Thursday, May 31, 2012

Doty, Bloomberg Visual Guide to Municipal Bonds

A month-old article on the CNBC website—and by the way one worth reading, "Seven Ways to Spot the Next Big Thing" by Thomas Goetz, listed “demand deep design” as number six. The author wrote: “Too often in technology, design is applied like a veneer after the hard work is done. That approach ignores how essential design is in our lives. Our lives are beset by clutter, not just of physical goods but of ideas and options and instructions—and design, at its best, lets us prioritize. Think of a supremely honed technology: the book. It elegantly organizes information, delivering it in a compact form, easily scanned asynchronously or in one sitting. The ebook is a worthy attempt to reverse-engineer these qualities—a process that has taken decades and chewed up millions in capital. But still, despite the ingenuity and functionality of the Kindle and the Nook, they don’t entirely capture the charms of the original technology. Good design is hard.”

Whatever your take on ebooks, technology is slowly replacing ink with pixels. I have no doubt that sometime in the not too distant future digital reading devices will reach a level of deep design.

In the meantime the Bloomberg “visual guide” series demonstrates that even established technologies can fall victim to veneer design. Robert Doty’s Bloomberg Visual Guide to Municipal Bonds (Wiley/Bloomberg, 2012) is more difficult to read because of the book’s design. And that’s too bad because there is a lot of good information here for the would-be investor in munis.

Start with the matter of issuer concentration in the municipal market. The top five states—California, New York, Texas, Illinois, and Florida—account for almost 46% of the market. California alone has $585.7 billion outstanding, more than the bottom thirty states and territories combined (if my math is correct).

Despite Meredith Whitney’s doomsday scenario for 2011, municipal securities issued primarily for essential governmental purposes have a minuscule default rate of less than 0.1%. An investor is subjected to greater risk with securities issued for other purposes—for instance, those intended to fund infrastructure for real estate developments or securities payable from revenues of start-up or rapidly-expanding projects. Securities with significant private participation are also on the “warranting special care” list. (p. 80)

Doty’s book is for the most part a series of questions and answers. Some examples:
What is EMMA? Quick answer: Electronic Municipal Market Access, a
 helpful resource.
What are special tax and assessment securities?
How do I know when ratings of my securities change?
When should I consider mutual funds and ETFs?
Does my receipt of Social Security affect tax-exemption of my
 municipal securities?

Investors contemplating entering the muni market will most likely have all their questions—and many they didn’t think to ask, or didn’t know enough to ask—answered in this book. It’s a thorough, reliable guide.

Wednesday, May 30, 2012

Weiss, The Big Win

Just as whale watching is a popular adventure tour for nature lovers, reading about the whales of finance is a popular pastime for investors. In The Big Win: Learning from the Legends to Become a More Successful Investor (Wiley, 2012) Stephen L. Weiss profiles one woman and seven men who have truly excelled.

First, a caveat about what Weiss describes as “the ugly reality of whale watching,” by which he means “blindly following large, smart buyers into a stock or other investment.” (p. 25) Unless an investor has insight into the whale’s rationale for making a particular investment, his time frame, and his risk appetite, the investor is at a considerable disadvantage. It is critically important, as Weiss writes, to “understand the process. … The true value of these case studies … is in understanding each investor’s methods, not standing in awe of their results.” (pp. 32-33)

Weiss’s eight legends—RenĂ©e Haugerud, James S. Chanos, Lee Ainslie, Chuck Royce, A. Alfred Taubman, James Beeland Rogers Jr., R. Donahue Peebles, and Martin J. Whitman—each carved out a niche and developed an investing style.

Haugerud, for instance, is a top-down investor. Her hedge fund, Galtere Ltd., has a five-stage investment process: taking the temperature of the global markets, developing a few themes, microanalyzing and selecting strategic investments, timing trades technically, and applying risk management. Her “big win” came in 1993. With gold trading as much as 40% above the world’s highest cost of production and the one-year bonds of Canada’s western provinces yielding 9 to 12%, she shorted gold for a rate of less than 1%, bought the bonds, and hedged her short gold position with undervalued small-cap stocks of mining producers in Australia that had high margins and low production costs. “’All three legs worked,’ as Haugerud puts it, and all kept working for a good long while. It was a simple trade, and the returns were good enough to carry that year’s performance to her stated goal and beyond.” (p. 50)

Chanos is a short seller, Ainslie a stock picker, Royce a small cap investor. Taubman and Peebles are both real estate developers, Rogers is a commodities investor, and Whitman is best known as a distressed debt investor.

What do all these legends have in common? Weiss catalogs seven traits: no emotion, no ego, long-term investors, discipline, thorough research process, passion and work ethic, and drive. Or, reduced to six words: “Drive. Passion. Process. Equanimity. Discipline. Humility. These are the commonalities between all those profiled in this book and the qualities that make for a great—and legendary—investor.” (p. 17)

The Big Win is an easy, thoroughly enjoyable read for those who want to learn from the whales.

Thursday, May 24, 2012

Mauldin, The Little Book of Bull’s Eye Investing

As long-time readers of this blog know, I am a big fan of the “little book” series. Most of the titles in this series are wittily written distillations of major investment themes. Unfortunately, John Mauldin’s The Little Book of Bull’s Eye Investing: Finding Value, Generating Absolute Returns, and Controlling Risk in Turbulent Markets (Wiley, 2012) falls short of the mark.

Mauldin, who has written extensively about our muddle-through economy, believes that we are still in the secular bear market that began in 2000, that “we will not get to the real bottom of this bear cycle until after the next and third recession” (p. 147), and that we probably can look forward to another five to six lean years. What is an investor to do in this environment?

Buying gold is one choice; the author devotes a chapter to explaining why he’s bullish on gold. But the main thrust of the book is that the investor must buy value, preferably in small- and micro-cap companies. Referencing The Millionaire Next Door, he notes that “you are trying to find the right people to partner up with, those hard at work on becoming one of those next-door millionaires, who will take you along for the ride, even if in a small way.” (p. 138)

In fact, Mauldin, a self-confessed serial entrepreneur, seems conflicted between recommending that his readers invest in the businesses of others and encouraging them to start their own. As he writes, “Starting (or buying) and growing a business remains the single best way to create wealth. If you plan well and grow, maybe yours will become one of those small-cap value companies that will be perfect for Bull’s Eye investors.” (p. 177)

Mauldin spends much of this “little book” summarizing studies on a variety of topics such as market cycles, the macro scene, and behavioral finance. With so little space left for his own ideas, the book has an intellectually second-hand quality to it. And that’s too bad, because Mauldin doesn’t have over a million followers for nothing.

Wednesday, May 23, 2012

Anson, CAIA Level I: An Introduction to Core Topics in Alternative Investments

The Chartered Alternative Investment Analyst Association offers the CAIA Charter, designed for individuals specializing in institutional quality alternative investments. Attaining the charter requires a candidate to pass both Level I and Level II exams. This second edition of An Introduction to Core Topics in Alternative Investments by Mark J. P. Anson with Donald R. Chambers, Keith H. Black, and Hossein Kazemi (Wiley, 2012) was written primarily for those studying for their Level I exam. (The text geared to the Level II exam is Advanced Core Topics in Alternative Investments.)

For most folks, preparing for the Level I exam would definitely not be a weekend project. For starters, the text is almost 900 pages long. It is divided into seven parts: introduction to alternative investments, real assets, hedge funds, commodities, private equity, structured products, and risk management and portfolio management. Lest you think that the book is merely an overview of the field, the first part of the book takes up such topics as statistical foundations; risk, return, and benchmarking; correlation, alternative returns, and performance measurement; alpha and beta; and hypothesis testing in alternative investments.

Although I have no intention of becoming chartered in anything, I’m delighted with this book. It is a first-rate reference, bringing together in one well-structured, clear text a broad range of material that it’s probably taken me close to fifty books to cover, more or less. Although some of the material is intrinsically complicated, the authors have done a yeoman’s job of making it seem almost simple.

All in all, CAIA Level I is a solid achievement and should be a core holding in the libraries of serious investors.

Monday, May 21, 2012

Davis and Nairn, Templeton’s Way with Money

Sir John Templeton was one of the most successful fund managers of the twentieth century. At his peak, during the two decades after his move from New York to the Bahamas in the late 1960s, he outperformed the market by 6% per annum. Over his career he outperformed by 3.7% per annum.

In Templeton’s Way with Money: Strategies and Philosophy of a Legendary Investor (Wiley, 2012) Jonathan Davis and Alasdair Nairn chronicle the principles that informed Templeton’s investing style, relying extensively on Templeton’s letters to clients of his investing firm. In a fifty-page appendix they reproduce some of his observations on investing. The result is a compelling portrait of an innovative thinker, a disciplined investor, and a principled human being.

Templeton was a global investor long before it became fashionable to look beyond national borders for opportunities. And, though known as a value investor, his first and most famous fund (initially domiciled in Canada) was the Templeton Growth Fund. He looked for bargains, but “In his analysis of individual stocks, he recognized that there were various combinations of value and growth that could produce a company that was ‘cheap’ on a five-year forward earnings view. It could be a slow growing dividend-paying company whose shares were simply too low, or it could be a fast-growing company whose shares did not yet fully reflect that rate of future growth. ‘Never adopt permanently any type of asset or any selection method’ was one of his maxims. … investors need to ‘stay flexible, open-minded, and skeptical.’” (p. 110) Put another way, as Templeton wrote in one of his sixteen rules of investing, “Success is a process of continually seeking answers to new questions.” (p. 128)

As an example of Templeton’s flexibility the authors cite his decision in the spring of 2000 to personally invest more than $100 million in U.S. Treasuries funded by cheap borrowing in yen and to short technology stocks. “Both positions produced handsome rewards; shorting the technology stocks made a profit of $90 million and the Treasuries produced a gain of more than 80 percent over the subsequent three years.” (p. 110)

Templeton’s advice is by and large commonsensical but nonetheless devilishly difficult to follow. There are no shortcuts. For instance, he disputes the claim of modern portfolio theory that diversification is one of the few free lunches in investing: “Everyone should read about modern portfolio theory, but honestly they are not going to make much money with it. I’ve never seen anybody that came up with a really superior long term record using only modern portfolio management.” As the authors comment, “His point here was not that diversification was wrong, but that the notion that building portfolios on the basis of unreliable and irrelevant statistical inputs, such as historical volatility, was doomed to failure.” (p. 129)

Investing is hard, and it requires hard work. Trying to figure out what a company’s P/E will be in five years is not a task for the slacker. For most of his life Templeton himself worked twelve hours a day for at least six days a week and exhibited an “ability to focus single-mindedly on the task in hand.“ (p. 24) Successful investing also requires “the temperament and patience to wait for superior results to come through.” Templeton was fortunate in this regard; he was “blessed with a temperament in which patience, forbearance, and confidence in the face of adversity were constants.” (p. 165)

Templeton’s Way with Money is a tribute both to an investing legend and to enduring investment principles. It’s a welcome addition to the literature of finance.

Thursday, May 17, 2012

McIntosh, The Sector Strategist

Pension funds, wealthy families, and risk-averse dreamers with portfolios of stocks and bonds expect an 8% long-term rate of return on their investments. Timothy J. McIntosh quashes these expectations. Over the next ten years he thinks that 5% to 6% is the more likely outcome for a portfolio split evenly between stocks and bonds.

In The Sector Strategist: Using New Asset Allocation Techniques to Reduce Risk and Improve Investment Returns (Wiley, 2012), however, he offers tips on how to get to the magic 8% level of returns. His primary thesis is that “sectors are just as important, if not more so, than international or cap size exposure.” (p. 37) Moreover, “if investors are to consider sectors as a primary component to their investment strategy, three criteria should be used: superior historical investment returns, low correlations with other sectors, low volatility or beta.” (p. 48) The sectors that meet all of these criteria are health care, consumer staples, and energy. Runners-up, with higher risk, are financials and technology.

McIntosh examines these five sectors in some detail, complete with case studies of stocks he purchased for his own clients using fundamental analysis.

Rounding out McIntosh’s recommended portfolio are corporate bonds, some gold, and REITs. McIntosh directs those investors with small accounts (under $30,000) to ETFs and mutual funds rather than individual stocks and offers specific suggestions.

He also presents three model portfolios by asset class: the aggressive, moderate, and balanced. The moderate portfolio, for instance, designed for those between the ages of 40 and 55, contains 25% health care stocks, 25% consumer staples stocks, 10% energy stocks, 7.5% technology stocks, 2.5% financial stocks, 20%BB- to BBB-rated corporate bonds, 5% REITs, and 5% precious metals. The balanced portfolio increases the weighting of bonds to 35%. Over the period 1986-2010 the aggressive portfolio had an annualized return of 11.94%, the moderate portfolio 11.73%, and the balanced portfolio 11.51%. The S&P 500 index had an annualized return of 10.36% and an equally weighted portfolio of stocks and U.S. Treasuries 9.34%.

McIntosh’s asset allocation method is grounded in academic research, but this book is thoroughly practical. For investors going the ETF or mutual fund route, it provides turnkey portfolios. For those who want to be stock pickers, it describes how to winnow down a list of stocks to find the most promising candidates.

Wednesday, May 16, 2012

Thomsett, Bloomberg Visual Guide to Candlestick Charting

Bloomberg Press, an imprint of Wiley, has launched a new high-end paperback series that stresses visual learning. Michael C. Thomsett’s Bloomberg Visual Guide to Candlestick Charting (2012) is the first book in the series.

I rarely write about book design even though I spent many years working with some of the top book designers in the country (and, yes, some painfully mediocre ones as well). But since Bloomberg’s new series is essentially a design statement, it is worth spending a little time on layout.

I have two books from this series here for review, so I think I have a pretty good sense of how the series is being structured. Each book is 10” x 7”—that is, it’s wider than it is tall. This extra space is necessary to accommodate marginal boxes with white text on color-coded backgrounds. These boxes contain key points, definitions, smart investor tips, step-by-step tutorials, and do-it-yourself worksheets, formulas, and calculations. The boxed text can be very difficult to read, especially when the background color is light. The task is even more difficult when the text is italicized.

Personally, I find these boxes distracting. The key points, for instance, are “designed to help the reader skim through definitions and text.” But why does the reader need to squint to read the key points from a perfectly lucid two-paragraph text? I’m not exaggerating; there are several such examples in Thomsett’s book. Thankfully, this book isn’t cluttered with boxes in all the colors of the rainbow; by and large the only distractions are orange boxes with white text. (But just wait for the second volume in the series.)

So if you, like me, skip the boxes, what’s left? In the case of Bloomberg Visual Guide to Candlestick Charting, a great deal. The bulk of the book is devoted to individual candlestick patterns, presented alphabetically. Facing pages describe the pattern and its significance in words (verso) and present the pattern graphically (recto). The graphics are absolutely first-rate. The pattern is first shown in a stylized form and then highlighted on a large, clean chart.

Another major section of the book addresses noncandlestick confirmation indicators and terms. For the most part, it deals with chart patterns and technical indicators, some of which are appropriately illustrated. But there’s also a “kitchen sink” element to this section. One finds entries, for instance, on day trading, paper trading, and technical analysis.

A final design quibble. If you’re hard on books, you’ll break the binding of this paperback in no time because the inner margins are very tight. If you prefer to go the e-book route, you’ll get extras: video tutorials and “special pop-up features.”

The book’s core (that is, the text and charts, especially in the candlestick pattern section, sans marginalia) is beautifully executed. It is an invaluable reference guide to candlestick charting. In fact, were it not for the extra “helpful” learning aids, I would unequivocally recommend Thomsett’s book to anyone interested in an elegantly presented catalogue of candlestick patterns. The ill-conceived pedagogical ideas on display in this book only modestly temper my recommendation.

Monday, May 14, 2012

Bernstein, The Power of Gold

Peter L. Bernstein, who died in 2009 at the age of 90, had a full life managing money, running an economic consulting firm for institutional investors, and writing ten books, several of them bestsellers. One that I particularly enjoyed was Against the Gods: The Remarkable Story of Risk. Right up there was The Power of Gold: The History of an Obsession, originally published in 2000. Wiley has just reissued the book in paperback, with a new foreword by Paul A. Volcker, offering yet another generation of readers a chance to profit from Bernstein’s erudition and thoroughly engaging writing style.

Bernstein begins with God’s reported fixation with gold. “When Moses climbed Mount Sinai to receive the Word from God, God gave him a lot more to do than just transmit the Ten Commandments and many associated rules and obligations. God also issued precise directions for the construction of a sanctuary where the Jews were to worship Him, together with a tabernacle to go inside the sanctuary. God began right off by specifying that ‘thou shalt overlay it with pure gold, within and without shalt thou overlay it, and shalt make upon it a crown of gold round about.’ That is just the beginning: God even ordered that the furniture, fixtures, and all the decorative items such as cherubs were to be covered in pure gold.” (p. 11)

The golden-laden sanctuary and tabernacle disappeared, but the practice of “using gold to proclaim the power of the church” was repeated many times since. Gold also became one of the most common symbols of temporal wealth—robes woven in gold thread, gold jewelry, and gold dinnerware.

Most important for Bernstein’s story, gold was viewed as a form of money. The Egyptians cast gold bars as money as early as 4000 BC; the Lydians, the first retail tradesmen, minted and used both gold and silver coins beginning around 635 BC. “In a sense, the transformation of gold into money democratized it. Thanks to coinage, the ownership and use of gold after Lydia was no longer a royal prerogative. It was now literally in the hands of common citizens, even if only the most wealthy, who could touch and feel it, hoard it in their homes, buy things with it, and pay their debts with it—even as they continued to put their gold through their ears and noses and to wrap it around their necks, wrists, and fingers. Before long, they would be paying their taxes with it. The notions of power and wealth thus blended into one.” (p. 39)

The minting of gold coins was a process crying out for technological innovation. Not only was it tediously slow to hammer out coins by hand, one at a time, but “the smooth edges of hammered coins … encouraged people to clip or file off tiny pieces of metal that could be accumulated until the quantity was sufficient to be melted down into bullion, which the clippers then resold to the mint for a fresh supply of coins. … In the thirteenth century, Jews were often accused of clipping even when they were innocent. In 1270 alone, 280 Jews were beheaded for the crime.”

It wasn’t until the reign of Queen Elizabeth of England that one Eloy Mestrell tried to mechanize the minting process, “using horses to power the coin-stamping machines and using this machinery to redesign the edge of the coins so that clipping would be immediately visible. Ingenious as he may have been, Mestrell generated little enthusiasm for his efforts and was fired in 1572. That was not the last to be heard of Mestrell, for he was hanged in 1578 for counterfeiting!” It wasn’t until 1661 that Charles II ordered that “All coin [was] to be struck as soon as possible by machinery, with grained or lettered edges.” (pp. 176-77)

Bernstein, of course, recounts highlights from the history of gold, including how Sir Isaac Newton became Master of the Mint , how Napoleon conducted probably the only major war in history without currency depreciation in one form or another, and how poor Johann Sutter spent years unsuccessfully trying to reclaim his land (and sawmill) from squatters.

Fast forward to the international gold standard, which “shimmers from the past like the memory of a lost paradise, embodying all the nostalgia of the Victorian and Edwardian eras—stability, harmony, respectability.” (p. 239) In his discussion of the protracted decoupling of gold and money, Bernstein writes: “It is easy to understand the nostalgia for the prewar world that encouraged the struggle to return to gold. It is easy to understand the desire for a system whose simplicity and elegance was unmatched in the history of money. … But it is not so easy to understand that men could make such mighty decisions on the basis of obsolete visions rather than objective analysis.” (p. 326)

Bernstein’s book is a fascinating read, especially in light of the recent run-up in the price of gold. Should gold once again be viewed as a currency, as so many commentators have suggested? Were he still alive, Bernstein might laconically answer, “Read my book.”

Friday, May 11, 2012

Toma, The Risk of Trading

A truly first-rate book on risk management for the individual trader has yet to be written. In the meantime Michael Toma’s The Risk of Trading: Mastering the Most Important Element in Financial Speculation (Wiley, 2012) helps to fill the void.

If I had to choose the two key sentences in this book they would be: “Risk management is not limiting losses. It is the art of maximizing profits for a given optimal risk.” (p. 173) That is, contrary to commonly-held views, risk management goes far beyond placing stops or calculating position size. It also goes beyond the purely mathematical, even though it would still behoove traders to be familiar with the seminal works of Ralph Vince (The Mathematics of Money Management, 1992) and the many books and papers that followed in a similar vein.

Toma, a corporate risk manager and the author of Trading with Confluence, offers a simple, math-free analysis. (Well, here and there a spreadsheet comes in handy.) He is at his best when discussing how to track performance.

One recommendation that I consider especially sound is that the trader track opportunity risk. “Auditing ‘opportunity risk’ is equally as important as measuring your actual trades. … In all the risks associated with trading, I find opportunity risk, whether in the form of unexecuted trades or pretarget exits, to be the difference between traders who reach that much-talked-about top 10 percent in the profession and those who remain in the novice pool, struggling to keep their heads (and P&L) above water.” (p. 126) If you were presented with a valid trade setup in your plan and you sat on your hands, track that trade. Are you actually skilled at overriding your system or should you, as Toma argues, take advantage of every opportunity that your plan presents?

Toma recommends that every trader construct his own key performance indicator (KPI) dashboard. Keep it simple, sticking to five to eight measurable items initially. And keep it balanced in scope. “The indicators should represent a balanced monitoring synopsis of performance, compliance, and business metrics. A common gap in KPI programs is that it is completely dominant in trade result metrics. A measure that detects rule breaking is far more indicative of trading success than a KPI that measures current win percentage over a small time period.” (p. 133)

A trader’s dashboard metrics could include such items as average number of trades per day, average quantity of shares (or contracts) traded, ratio of trades reaching target vs. trades hitting a stop, trades reaching target vs. total trades, opportunity risk, performance consistency, risk-to-reward ratio, number of days in full compliance, performance edge by setup opportunity, and peak performers by day and time. “Adjust these samples to your liking or create your own key performance indicators. As long as they alert you to areas of development or internal issues that are preventing your success, they truly live up to their ‘key’ performance acronym.” (p. 139) By the way, Toma suggests that updating your dashboard data is better done over the weekend than on a daily basis.

Traders often fall short when it comes to setting stops and targets. Toma proposes that traders use backtested values for MAE and MFE (maximum adverse excursion and maximum favorable excursion), powerful concepts introduced by John Sweeney in Campaign Trading (1996), to “find an area to consider for the initial stop and target. When these levels coincide with multiple layers of support and resistance, then you are trading with a confluence edge, which is the most powerful formula for success.” (pp. 173-74)

The Risk of Trading is a call to arms for the trader who either keeps no trading journal at all or simply records profit and loss. Metrics are critical to success. Just think where Amazon would be today if management didn’t bother to track consumer preferences and left inventory control to chance.

Wednesday, May 9, 2012

Damodaran, Investment Valuation, 3d ed.

Aswath Damodaran’s work is always worth reading. Earlier I reviewed The Little Book of Valuation. The subject of today’s review, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3d ed. (Wiley, 2012), is the big book of valuation. It measures 7” x 10” and runs about a thousand pages. Damodaran has a web site designed to support the book, including solutions to the problems at the end of each chapter, spreadsheets and datasets that he updates periodically, and web casts of his course on valuation at NYU’s Stern Business School.

In 34 chapters Damodaran covers methods of estimating risk parameters, growth, terminal value, and equity value per share. He analyzes various valuation models. He discusses how to value companies that present challenges, such as financial service firms, firms with negative or abnormal earnings, distressed firms, start-up firms, and private firms. And much, much more.

There is, of course, no way I can possibly do justice to this book in a few paragraphs. So, by way of illustration of the book’s contents, let me share Damodaran’s explanation of a big-picture chart that tracks S&P 500 earnings-price (EP) ratios, T-bond rates, and the yield spread (T-bond minus T-bill rate) at the end of each year from 1960 to 2010. He regresses EP ratios against the level of T-bond rates and the yield spread over this data period; R2 = 0.478. “Other things remaining equal, this regression suggests that: Every 1% increase in the T-bond rate increases the EP ratio by 0.6869%. This is not surprising, but it quantifies the impact that higher interest rates have on the PE ratio. Every 1% increase in the difference between T-bond and T-bill rates reduces the EP ratio by 0.3655%. Flatter or negatively sloping term yield curves seem to correspond to lower PE ratios, and upwardly sloping yield curves to higher PE ratios. While at first sight this may seem surprising, the slope of the yield curve, at least in the United States, has been a leading indicator of economic growth, with more upwardly sloped curves going with higher growth.

“Based on this regression, the predicted EP ratio at the beginning of 2011, with the T-bill rate at 0.13% and the T-bond rate at 3.29%, would have been … 20.77. Since the S&P 500 was trading at a multiple of 15 times earnings in early 2011, this would have indicated an undervalued market.” (p. 478) As of May 4, 2012, the market was still undervalued: the trailing 12-month EP ratio for the S&P 500 was 15.93.

For investors and students of the financial markets who want to embark on serious fundamental analysis it is critical to understand how to go about valuing stocks and other instruments. There is no short cut. The person who runs a bunch of screens (low P/E, high growth, etc.) and thinks his output gives him an investing edge is deluding himself. Fundamental analysis involves hard work and an artful touch. Damodaran’s Investment Valuation explains the hard work part. I fear no book can imbue the investor with an artful touch.

Monday, May 7, 2012

Linder, The Women of Berkshire Hathaway

For those who read everything about Warren Buffett they can lay their hands on or for women in search of models Karen Linder’s The Women of Berkshire Hathaway: Lessons from Warren Buffett’s Female CEOs and Directors (Wiley, 2012) is a pleasant, occasionally inspirational read. Linder offers portraits of nine women in the Berkshire Hathaway orbit. Seven are or were CEOs of companies that are subsidiaries of Berkshire or in which Berkshire holds a large stake, and two are directors of Berkshire itself.

Linder starts with the feistiest member of the group, Rose Blumkin of Nebraska Furniture Mart fame, who worked 12 to 14 hours a day, seven days a week, until a year before her death in 1998 at the age of 104. The other women featured in this book are Susan Jacques, CEO of Borsheims Fine Jewelry and Gifts; Doris Christopher, the founder of The Pampered Chef, and Marla Gottschalk, its current CEO; Cathy Baron Tamraz, CEO of Business Wire; Beryl Raff, CEO of Helzberg Diamond Shops; Katharine Graham, the late publisher of the Washington Post (for years Buffett was also on the board of the Washington Post Company, in which Berkshire has an 18% stake); and Charlotte Guyman and Susan Decker, both members of Berkshire’s board of directors.

What struck me in reading this book was how ordinary many of these women seemed and yet what extraordinary success they had. Doris Christopher, for instance, discovered that she was good at home economics in high school and subsequently majored in the field in college. After teaching adult education courses at a cooperative extension service and then being a stay-at-home mom for eight years, she was ready to get back into a career, this time with a more flexible schedule. She started buying kitchen items wholesale and selling them at home cooking shows (akin to what used to be known as parties, along the Tupperware line). Slowly she expanded The Pampered Chef, hiring both employees and consultants, who hosted shows. By the end of 1981, its first year in business, the company had 12 kitchen consultants; in 2001 there were 71,000. Revenues were $67,000 in 1981, $740 million in 2001. In 2002 Buffett purchased the company.

The Women of Berkshire Hathaway is not a must-read book, but it amply demonstrates that with ambition, hard work, and the right fit women can become highly successful entrepreneurs.

Friday, May 4, 2012

Powers, Acts of God and Man

I don’t know what there is about the idea of risk and the people who think and write about it. Perhaps it’s that the analysis of risk inevitably leads to an epistemological abyss. Whatever the case, the idea of risk seems to attract the most imaginative, philosophically minded, even humorous writers. Michael R. Powers falls squarely within this group. His Acts of God and Man: Ruminations on Risk and Insurance (Columbia University Press, 2012) is a challenging book but definitely worth the intellectual effort necessary to read it.

In this post I’m going to concentrate on two chapters, “What Is Randomness?” and, more briefly, “Patterns, Real and Imagined.”

Common examples of presumed randomness include stock prices, coin tosses, weather patterns, and industrial accidents. “The most salient aspect of these and similar phenomena is their unpredictability; that is, they are unknown ahead of time and generally cannot be forecast with anything approaching perfect accuracy. There are, however, certain limited circumstances under which such phenomena can be predicted reasonably well: those in which the forecaster possesses what financial traders might call ‘insider’ information.” (p. 178) For example, a magician who is skilled at tossing coins may be reasonably certain that his next coin toss will come up heads.

Powers calls any uncertainty that can be eliminated by means of “insider” information (that is, “any and all information potentially available to the most privileged, persistent, and conscientious observer, whether or not such an observer exists in practice”) as knowable complexity (KC). “Any residual uncertainty, which cannot be dispelled by even the ideal observer, will be called unknowable complexity (UC).” Powers equates UC with true randomness.

It doesn’t take a great leap of faith (indeed, Chaitin’s work on incompressible sequences of integers, specifically his impossibility theorem, takes us most of the way) to show that “no systematic approach to the study of randomness can ever: (1) confirm a source of uncertainty as UC; or (2) confirm some sources of uncertainty as KC without inevitably creating type-2 errors in other contexts. These are the cognitive constraints under which we operate.” (p. 187)

Moving from theory to practice, the author points to one of the empirical problems of randomness traders face every day: trying to separate signals from noise. This problem often manifests itself in the phenomenon of pareidolia, “in which a person believes that he or she sees systematic patterns in disordered and possibly entirely random data.” Powers doesn’t have a workable solution to this problem, and he finds the meta-problem also lacking a satisfactory answer: “Rather ironically, the line between the overidentification and underidentification of patterns is one pattern that tends to be underidentified. In addition to dubious uses of data in pseudoscientific pursuits such as numerology and astrology, there also are various quasi-scientific methods, such as the Elliott wave principle employed by some financial analysts and neurolinguistic programming methods of business managers and communication facilitators that haunt the boundary of the scientific and the fanciful.” (p. 192)

Some reviewers have described Powers’ work as idiosyncratic, which, we know, is a fancy way of saying half-baked or crazy. But how much more satisfying it is to read the so-called idiosyncratic than the mundane.

Wednesday, May 2, 2012

Carter, Mastering the Trade, 2d ed.

Six years after John F. Carter’s Mastering the Trade: Proven Techniques for Profiting from Intraday and Swing Trading Setups first appeared, the second revised edition has been released (McGraw-Hill, 2012). In the interim, his main website, Trade the Markets, “has grown into a ‘real business.’” Carter and his partners seem to be very busy entrepreneurs, with a live trading room, video training sessions, and mentorships. They also sell trading videos and the indicators featured in this book (which cost many multiples the price of the book, although most of them have long since been hacked). It is therefore not surprising that at the end of each chapter Carter points the reader to a link on his site (either his main site or his site on options) for updates on how he’s using particular indicators and other information. Of course, you’re also immediately confronted with an ad to join the author’s premium membership newsletter.

These promotional caveats aside, there’s a lot of excellent material available here for the not yet profitable trader. First of all, in terms of markets Carter casts a wide net—stocks, futures, options, forex. Second, he offers a broad range of setups (he has not updated the first edition here, so most of the charts are from 2004), some of which are admittedly dependent on his own indicators. Do they work? I have no idea; the reader would have to do his own backtesting. Perhaps most important, the author deals at length with the kinds of issues that hold traders back or lead them to blow out their accounts.

Carter is a very chatty writer. An example: “If $5,000 or $10,000 is all you can manage, that’s fine. Just be careful not to piss your capital away on undeserved risks, trades that are typically taken out of boredom. Wait for the ‘Porsche setups’ and pass on the ‘Pinto setups’….” (p. 55) He is also willing to tell out of school tales about himself in order to help other traders.

Mastering the Trade is a big book—some 450 pages. It covers just about everything a person needs to know to get started trading or to jump start his lackluster, or worse, trading. It’s one of the most comprehensive and most accessible introductory trading books available.