs more capital.  In the process of growing, he taps bank loans, private investors, public investors, bonded debt, and preferred stock.  All of this is done with simple explanations in a step-by-step manner.

The book then explains bonds and preferred stocks.  At first I was a little skeptical, because this is supposed to be a book about stocks, and the authors made a small initial error in that section.  That was the last error they made.  I became impressed with their ability to explain corporate bonds and preferred stocks, even some arcane structures like trust preferred securities, and other types of hybrid debt.

Now, if I were trying to shorten the book, a lot of those sections would have been cut.  For those that do want to learn about bonds in the midst of a stock book, you get a free bonus.  If you don’t want to spend the time on bonds, you can skip those sections with little effect on your ability to understand the rest of the book.

Then the book turns to trickier aspects of accounting, explaining cash flow from operations, and free cash flow.  It’s all good stuff, but here is my first problem with the book: what is the most common way of giving a distorted picture of earnings?  Revenue recognition policies.  The book does not talk about revenue recognition, and the most basic idea of Generally Accepted Accounting Principles [GAAP], which is revenue gets taken into earnings proportionate to the delivery of goods and services.  With financial companies, revenues are earned proportionate to release from risk.

That brings up another point.  The book is very good for describing the analysis of an industrial company, but does little to describe how to deal with financial companies.  Financial companies are different, because most of the cash flow statement has no meaning.

Then the book moves on to valuation of common stocks, and that is where I have my biggest problem with the book.  Though they mention other means of valuing stocks, their main valuation method is earnings.  The book does not mention price-to-book as a metric, which is a considerable fault.  Price-to-book is the main way to value financials versus ROE, while price-to-sales is a very good way to measure industrials relative to relative to profit margins.

Further, it suggests that P/E multiples should remain constant as a company grows.  I’m sorry, but P/E multiples tend to shrink as a company grows.  This is because the highest margin opportunities are exploited first, and then lesser opportunities.  For the P/E to remain constant, or even expand means that new opportunities are being exploited that have higher margins.  Investors should not count on that.

These mistakes are minor, though, compared to the good that the book does for an inexperienced investor.

Quibbles

Already expressed.

Who would benefit from this book: This is a classic book that will aid inexperienced investors to learn the basics.  Just remember, it is only the basics, and it covers most things, but not all things. It would be an excellent book for one of your relatives or friends that think they know what they are talking about in investing, but really doesn’t know.  If you want to, you can buy it here: Why Stocks Go Up and Down.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

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By David Merkel, CFA of Alephblog



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.