Sunday, March 29, 2015
The financial markets are complex adaptive systems. They cannot be described by deterministic formulas. They don’t lend themselves to statistical prediction. What, then, is an investor or a trader to do?
MIT and Stanford professors Donald Sull and Kathleen M. Eisenhardt offer some suggestions in their forthcoming Simple Rules: How to Thrive in a Complex World (Houghton Mifflin Harcourt, 2015). Their book will inevitably be compared to Daniel Kahneman’s Thinking, Fast and Slow and Malcolm Gladwell’s Blink. But it is more practical than its predecessors, written for people (especially business people) who have to make tough decisions.
Simple rules often work best. “In contrast to complicated models, simple rules focus on only the most critical variables. By ignoring peripheral factors and tenuous correlations, rules of thumb eliminate a great deal of noise. The absence of noise results in decisions that work reasonably well across a wide range of scenarios, rather than being optimized for a single situation. … In very complex systems, like the stock market or the economy as a whole, where causal relations are poorly understood and shift over time, the risks of overfitting past data are particularly acute. Statisticians have found that complicated models consistently fail to outperform simple ones in forecasting economic trends, and the accuracy of their predictions has not improved over time. When it comes to modeling complex systems, sophisticated does not equal effective.” (pp. 34-35)
Simple rules “are particularly effective when the situation is in flux, flexibility trumps consistency, and the benefits of seizing opportunities exceed the cost of making mistakes. “ (p. 44)
Admittedly, there are situations in which complicated decision-models work better than simple rules. For instance, “decisions that can be made by computers, such as via automated trading programs, are better candidates for complicated models than those that rely on human willpower to implement.” (p. 37) In general, however, simplicity wins the day.
Effective simple rules can be sorted into six broad categories: boundary, prioritizing, stopping, how-to, coordination, and timing. The authors give examples of each type of rule, drawing on a range of behaviors (from which house to rob to when to sell a stock, from how to deal with out-of-control forest fires to how starlings flock).
The authors describe ways to develop simple rules in business, non-profit, and personal settings. These rules, of course, cannot be created in a vacuum. “Investing the time upfront to clarify what will move the needles dramatically increases the odds that simple rules will be applied where they can have the greatest impact.” (p. 144)
Investors and traders who want to simplify their overly complex systems or who want to create an efficient rule-based system or plan will be well served by this book. The task will remain difficult (or not, if they opt to follow the 1/N rule). In any event, the recommendations in Simple Rules should keep the investor or trader from straying too far off course.
Wednesday, March 25, 2015
Keith A. Allman and Ximena Escobar de Nogales have written a how-to manual for the would-be investor. Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis (Wiley, 2015) takes the reader through the steps that an investor would normally follow: sourcing and screening, investment analysis and valuation, due diligence and investment structuring, term sheet and documentation, and building value to exit.
The process is arduous and more constrained than traditional private equity investing. Private equity funds have a single mission—to make money. Impact funds have a dual mission—to deliver both financial and social/environmental returns. This means that impact investors will have a smaller pool of potential investments from which to choose. It entails a more complicated set of metrics throughout the process. It also means that the compensation of the fund manager has to be pegged to both financial and social goals—a tricky calculation at best.
Impact Investment is an excellent guide for investors who want to venture into the field of idealistic capitalism. As this book amply demonstrates, they will need all the help they can get.
Sunday, March 22, 2015
Lichtenfeld provides a step-by-step guide to constructing a winning dividend portfolio. Since his guide doesn’t lend itself to brief summary, I’ll focus on two points: (1) the historical performance of stocks that raise their dividends and (2) buybacks versus dividends.
According to Ned Davis Research, assuming an initial investment of $100, between 1972 and 2010 dividend cutters were worth $82 (a compound annual growth rate of -0.52%), companies that didn’t pay a dividend were worth $194 (1.76%), companies that paid a dividend but kept it flat were worth $1,610 (7.59%), and dividend raisers were worth $3,545 (9.84%). The author’s system would turn the initial $100 investment into nearly $7,500 over the same period.
As for the performance of stocks versus high-yield bonds, historically, stocks have “a greater chance of suffering a loss, but only by 3%. To compensate for the risk, stocks generate 92% in extra return. …[I]n the past, you’ve had a 9% chance of losing 27% of your money over 10 years investing in stocks or a 6% chance of losing 40% of your money investing in high-yield bonds.” (p. 49) Dividend stocks, the author concludes, are a better investment than junk bonds.
When companies have excess cash, they can pay a dividend, buy back stock, make an acquisition, or simply horde the money. Which is better for the investor—a dividend or a stock buyback? Not surprisingly, Lichtenfeld comes down in favor of dividends.
A stock buyback does not require a company to repurchase the amount of stock it announces in its stock repurchase authorization. But when it does buy back its own shares, it decreases the share count and thereby increases the earnings per share. So when a company announces a stock buyback, it normally sees a pop in its stock price, even if its profits don’t move at all. “It’s simply an accounting trick that doesn’t reflect any change in the business.” (p. 60)
By contrast, “when a company pays a dividend, that’s real. It’s not part of an authorization plan that may or may not be executed. … A dividend declaration is like a vote of confidence by management not only affirming that there will be enough cash to pay the dividend and run the business but also stating that it has set an expectation for a certain level of earnings and cash flow.” As a 2007 study concluded, “share repurchases are associated with temporary components of earnings, whereas dividends are not.” Or, as another study found, “dividends are paid by firms with higher ‘permanent’ operating cash flows.” (pp. 60, 61)
Investing in dividend-paying stocks is a sound strategy for those who seek income or, if they have time on their side, who want to reap the wondrous rewards of compound interest. Long-term investors will find an abundance of valuable, actionable advice in Get Rich with Dividends. It’s definitely worth a read.
Wednesday, March 18, 2015
For decades investors were told to buy and hold. They bought into myths that perpetuated this advice: the market always comes back, don’t miss the 20 best trading days, don’t be the fool who sells at the bottom, diversity your portfolio … that’s all you need to do, you won’t make any money if you sell and sit in cash, and you haven’t lost any money unless you….
Moraif debunks these myths and tackles what I consider to be the toughest part of investing—selling. When should you take profits or cut your losses? He offers a couple of simple alternatives. First, looking at the equity market as a whole, you can use the 200-day moving average, preferably with a band around it to prevent whipsaw. Second, when it comes to individual stocks, you can use a stop-loss or, if you have a profit, a trailing stop-loss tied to the stock’s volatility.
When shouldn’t you sell? Single event-driven market selloffs are a bad time to bail because the market usually rebounds quickly. If, however, there’s more than one reason, especially if there’s an accumulation of ugly economic data, the investor should pay close attention.
Moraif’s book offers those who worry about their financial futures, particularly those who don’t have time to recover if something goes badly awry, a few basic risk management principles. He tries to take some of the angst out of selling and aims to give the investor “peace of mind, … a feeling of security in a world of volatility, risk, and economic unrest, … the chance to enjoy your retirement as you should—as a second childhood without parental supervision.” (p. 179) Would that disciplined investing lent itself to such emotional calm.
Sunday, March 15, 2015
The companies that investors choose for their portfolios should have a ROE that is high and consistent over time. The problem is that practically all investors calculate ROE in a way that is both inefficient and unreliable. Traditional ROE is not a useful ratio for comparing the operating efficiency of one company to that of another because, for most companies, it is inconsistent from year to year. Worse, there is almost no correlation between book value (equity) and stock returns.
Traditional ROE uses earnings to calculate the return portion of ROE. But earnings include both non-recurring items, which are not predictable, and future liabilities. As Belmonte argues, “[i]n no way do these events show how efficiently you’ve been running your operation. And we’re concerned with operating efficiency in our ROE ratio and not branches falling out of the sky because of a hurricane passing by.” (p. 59) So, for the return portion of the ROE ratio one should use net income, not earnings.
What about the equity portion of ROE? Owners’ equity (or book value) equals the common stock issuance plus all retained earnings, where these retained earnings can come only from net income minus dividends.
Based on his research, indicating that stocks with a history of high Clean Surplus ROEs outperformed the S&P 500, Belmonte came up with six simple rules for structuring a portfolio.
- 1. Choose stocks with Clean Surplus ROEs above 20%.
- 2. Choose stocks that have a good history of operation, either a solid ten years or a shorter history but with high and rising ROEs.
- 3. Choose stocks with low or no dividends.
- 4. Choose stocks with little debt.
- 5. Stocks with rising ROEs are attractive even if their ROEs are below 20%.
- 6. Sell a stock when the Clean Surplus ROE drops below 20%.
The top stocks in Belmonte’s 2014 screen were Gilead, Priceline, Lorillard, Apple, and BlackRock. Panera was a stock that came out of his portfolio when the forecasted ROE for 2014 fell below 20 percent. Monster Beverage, by contrast, held to a steady ROE around 23% over the last three years. “In the two years since we made that change, Panera has no gain, while the S&P 500 index has risen 35 percent and Monster Beverage has risen 70 percent.” (p. 128)
Belmonte ran numerous backtests, but they are not models of rigorous quantitative research. Investors might want to crunch their own numbers before committing hard-earned money to his system.
Wednesday, March 11, 2015
The book is divided into six parts: fixed-income essentials, analysis of risk, asset-backed securities, valuation, term structure analysis, and fixed-income portfolio management. The individual chapters are written by both practitioners and academics.
Although this book is aimed at those who either are or want to become fixed-income professionals, I would highly recommend it to serious equity investors as well. Equity investors rarely know as much as they should about fixed-income assets. Their knowledge usually comes to an abrupt halt somewhere in the neighborhood of the yield curve. They cede the fixed-income turf to the “smarter” guys. But, as this book shows, even those with only a modicum of math skills can understand the principles of fixed-income investing. It’s high time for serious equity investors to expand their horizons and perhaps, in the process, better understand their own domain.
Sunday, March 8, 2015
Fed policies, especially since the financial crisis, have played a major role in shaping the trajectory of U.S., and even foreign, markets. Interest rates matter—a lot. They matter, as the authors (Robert R. Johnson, Gerald R. Jensen, and Luis Garcia-Feijoo) of Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy (McGraw-Hill, 2015) tell us in an appendix, in four key ways. First, they are critical inputs to asset valuation models. Second, they affect the level of business profits. Third, they affect the attractiveness of using margin to buy financial assets. And fourth, “there is a simple substitution effect that accompanies an interest rate increase as the attractiveness of newly issued securities (with higher promised payments) rises relative to the desirability of other securities.” (p. 277)
To invest with the Fed, it is helpful to know what equity classes have been the top performers in three monetary environments: expansive, indeterminate, and restrictive. Between 1966 and 2013, when the Fed was expansive the winners, with their mean annual percentage returns in parentheses, were small-value (44.04%), past performance losers (30.16%), apparel (28.45%), retail (27.03%), and autos (25.42%). When conditions were indeterminate the top performers were energy (15.35%), consumer goods (14.95%), financials (14.55%), food (14.39%), and average past performers (14.39%). Under restrictive conditions energy again topped the list at 11.47%, followed by consumer goods (8.36%), utilities (7.77%), food (7.00%), and steel products (6.93%). (p. 249)
The authors advocate (though perhaps “advocate” is too strong a word since they say that the strategy is not intended to be a definitive recommendation) an expanded rotation investment strategy, using five asset classes: equity classes, equity sectors, foreign country equities, real estate, fixed-income, and commodities. Investors who are anticipating restrictive monetary conditions and who believe that past is prologue might start looking at defensive stocks, mid-cap stocks, blend stocks, and past performance losers; energy, utilities, food, precious metal mining, consumer goods, financials; emerging markets, Scandinavian countries, Canada, BRIC countries; equity REITs, composite REITs; short-term T-bills; and a composite commodity index, industrial metals, energy, and agriculture. Those who believe that this time is different, at least in some respects, might want to make some substitutions in this list of past winners.
Invest with the Fed is, of course, far more than a set of performance tables. But as Fed “lift-off” nears, even though interest rates are expected to remain low for quite some time, investors would do well to review their portfolios. And to ratchet down their expectations. There’s a huge difference in returns between the top performers in expansive environments and the top performers in restrictive environments.
Wednesday, March 4, 2015
Diamond slowly morphed into a short-term technical trader, comfortable with both long and short trades. He incorporated options into his trading arsenal. After the CME introduced E-mini futures in 1997, they became his preferred day-trading vehicle.
In this book Diamond shares the MetaStock templates he uses to make his trades. Traders who don’t have the MetaStock platform can most likely replicate three of his four templates—the moving average template, the moving ribbons template, and the RMO template. But they won’t have access to the Bressert indicator, which is based on cycle analysis and shows trend direction.
Diamond is always on the lookout for the 80/20 trade, the high-probability setup. Throughout the trading day he reads the market with his indicators, asking (1) whether the indicators are flat, trending, or somewhere in between, (2) whether the moving averages are separating or converging, (3) whether any divergences between price and momentum are developing, (4) whether the indicators are confirming each other or are in conflict, and (5) what the next most likely 80/20 trading opportunity is. (p. 118)
Trading as a Business is a thin book, devoted primarily to describing and illustrating the four templates. But it’s a decent starting place for the would-be technical trader.
Sunday, March 1, 2015
The roughly 500-page book is divided into five sections: an investor’s guide to mutual funds, mutual fund portfolio management, sales and operations, beyond traditional funds, and the internationalization of mutual funds.
When I reviewed the first edition of The Fund Industry, I called attention to a little understood technical point: how the daily net asset value of funds is calculated. This time I’m going to summarize the authors’ discussion of a hotly debated issue: index vs. actively managed funds. There are a couple of claims and counterclaims that might be new to readers.
Index fund advocates make four arguments. (1) Passive investing minimizes expenses. (2) It is extremely tax-efficient. Index funds rarely buy and sell stocks, so they rarely realize capital gains. (3) Since the market is efficient, it’s impossible to outperform an index for any length of time. (4) Elaborating on the last point, studies show that “performance persistence, if it exists at all, is a short-term phenomenon and is largely confined to the worst-performing funds, not the ones that anyone would want to include in their portfolios.” (p. 129)
Proponents of active management counter with five arguments. (1)There is a small group of managers who outperform over time. (2) There are cycles in the relative returns of active and passive management; index funds don’t outperform in every environment. “Active managers tend to do well when the performance of the stock market is driven by stocks of every capitalization as opposed to a narrow band of the largest cap stocks.” (p. 130) (3) There is a potential tax time bomb that might make index investing unattractive. “[W]hile index funds are very tax efficient right now, that’s partly because the total assets in these funds are growing, so that there are no net redemptions by shareholders that force the funds to sell securities to generate cash. If index funds should ever start shrinking, they could be forced to start generating enormous capital gains for investors.” (4) Index fund investors are free riders on the backs of active managers. “Markets are efficient only because so many analysts are digging for information that will give them an edge. With so many eyes trained on every security, it’s hard for mispricings to last for every long. But if index funds became the predominant form of investing, the securities they held would frequently be under- or overvalued.” (p. 131) In fact, recent increases in market volatility can be attributed to the growth of index funds since these funds buy and sell in response to cash flows into and out of the funds rather than changes in stock prices.” (pp. 131-32) (5) Markets are predictably irrational.
Who is winning the argument? If investor money decides, actively managed funds are the clear winner. They account for 80% of fund assets, excluding money market funds. But over the last twenty years the index fund share of fund assets has been growing steadily, from 1% in 1993 to 15% in 2010 and 20% in 2013. Momentum is on the side of index funds.