Petitt et al., Fixed Income Analysis, 3d ed.

Fixed Income Analysis, edited by Barbara S. Petitt, Jerald E. Pinto, and Wendy L. Pirie, is part of the CFA Institute Investment Series. Now in its third edition (it was originally published in 2000), the book, nearly 700 pages long and weighing about two and a half pounds, is an exhaustive treatment of fixed-income securities. The text is suitable for both classroom teaching and self-study. It is clear enough for beginners, meaty enough for professionals. It has useful examples, study questions, and an extensive glossary.

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.

Johnson et al., Invest with the Fed

On the back of a strong nonfarm payrolls number and a 5.5% unemployment rate U.S. markets sold off on Friday. Good news was once again bad news. The reasoning was that the Fed might start raising interest rates in June rather than September or even 2016 and that such an action would have a negative impact on stock prices.

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.

Diamond, Trading as a Business

Dick Diamond has been trading fulltime since 1965. By my calculation that’s fifty years, although the subtitle of Trading as a Business (Wiley, 2015) is The Methods and Rules I’ve Used to Beat the Markets for 40 Years. Ah yes, at the beginning of his trading career Diamond didn’t beat the market. In fact, in late 1968, when he had positions in fifteen low-priced, go-go AMEX stocks, he went on a vacation and let the positions ride. Two weeks later he had lost 70% of his trading capital. It was a pivotal moment: either throw in the towel or change course.

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.

Pozen & Hamacher, The Fund Industry, 2d ed.

In this new edition (Wiley, 2015), Robert Pozen and Theresa Hamacher have updated all the data from their top-notch 2011 work, The Fund Industry: How Your Money Is Managed. They have also expanded the chapter on ETFs, added a chapter on hedge funds, increased coverage of retirement planning, created a separate chapter on fund expenses, and added an introduction to derivatives and their use in funds. The result is a timely, comprehensive book for retail investors who want to know how their funds work (or don’t), for financial planners, and for students who aspire to join the fund industry. In fact, for students, there are “career track” boxes scattered throughout the text that describe the kinds of jobs available.

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.

Pignataro, Mergers, Acquisitions, Divestitures, and Other Restructurings

Paul Pignataro is a master at explaining complicated financial concepts. Earlier I reviewed his work on Financial Modeling and Valuation and Leveraged Buyouts. Now comes his third book in as many years: Mergers, Acquisitions, Divestitures, and Other Restructurings (Wiley, 2015).

Pignataro, the founder and CEO of the New York School of Finance, draws on both his teaching skills and his extensive experience in investment banking and private equity. As in his previous books, he first sets forth some general principles and then takes the reader step by step through a case study. He assumes no prior knowledge, not even of basic Excel coding. By the way, according to standard investment banking modeling etiquette, “all hardcoded numbers and assumption drivers should be entered in blue font” and “all formulas should be entered in black font.” (p. 58) (My own spreadsheets follow this etiquette insofar as they distinguish between hardcoded and formula-generated numbers, but my color choice, which I always considered tasteful, is outright garish by Wall Street standards. Oh well, I guess that’s what happens when you code in a flannel shirt and sweat pants instead of accepted Street attire. But I digress, something Pignataro is careful not to do.)

The case study for this book is the 2013 all-stock merger of equals transaction between OfficeMax and Office Depot, a consolidation in which OfficeMax became a wholly-owned subsidiary of Office Depot. This is a particularly timely case study since Staples has recently made a play for the merged company.

How would an analyst go about determining whether the OfficeMax-Office Depot merger makes sense? He would, Pignataro suggests, build a full-scale model consisting of eight parts: assumptions (purchase price, sources, and uses), income statement, cash flow statement, balance sheet adjustments, depreciation schedule, operating working capital schedule, balance sheet projections, and debt schedule. (The template for the model can be found on the book’s companion website, accessible through the url that appears at the end of the book.)

Pignataro holds the reader’s hand every step of the way. It’s impossible to get lost in this book. Ideas follow one upon another—if not inexorably, at least logically. And painstakingly described Excel keystrokes capture numbers critical to financial analysis. By the end of the book the reader has a full-scale model, a model he can use as a template for his own future work.

Browder, Red Notice

Bill Browder has written a book that is by turns gripping, chilling, and moving—a book that impels a reviewer to pile one outraged adjective upon another. Red Notice: A True Story of High Finance, Murder, and One Man’s Fight for Justice (Simon & Schuster, 2015) is a scathing indictment of Putin’s brutal kleptocracy, which Browder and the people connected to his firm, Hermitage Capital, experienced firsthand.

Browder, the grandson of Earl Browder, head of the American Communist Party who ran for president twice on the Communist ticket, rebelled and became a capitalist, though he still felt the pull of Eastern Europe. His first major deal was for his employer, Salomon Brothers: buying $25 million worth of Russian privatization certificates that were then exchanged for shares in undervalued Russian companies. In a short time the portfolio was worth $125 million, and the 29-year-old Browder became a hero at Salomon.

Soon enough, he decided to go out on his own. With considerable difficulty he launched his firm, based in Moscow, in 1996. A year later his investors were amply rewarded: the fund was ranked the best-performing fund in the world, up 235 percent for the year and 718 percent from inception. Started with assets of $25 million, the firm now had AUM of more than $1 billion. In 1998, hit by the Russian currency crisis, it dropped a whopping 90 percent, but by the end of 2003 it had managed to climb out of its hole, and then some. It had rallied more than 1,200 percent from the bottom of the market.

Its spectacular recovery was the result of a joint, though uncoordinated effort. Hermitage Capital exposed corruption in Russian companies owned by oligarchs who posed, early on, a challenge to Vladimir Putin’s power. Putin was only too happy to use Hermitage’s research to his own ends. His intervention reined in some of the oligarchs and led to increased corporate profits. Putin won, Hermitage won.

In October 2003, however, Putin upped the ante: Mikhail Khodorkovsky, the CEO of Yukos and Russia’s richest man, was arrested. In June of the next year he was sentenced to nine years in prison. His fellow oligarchs got the message. What could they do to avoid ending up in that cage? Browder speculates that Putin’s response was “50 percent.” “Not 50 percent to the government or 50 percent to the presidential administration, but 50 percent to Vladimir Putin. I don’t know this for sure. It could have been 30 percent or 70 percent or some other arrangement. What I do know for sure was that after Khodorkovsky’s conviction, my interests and Putin’s were no longer aligned. He had made the oligarchs his ‘bitches,’ consolidated his power, and, by many estimates, become the richest man in the world.” (p. 164)

Browder, unaware that he and Putin were on a collision course, continued to name and shame Russian oligarchs. “There was a difference this time, though. Now, instead of going after Putin’s enemies, I was going after Putin’s own economic interests.” (p. 165)

This would not do. In 2005 Browder was expelled from Russia, and things would only get worse from there. As Browder’s lawyer Sergei Magnitsky told him, and as his own imprisonment and subsequent murder would make manifest, “Russian stories never have happy endings.” And in Putin’s Russia stories are a pack of lies, justice is a joke, endings are final.

Kogon, Merrill, & Rinne, The 5 Choices

Are you familiar with Stephen R. Covey’s book The 7 Habits of Highly Effective People, which has sold more than 25 million copies since it was published in 1989? And perhaps the sequel, The 8th Habit: From Effectiveness to Greatness? Okay, here’s a bit of corporate history that probably passed you by but that’s nonetheless important to the story: Franklin Quest, the company best known for its planners, bought the Covey Leadership Center in 1997 to form FranklinCovey. FranklinCovey is today a publicly listed (NYSE: FC) global professional services firm and specialty retailer selling training and productivity tools to individuals and organizations. Its clients have included 90% of the Fortune 100 and more than 75% of the Fortune 500. It holds the copyright to this book.

The three authors—Kory Kogon, Adam Merrill, and Leena Rinne—are all affiliated with FranklinCovey. Kogon, the company’s Global Practice Leader for Productivity, has already co-authored two other FranklinCovey books. Advanced praise for the book, blazoned on the cover of the uncorrected proofs, comes from New York Times bestselling author Sean Covey. As you should begin to understand by now, The 5 Choices: The Path to Extraordinary Productivity, published by Simon & Schuster (who also published Stephen Covey’s books), was written in-house as part of the firm’s productivity suite.

So, after all this background, what does the book actually promise? Its claim is straightforward: to achieve extraordinary productivity you need to make the correct five choices in three areas: decision management, attention management, and energy management. When making a decision, act on the important and go for the extraordinary, don’t react to the urgent or settle for the ordinary. With respect to attention, schedule the big rocks, don’t sort gravel, and rule your technology, don’t let it rule you. As for energy, fuel your fire, don’t burn out. The combination of high-value decisions, focused attention, and high energy will yield extraordinary productivity.

If these principles sound familiar, it may be because they “are anchored in the timeless principles of human productivity that we and others have taught at FranklinCovey for over thirty years.” (p. 20)

The authors describe the Time Matrix, which is divided into four quadrants. Q1 is necessity, and includes crises, emergency meetings, last-minute deadlines, pressing problems, and unforeseen events. Q2 is extraordinary productivity, with proactive work, high-impact goals, creative thinking, planning, preventing, relationship building, and learning and renewal. Q3 is distraction: needless interruptions, unnecessary reports, irrelevant meetings, other people’s minor issues, unimportant email, tasks, phone calls, status posts, etc. Q4 is waste: trivial work, avoidance activities, excessive relaxation (television, gaming, Internet), time-wasters, gossip.

If you’re like most people, you’re spending only 60% of your time on important things and 40% on things that aren’t important to you. (Actually, the self-reported 60% figure sounds high to me.) You wouldn’t be satisfied if your car only worked a little more than half the time or if only half of the players on your favorite team showed up for a championship game. So, the authors ask, “why settle for less when it comes to your time?”

To be extraordinarily productive, you not only have to use your time wisely, you have to make wise decisions. And, the authors explain, “high-value decisions don’t come in a predictable order. They are nonlinear opportunities. If we are not aware, we might miss them entirely, or only address them in a rushed, low-quality way. A linear approach in a nonlinear reality is a recipe for failure.”

Consider the gap between the least and most productive performers in low-complexity, medium-complexity, and high-complexity jobs. In the first case (for instance, a worker in a fast-food restaurant) the most productive workers are three times more productive than the least productive; in the second (like a production worker in a high-tech factory), top performers are twelve times more productive. “However,” the authors write, “in high-complexity jobs, where the right decisions make all the difference (like software engineer or an associate in an investment banking firm), the differences between the top and the bottom performers were so profound they were unmeasurable.”

Well, that should make you put down the potato chips, stop mindlessly surfing the web, get up off the sofa, and take notice.